Is the REIT run over?
Major economic indicators make clear that after five years of escalating share prices, the outlook for most real estate investment trusts has become a lot more complicated.
Interest rates are headed up, inflation is creeping in, and the much-heralded real estate boom appears to be officially over.
“The last handful of years has been great, wonderful, a terrific environment,” said Craig Schmidt, a Merrill Lynch & Co. REIT analyst. “But it’s unrealistic not to expect a slower rate of growth going forward.”
Indeed, the Morgan Stanley REIT index, which averaged annual gains of more than 22 percent over the last five years, has slipped about 1 percent since the end of July.
REITs typically are holding companies for commercial real estate properties–apartments, offices, malls and strip malls. Because REITs don’t pay taxes at the corporate level, they are required by law to distribute at least 90 percent of their taxable income back to shareholders in the form of a dividend.
Not all REITs are created equal.
Although experts said a few retail REITs remain compelling, including General Growth Properties Inc. and Simon Property Group Inc., those that hold hotels and apartments must grapple with overcapacity, slowing demand and sluggish job growth. Fewer jobs mean fewer people looking to travel or rent an apartment.
Elsewhere, office REITs are shackled by signs of falling rents and higher construction costs because of climbing commodity prices. And mortgage-backed REITs have been hammered for months by fears that home lending ultimately went overboard.
“In the long run, these stocks are driven by underlying fundamentals, but right now real estate has been bid up quite handsomely, and that is the concern,” said David M. Lee, portfolio manager of the T. Rowe Price Real Estate Fund.
But even as earnings for retail REITs are likely to slow in 2006, Schmidt points out that because the demand for retail mall space exceeds supply, the sector’s longer-term prospects are quite good. New mall construction this year, he said, will add less than one-half percent to a base of 12,000 facilities nationwide.
So even as discounters like Wal-Mart Stores Inc. basked in a promotion-filled Thanksgiving weekend, malls, especially higher-end ones, remained reasonably busy. And REITs are the landlords, not the retailers; unless heavy economic woes lead to multiple retail bankruptcies, demand for mall space will remain strong, Lee said.
“Soft consumer spending doesn’t directly impact REITs,” he said. “But fairly or not, even the perception can hurt REIT share prices.”
However, not everyone who follows REITs is particularly concerned with the health and welfare of the average consumer, the engine of the American economy. Matthew Ostrower, REIT analyst at Morgan Stanley, argues that REIT stocks in 2006 will live or die by interest rates. With many REITs offering dividends equal to the 10-year Treasury note, about 4.5 percent, investors looking for a wider spread are more likely to opt for the risk-free government note.
“It’s an oversimplification of the group, but with the spread almost at zero, REITs are no longer as attractive to a sizable group of investors,” Ostrower said.
As for some stock picks, Schmidt likes Regency Centers Corp. and Federal Realty Investment Trust among the strip malls. He and Ostrower place Simon Property Group at the top of the malls. Ostrower credits General Growth Properties for its acquisitions but warns that higher interest rates could put pressure on a leveraged balance sheet.
An intriguing buy is Mills Corp. Pounded last month when it revealed accounting problems, the stock arguably has been oversold, leaving its price-to-earnings ratio lower than its breakup value, Schmidt said. That makes for an unusually attractive buying opportunity, he said.
“For the most part, Mills will have strong earnings going forward but not as good as in the past,” he added.
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Leon Lazaroff is a staff reporter at the baiduhai. E-mail [email protected].