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No. of Recommendations: 76
Hi, everyone...I regret being so scarce during the past week or so. Too much of earnings season and all sorts of other stuff. I hope you are all well, and taking the REIT slide in stride. Anyway, here's the Essential REIT I somehow got out today, for what it's worth:

Formerly known as
May 10, 2004

“There is nothing more frightful than ignorance in action.” --
Johann Wolfgang von Goethe

“Life is a long lesson in humility” –
James M. Barrie

“A fanatic is one who can't change his mind and won't change the subject”- Winston Churchill

1. Dealing with Pain – and Searching for Perspective.

It may not be very pretty or very pleasant, but at least we Reitsters now know that the Iron Law of Investing – “Reversion to the Mean” – is alive and well. The past four-plus years were glorious (REITs' average annual return from January 2000 through December 2003 was a stunning 26.6%), and that outperformance continued through Q1 of this year (total return from January through March 2004 was 12.1%). Then, we suddenly learned that REIT stocks couldn't walk on water after all. At Friday's close, the Morgan Stanley REIT index was down 6.9% for the year (total return), and the drop from REITs' interday high on April 2 through Friday's close was 17.8% (and this would be worse, of course, on a price-only basis). Equity REITs yielded an average of 4.97% on April 1, according to NAREIT, and yielded 6.05% at Friday's close – that's 108 basis points of pain. Coincidentally (ha, ha!), the yield on the 10-year T-note (as represented by the index symbol ^TNX) has risen, during that time, by 87 bps. Are REITs bonds? No. But, at certain times, when the moon is full, they can walk, swim and quack like a bond.

Personally, I am taking all this in stride. REIT valuations were somewhat uncomfortable on April 1, and we witnessed a fair amount of irrational exuberance in the action of REIT stocks earlier this year; I knew we would eventually have to pay the Piper (whoever he is), but of course I had no idea of when that day of reckoning would arrive. The shares were priced for perfection on April 1, and sustaining those price levels required that we'd see stronger growth in the US economy, but without a concomitant increase in interest rates – but free lunches aren't the norm. In any event, at the risk of boring those of you who follow the REIT industry every day and thus have your own ideas of what's going on, I'd like to speculate a bit.

Me. Over there, sitting under that old oak tree, I see SammyDog, but I'm not sure who that old guy is, sitting right next to him and rubbing Sammy's tummy. Excuse me. Who are you, and who authorized you to befriend Sammy?

Reitnut. They call me Reitnut, and I'm Sammy's foster father. What's it to you? What do you want?

Me. Ah, Mr. Reitnut…I understand that even though you've been studying the REIT industry for almost 30 years, you've made as many bad calls as good ones. Still, you've written a pretty decent book, your track record is reasonably good, and you do, I've heard, expend an unreasonably large amount of your time studying the REIT industry. I recognize that every “guru” is wrong at least as often as he is right, but I still would like to have your take on what's going on in Reitland. Thanks to the swoon in REIT stocks, my net worth has been heading south since April Fool's Day. By the way, is there any significance in that date?

Reitnut. All right, Ferd, sit down here and keep us company. I'll give you my thoughts, for what they might be worth (none of which can be taken to the bank). REIT shares have been pasted badly since April 1 for a number of reasons, some having to do with valuation issues and interest rates, others with fund flows and investor psychology. I'll list them, in no particular order:

a. Valuation Issues. On a valuation basis, REIT stocks were thumbing their noses at the gods. Due to their stunning performance over the past 4+ years, they were trading at 22% NAV premiums (on average) at April 1, and thus were priced on the thesis that interest rates wouldn't move up, but that the prospects for property owners would. Those are dangerous assumptions to make in combination with one another, but REIT investors made 'em. Of the roughly 18% decline from their peak, my guess is that 14% of that can be blamed on a “correction” in valuations, i.e., REIT stocks should trade at an NAV premium of about 7-8%, on average, not 22%. I did not, however, expect that a reversion to the mean would occur within a time period that's shorter than the time it takes to play the first 20-30 games of the baseball season. Everything happens more quickly in today's markets, as stocks and bonds move in warp speed.

b. Exit of the Hot Money. Although valuations don't matter much over short time periods, fund flows do. My guess, based upon trading volumes and price volatility in April, repeated again last Friday, is that a number of momentum investors who bought REIT stocks over the past 18 months saw the jobs report and initial share decline on April 2 as a two-barreled catalyst for a major REIT market reversal, and took little time bailing out. It's impossible to know to what extent REIT shares had been accumulated by hedge funds, momentum boys and carry traders, but Spockian logic would dictate that it was substantial. And when these guys decide to bail, they can move faster than Sammy when he spots a rabbit in “his” backyard.

c. Yield Investors Worry. Part of REITs' increasing popularity in recent years has been the sea change in investors' attitudes towards the dividend. Not many years ago, when tech stocks ruled the world, dividends were considered an annoyance at best, and a hindrance to performance at worst. But times have changed, and dividend yields have become quite important to many investors today – and many of them have been using REITs as bond proxies. The tremendous popularity of REIT preferreds and REIT closed-end mutual funds is a testament to Yield Zeal. Well, bonds, almost by definition, are interest rate sensitive, so when interest rates move up, other high-yielding securities can be very competitive with REIT stocks. Also, some marginal amount of selling might have been caused by newbie REIT investors deciding to sell when they realized that they can lose a couple of years worth of dividends when REIT stocks decline in price (note, however, that the redemption volume from REIT mutual funds hasn't been huge). In any event, REIT stocks must be priced, for yield-oriented investors, so that their dividend returns have to be very competitive with those of bonds; and this, of course, means lower REIT prices when bond yields rise.

d. Cap Rate Fears. Real estate investors know that rising interest rates often put upward pressure on real estate cap rates. While we haven't yet seen this happen in this cycle – and it may never happen – it certainly must be regarded as a risk. This could, of course, negatively impact REITs' estimated net asset values (NAVs) if the higher cap rates that most expect are not offset with greater property net operating income that is factored into NAV calculations. Green Street Advisors recently speculated about this trade-off between prospectively higher cap rates and rising NOIs, and (using Equity Residential as an example) suggested that higher cap rates might not have a significant impact upon REIT NAVs. I have no reason to doubt that analysis, but suspect that some traditional real estate investors and institutional equity investors may have been lightening up on REIT shares due to their fear that NAVs could decline modestly over the next 12 months.

e. Increasing Required Returns. It is important to note that higher interest rates don't affect REIT business prospects or profitability very much; indeed, in many sectors, REITs benefit from the higher interest rates that arrive with stronger business conditions and greater demand for apartment, office and retail space. However, higher levels of interest rates DO impact REIT stock pricing (just as they affect the pricing of ALL equities) because they can change investors' required returns (the more athletic investors call these “hurdle rates”) on their investments. Thus, if investors expect a return on REITs that is 500 basis points over the 10-year T-note, and the yield on the latter rises 100 basis points, then our required returns on REIT stocks may also increase by 100 basis points, all else being equal (which it never is). This is similar to the “Fed Model,” which assumes that warranted P/E ratios for equities rise when interest rates decline, and vice-versa. This seems to be happening today in the broader equities market, as well as in the REIT market. So when interest rates rise, prevailing prices are likely to decline to provide investors with their higher required returns. Therefore, a significant portion of the REIT sell-off can be attributed to the mechanics of adjusting prospective returns to prevailing (and anticipated) levels of interest rates.

Me. Thanks, Reitnut. But now let's look forward, not backward. Is this the beginning of a REIT bear market, such as we suffered through in 1998-1999?

Reitnut. Well, I don't like playing those word games. First of all, the label “bear market” is most often properly applied after the fact; furthermore, bears, while always dangerous, come in different shapes and sizes. Too, the term engenders a hormonal flow equal to that of teen-age boys while watching an R-rated movie, and thus interferes with rational thought. Finally, nobody can predict the future anyway. That said, there are a huge amount of differences between today and 1998 that argue against a long, grinding and dispiriting “bear market.” Here are just some of them:

1998-1999 vs. 2004. Back then, REIT stocks traded at a peak valuation of 33% over NAV. Today, following the Slide from Hell, REIT stocks are already trading at NAV itself – thus there would seem to be less room for prices to fall further (though, of course, there's nothing preventing them from trading at NAV discounts, for some temporary period of time). REITs raised $40 billion in fresh capital in '97-'98, or roughly 31% of total market cap; more recently, the capital raising has been much more modest. Only $14 billion was raised in 2002-2003, slightly below 7% of the 2003 year-end market cap. Notwithstanding a currently-sizeable REIT equity offering calendar (not all of which will get done), these lower equity raises should help to prevent the type of share supply/demand imbalances we suffered through several years ago.

Also, the psychology of yield was different then. High-yielding stocks languished while investors chased tech and Internet stocks; today, dividend yields are still highly regarded, which should attract investors to REIT shares at some point, depending upon the perceived stabilized level of bond yields. There is also a substantial difference in the real estate cycle; in 1998-1999, real estate was peaking with respect to rents and occupancy rates; today, we appear to be coming out of a long and difficult trough. There may also be a very different perception of REIT stocks today. Back then, they were often treated as a small sub-sector of the world of equities, and not an asset class unto itself. Today, REITs are more likely seen as proxies for commercial real estate, and their shares are often treated as a 4th asset class (in addition to stocks, bonds and cash) – and, at the least, an asset class similar to international stocks in their portfolio diversification prowess.

Finally, there has been a major change in the regard given to REIT management teams; REITs have completed a 10-year period in the “Modern Era,” have survived the real estate recession of 2000-2003 in pretty good shape, and have recycled assets, been disciplined with acquisitions and strengthened balance sheets. And their corporate governance is a lot better. These changes in perception are, of course, not likely to impact REIT pricing directly, certainly over the short term. However, they will certainly influence REIT stock price valuations, and will likely cause a large number of value-oriented investors (e.g., Jeremy Grantham) and intelligent financial advisors to step up their REIT allocations when prices slide – which we didn't see 5-6 years ago.

The bottom line, for me, is that we are very unlikely to see REIT stocks trading at the 20% NAV discount that we witnessed at the bear market nadir in late 1999/early 2000 (note that REIT stocks never got as expensive, either, at the peak of the bull market in early April). Sure, momentum alone could take us down another 10% over the next month or two, which would price the average REIT stock at a 10% NAV discount – though my gut tells me that prices won't get that nasty. Somewhere between 2% and 10% NAV discounts, a horde of value investors will step in, both real estate types and eclectic value guys, and staunch the bleeding in the REIT sector.

Me. OK, where exactly are we with respect to REIT stock valuations?

Reitnut. How do you define “valuations?” This is a topic for an entire “Essential REIT,” so I won't spend a lot of time on it here. REIT stocks are now trading, based upon my estimates (which, in turn, are based in large part upon Green Street estimates), at virtually zero NAV premiums. This compares with 22% at the peak on April 1, a 20% discount at the bottom of the last bear market and a 7% average NAV premium during the Modern REIT Era. So, depending upon one's level of cynicism, REIT stocks, from purely an NAV standpoint, are either fairly priced or modestly cheap.

If we look at AFFO yields (the inverse of P/AFFO multiples), REIT stocks are now trading at an AFFO yield of about 6.5%, which is very competitive with the average yield on intermediate grade corporate bonds (this has been the case for much of the past 10 years). So REITs, on that basis, would be reasonably priced vs. bonds. REITs still appear expensive when compared with the earnings yields on S&P 500 stocks; historically, REITs' earnings yield has been, on average, 55% above the earnings yield of the S&P index (in plain English, earnings multiples for non-REIT stocks have historically been much higher than for REITs). Today, multiples are similar, as the average REIT AFFO yield is only modestly above that of the S&P 500 index. However, I think I can develop a pretty good argument for the proposition that, going forward, REITs' AFFO yields should be a lot closer to the earnings yields on S&P 500 stocks.

Me. I suppose investors are focused only on the direction of REIT stock prices these days, and earnings don't matter. However, can you give me a brief recap of the REIT earnings season that just concluded?

Reitnut. Well, I won't pretend to adequately summarize in one paragraph an event that unfolded over a period of four weeks, dripping with hundreds of hours of conference calls and spewing forth thousands of pages of supplemental packages. So, to vastly over-generalize, here are the central points that we've learned from this exercise. First, the retail guys are continuing to kick butt and take names; demand for retail space is very robust, occupancy rates are holding (any losses from post-Christmas bankruptcies are being back-filled), and rental rate spreads on new leases remain healthy. Going forward, everyone worries about the consumer: Will he stop spending for anything other than his high-cost mortgage and more gasoline for his S.U.V.? Well, so far, we haven't seen this happen at the retail stores – sure, it could happen, but we've not seen it yet.

Second, the apartment sector is now bottoming out; occupancy rates have been firming nicely, concessions appear to be declining modestly and the comps are becoming easier. The only issue here is how quickly apartment owners will be able to raise rents enough to offset naggingly persistent expense growth and generate positive NOI and FFO growth; higher interest rates will, clearly, help the apartment owners, and that's been reflected in better relative performance by the apartment REITs.

Industrial and office property owners are reporting more traffic, better absorption and more demand for new space (not just a reshuffling of the deck chairs), as well as some potential built-to-suit development opportunities, but rental rate roll-downs will continue to prevent FFOs from rising much for at least another 18 months (industrial will, obviously, recover faster than office). The best office markets appear to be in New York, DC and Southern California; in industrial, most management teams like Northern New Jersey, D.C. and Southern California. No surprises there. The weakest markets are the usual suspects, e.g., Dallas, the Bay Area, Charlotte, Denver, et al.

Finally, we are hearing from virtually all management teams that investor demand for commercial properties remains very, very strong, with a wide variety of bidders looking at virtually all deals. A month into the beginning of the rise in interest rates, nobody has noticed any softness in deal pricing. Of course, it's still early, and most of us would be surprised if cap rates (to the extent anyone can really figure out what those things are) don't rise – at least a bit. We also need to remember, however, that cap rates never fell as much as interest rates in this cycle, and that many more factors besides the prevailing level of interest rates determine what buyers will be willing to pay for a dollar of free cash flow; a perception of faster growth in NOI can offset quite a bit of adverse interest rate movement. My guess is that cap rates don't move up by more than 25-50 bps over the next 12 months; a move like that isn't going to create lots of buying opportunities for acquisitive REIT organizations, nor much NAV pain for REIT investors. The smartest asset allocation for REITs may be to repurchase their shares, given the NAV discounts at which many of them now trade.

Me. Reitnut, this price drop in REIT shares has been terribly painful to me. Why don't I just sell all my REIT stocks and buy them back when the selling is over and they're ready to rebound?

Reitnut. Why don't you just buy tomorrow's newspaper and bet on today's 7th race at Hollywood Park? It seems so simple, doesn't it? And we all have such short investment time horizons; I suspect that the average investment time horizon today is shorter than Larry Silverstein's neck. But let's get back to basics. Why did you buy your REIT stocks in the first place? If you bought 'em to ride the momentum wave, then you should have sold 'em already – if not, sell 'em now; they're as popular today as Don Rumsfeld at a DNC convention (hmmm…maybe those guys DO like Rumsfeld, given what he's done to his boss).

Why Own REITs? But if you bought REIT shares for investment income, hold on; dividends, for the most part, are pretty safe today, and will get a lot safer with the stronger real estate markets that appear to be evolving. If you bought REITs to diversify your portfolio, hold on; as we sadder but wiser REIT investors know, the desire of REIT stocks is to march to their own drummer, and nothing has changed in this regard. If you bought them as a bond proxy that might also provide a potential long-term hedge against higher inflation, hold on. REIT stocks have merely declined with the rise in interest rates, and their long-term story remains very much intact. When supply and demand for real estate space by tenants reaches equilibrium, landlords will regain pricing power, and be able to offset inflation with higher rental rates.

If you bought REIT stocks as a proxy for commercial real estate, hold on. The prospects for owners of commercial real estate appear to be on the eve of improvement, even in the apartment and office sectors (though the latter won't see any improvement in cash flows for awhile), and REITs, as real estate owners, will continue to participate in the long-term prospects for commercial real estate. Indeed, their size and heft will cause their stocks to perform even more in line with real estate than ever before, as internal growth will dominate and real-world cap rates (and perceptions of same) will influence REIT stock prices. The obvious bottom line: RETAIN your allocations to REIT stocks, and continue to rebalance regularly.

Me. I have several more questions, Reitnut. Should I move more of my REIT holdings from retail to the apartment sector? That's what the sell-siders have suggested that I do. Also, I've heard from the guys at General Growth Properties that REITs should be viewed and valued as active businesses, and that we investors should ignore NAV; is that a good idea? Finally, what should be my proper allocation to REIT stocks? 5%? 10-20%? Or more?

Reitnut. Well, my friend, you are certainly a curious bloke. However, why don't you come back in a few weeks and we'll address them. Right now, Sammy's had enough belly scratching and needs to run after a few tennis balls. Come visit me soon, and we'll continue this dialogue.

Ralph (Block)

Disclosure: I and/or the firm(s) to which I provide services may from time to time have long or short positions in some or all of the stocks (if any) mentioned above. Further, this “newsletter” is not intended as a recommendation for the purchase or sale of any particular security and is not intended to be investment advice – or any other advice for that matter. The statements made in this newsletter are my own personal opinions, and do not represent the views of any other person, real or fictitious, or even the views of Sammy, my Golden Retriever. © 2004 Ralph L. Block
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