Contributed: Where Are We?
It’s been said that before you can figure out where you’re going, you need to know where you are. REIT investors are faced with many challenging issues today. While officially it looks like we have emerged from the worst recession in recent memory, unemployment continues to rise while real estate fundamentals continue to erode.
Financial distress continues to hurt countless owners, large and small. Extend and pretend has been the rallying cry of lenders across the nation faced with rapidly declining property values but properties that often continue to provide adequate cash flow. After a peak to trough decline of more than 70%, REITs have risen in value more than 100% from the lows they set in March of this year. But, even after this strong recovery, REITs remain more than 40% below the peak values set less than 3 years ago.
But where should REITs be valued today? Are they painfully overvalued based upon what will likely be declining fundamentals for the foreseeable future, or are they incredible bargains based upon what should be a once-in-a-lifetime buying opportunity for distressed real estate? The answer lies somewhere between the two extremes.
A recent newspaper headline asked the question, “What Recovery?” That’s a pretty fair question. As GDP turns positive after the longest sustained recession since World War II and some Wall Street firms prepare to pay out record bonuses, unemployment continues to rise, foreclosures continue to run apace and retail sales are still suffering. I think we can all forgive the 10% of our population that remains unemployed for asking “What recovery?”
There have been predictions that we may be experiencing a jobless recovery, but if we aren’t adding jobs, what does that mean for the office space market? Unemployment is rarely a good thing for retail sales either. So, if people aren’t buying as much, what happens to demand for retail space? Let’s not forget industrial space, our consumer-based economy has created an industrial space market that is largely driven by distribution. If people aren’t coming to the stores because they don’t have a job, then the stores don’t need the goods that they would have sold to the consumer who no longer has a job, then the logistics companies that deliver the goods that the stores can no longer sell doesn’t need a place to store the goods that they are no longer selling... well, you get the point, demand for distribution space goes down.
The case for apartments is just as straightforward. So where are real estate fundamentals today? I haven’t spoken to anyone willing to predict when fundamentals will hit bottom. Fundamentals will improve, eventually; but when?
Only 20 years ago, U.S. equity REITs represented a total market capitalization of $6.8 billion. Today that number represents little more than a day’s trading volume. The recognition and popularity of REITs has clearly grown dramatically over the past few decades, but that growth has not come without its pains. Since the start of what is commonly referred to as the modern REIT era in 1991, there have been 225 initial public offerings of REITs in the U.S., raising more than $48 billion of equity. Nearly 2,000 follow-on offerings have added another $194 billion of equity to the sector.
M&A activity over the years has reduced the number of REITs significantly, some returning to private ownership, some being swallowed up by other public REITs. All this activity, however, leaves no doubt that in the course of two decades, REITs have risen from irrelevance to become a major force in commercial real estate globally. The ability of REITs to raise more than $20 billion in public equity offerings this year, despite the economic undercurrents they were facing, provides some evidence that REITs will be able to raise the capital necessary to acquire distressed real estate over the next few years.
The question is what level of distress selling will we see? While there has been significant, and wide-spread distress—both at the property and the sponsor level—the willingness of banks to extend maturing loans, or loans in default of valuation covenants, is delaying what many believe to be the inevitable. The banks are in no hurry to foreclose on properties that may have fallen below loan-to-value limits, but are still generating enough cash flow to cover the mortgage payment. As market fundamentals deteriorate some of these properties will no doubt lose their ability to cover their mortgage payments.
So, when will we see these properties come to market, and how much demand will there be for them when they do? Well, when they do finally come to market; in an environment such as the one we face today, where debt is difficult or expensive to obtain, investors with access to cash (i.e. REITs) will have an advantage. But, if we don’t see the tidal wave of distressed assets that many are expecting, or if those distressed sales are delayed into 2011 or 2012, then the value proposition for REITs may change.
Creation and destruction often go hand in hand, and in the past two years we have seen tremendous economic loss, upheaval, and destruction. But, much like the mythical Phoenix rising from the ashes of its own demise, the economic destruction we have suffered will give way to opportunity and the creation of wealth. Countless industries on a global basis, from automobiles to airlines, banking to computers, will have to rethink their business models. As business models change, so will the way that they use real estate. This will show itself as opportunities in the future. As economic dislocation continues to make itself felt, distressed owners will eventually become distressed sellers. Distressed sellers will provide opportunities for well financed buyers. How widespread will these new opportunities be? Only time will tell. REITs are well positioned today to take advantage of the opportunities that are beginning to reveal themselves, but REITs will not be alone in trying to mine these opportunities. So are REITs overvalued today? That all depends on where you think we are, and where you think we're going.
As we look at the situation we find ourselves in today there is a natural tendency to look for corollaries in history. Many of us, myself included, look to the real estate recession that took root in the 80s and resulted in an explosion of REIT IPOs in the mid-90s. There are many differences between the world we lived in at that time and today. One important difference is that today we have a mature REIT industry. The shift from private to public ownership this time, if it happens, will likely make greater use of existing REITs, rather than a slew of IPOs from troubled entities. There are many players, both public and private, gearing up for what they believe will be a once in a lifetime opportunity to acquire assets at incredible values
One Final Note...
Four short years ago, when I first launched REIT Cafe, you could almost count on one hand the number of people old enough to vote that had heard of a podcast, let alone know what one was. Today, you’d be forgiven for thinking that everyone has an iPhone and that every newspaper, magazine, and radio station is publishing at least one podcast. The idea behind REIT Cafe was a pretty simple one, let investors hear directly from the executives running the companies they are investing in. Over the years REIT Cafe has added more content, but the basic concept remained the same.
As REIT Cafe begins its fifth year of operation, it does so with a few new faces and a few new names, but the same focus of giving investors what they need to make informed decisions. Even though I will no longer be involved in REIT Cafe’s day-to-day operations, I hope the new owners will give me the opportunity from time to time to participate in the discussion that has come to define REIT Cafe.
by Anatole Pevnev, Principal, Townsend Group