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WILL CAPITAL KEEP ON FLOWING?

BY DONNA MITCHELL

With the real estate market awash in funds from both old and new capital sources for more than two years now, some may be tempted to ask, “Is this as good as it gets?”

Consider that the publicly traded REIT sector’s market capitalization grew nearly 35 percent in 2003, to $218.6 billion from $162.3 billion. It was a banner year for open-ended real estate mutual funds too. Some $4.1 billion flowed into these funds through November, says Robert Adler, president of AMG Data Services, an Arcata, Calif.-based mutual fund information firm. At the beginning of 2003, real estate mutual fund assets stood at $15.3 billion; by the end of November, that had grown to $25.7 billion, according to AMG.

These robust statistics and other signs of economic recovery were on many minds and tongues at a conference of the National Association of Real Estate Investment Trusts in November.

And things could grow brighter still, some say. For one thing, yield-hungry investors continue to crowd the real estate market. They remain interested in the sector, whose dividend yields have outperformed those of other sectors, even after taxes, says Arthur Oduma, a real estate analyst at Chicago-based research firm Morningstar. According to Standard & Poor’s, REITs yielded 5.88 percent at year-end 2003, compared with 3.51 percent for utilities, its nearest competitor.

Net operating income levels for the retail real estate sector in particular have overwhelmed the other real estate groups over the past year or two, says Michael Kirby, a principal at Green Street Advisors, a Newport Beach, Calif.-based REIT research firm.

Further, American REIT stocks have benefited from British and German tax changes affecting pension funds that invest in U.S. real estate. For investors in those two countries, “it has become an effective tax-planning strategy,” said Oduma.

Investors continue to buy real-estate-secured debt as well. By mid-December the commercial-mortgage-backed securities market had originated about $77.5 billion in deals, of which retail CMBS deals accounted for some 35.5 percent, according to Intex, a Needham, Mass.-based company that provides data for the structured fixed-income finance market. That far outpaces the $53.6 billion issued for all of 2002.

At press time CMBS market participants expected that 2003 would be a record-setting year for issuance; retail real estate played a major role in that.

A year ago few, if any, were predicting that it would work out this way. At the beginning of 2003, the economy was stalled and the job market remained soft. Same-store sales were coming off an uninspiring year: November 2002 comp-store sales dropped for the first time in 30 years, and specialty store sales were flat during the 2002 holiday season, according to ICSC research.

“Everyone assumed retail sales would be awful [heading into 2003],” said Lawrence Brown, president and CEO of Deutsche Bank Mortgage Capital. The resulting drop in occupancy rates would thus pressure landlords to maintain property revenues. Commercial lenders would in turn be more cautious about lending to the group.

Surprisingly, retail real estate occupancy levels were solid, despite slower sales. For the third quarter of 2003, the office sector’s overall vacancy rate was 17.9 percent, according to Property & Portfolio Research, Boston. The vacancy rate for the apartment sector was 7 percent. Neither sector has seen such dismal rates since the early 1990s, says Kelly Whitman, a senior real estate economist at Property & Portfolio Research.

Though the retail vacancy rate was 12.7 percent, many retailers continued to pay rent on empty space. Do you have percentage covering vacant stores on which rent was not being paid?

“There is continued demand for retail paper,” said Brown. “It has earned its stripes.”

That demand is evident in the corporate bond market as well, according to analysts. REITs had issued $10.1 billion of corporate debt by early December 2003, according to the bank’s research. Though that was slightly less than the $10.7 billion for issuance for 2002, investor appetite for REIT corporate debt remains strong, says Thierry Perrin, head of fixed-income research at Credit Suisse First Boston.

But such heady cash flows and other signs of superior performance give some market observers pause about the immediate future for real estate funding.

“We’ve seen funds flow from every source imaginable,” said Theodore Bigman, a Morgan Stanley Investment Management managing director, at the NAREIT conference, but he noted that there are factors ahead that could stem the flow of money into real estate.

One factor, according to analysts, is the inevitable climb of interest rates. When that happens, investments other than real estate will start to look attractive.

Another factor is cyclical sector rotation. After several years of weakness in the apartment and office sectors, investors may be thinking that things have bottomed out, analysts say, especially with the economy firming up.

But Green Street’s Kirby deems such talk premature. Net operating income for the office sector has been disappointing for the past three years, and rent rollbacks in that sector have offset higher occupancy levels.

Besides, cap rates rose during the 1990s, while retail properties delivered investment income of 7 to 8 percent; they have been falling for only the past six or seven quarters, suggesting that they have a ways to come down yet, says Whitman. Those rates rose during the 1990s, despite the fact that they delivered consistent income returns of 7 to 8 percent, she says.

And yes, says Whitman, cap rates have come down on regional malls and grocery-anchored shopping centers. There is still room for cap rate decreases among upscale community and power centers.

So maybe it does get “better than this” after all.

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