Sunday, July 6, 2008
REITs Bruised by Credit Crisis
Real-estate shares registered bigger declines than the broader S&P 500 in the second quarter, weighed down by economic and credit concerns.
The Dow Jones Equity All REIT Total Return index, which tracks 118 equity real-estate investment trusts, declined 4.9% in the second quarter compared with a gain of 1.4% in the first quarter. REITs, which outperformed the Standard & Poor's 500-stock index in the first quarter, lagged behind in the second, with that broader index down 2.7% on a total-return basis. On the other hand, REITs outperformed the Dow Jones Industrial Average's total return, which was down 6.85% in the second quarter.
Analysts say REITs fell victim in the second quarter to broader market concerns, including growing trouble in the financial sector. "People are not expecting the credit market to open anytime soon," said Jeffrey Spector, a REIT analyst with UBS AG, meaning that REITs are facing a longer-than-anticipated drought for new loans and refinancings.
Real estate requires significant capital to build, acquire and maintain property, so the industry is much more dependent on bank lending than are other industries. As a result, when banks pull back on their lending, real-estate companies face a more difficult challenge to expand and deliver returns for investors. "For REITs, [the pullback in lending] stretches their balance sheets, hurts their earnings and negatively affects commercial real-estate values," said Jim Sullivan, an analyst with market-research firm Green Street Advisors.
REITs pool money from multiple investors -- often stockholders -- to use in purchasing, renovating and managing income properties such as malls, office buildings, warehouses and mortgages, among other things. They can forgo paying certain corporate taxes if they distribute most of their earnings to their shareholders.
Concerns about travel and consumer spending also affected REITs. Stocks of hotel REITs, the category with the biggest decline, at 14.9%, sank in response to moves by airlines to cut flights. That is expected to hurt hotels because less travel -- especially a decline in business travel -- reduces demand for hotel rooms. Hotel occupancy declined 2.5% in May from a year earlier, according to Smith Travel Research.
Another big decliner: retail strip-center REITs, which tumbled 10.3%. The sector has been hurt by weaker housing growth and scarce financing. Additionally, a pall on leasing efforts for all classes of retail REITs was cast by the bankruptcy filing of Linens 'n Things Inc., the sudden financial struggles of discounter Steve & Barry's LLC and the pared expansion of other retailers.
Gainers were few. The hottest category, with a 4.6% rise, was a miscellaneous grouping that includes timberland REITs Plum Creek Timber Co. and Rayonier Inc., among others. Next, with a 3.6% gain, were REITs specializing in hybrid office-industrial properties.
The second-quarter performance score card was complicated because both the biggest individual gainer and loser were commercial-mortgage REITs. What separated the two for investors was perceived liquidity. CapitalSource Inc., which reaped a 19.2% gain, added liquidity by purchasing the industrial-bank arm of Fremont General Corp., a mortgage lender. Rates on the bank's cash deposits provide a cheaper financing source for CapitalSource than it previously got from its bank lines.
In contrast, Gramercy Capital Corp., a REIT sponsored by SL Green Realty Corp., saw its stock plummet more than 40% amid investor concerns about its purchase of bank-branch REIT American Financial Realty Trust. Gramercy disclosed in April that its sales of certain AFR branches to defray the cost of the acquisition were behind schedule. Also in the second quarter, Gramercy divulged that three of its borrowers -- a Hawaii golf-course development, a California hotel and a California mall -- had committed what it considers defaults on its loans to them. A Gramercy representative declined to comment.
One trend from the first quarter carried into the second. REITs' shares continued to trade well below the companies' per-share net asset values, indicating that investors suspect property values have further to fall. A REIT's net asset value represents the price the REIT would fetch if it sold all of its assets on a given day.
On average, REIT stocks now are 12% cheaper than the per-share value of the companies' assets, according to Green Street. To be sure, REIT asset values are more challenging to calculate these days given that property-sales volumes are dramatically low. In May, property-sales activity was down 65% to 90% from year-ago levels, according to Real Capital Analytics.
"The public market is saying that the next move for real-estate values is going to be down," Green Street's Mr. Sullivan said. "The private market has a different view [as revealed by prices set in asset sales]. So somebody has to be wrong."
Some investors see a silver lining in Boston Properties Inc.'s May agreement to purchase four Manhattan office towers, including the famed General Motors building, from cash-strapped owner Harry Macklowe for $1.5 billion plus the assumption of $2.5 billion of debt. The deal signals that well-capitalized REITs might soon reap bargains in buying distressed real estate.
Write to Kris Hudson at kris.hudson@wsj.com
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