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ARE REIT STOCKS LOSING THEIR ALLURE?

BY DONNA MITCHELL

REIT stocks have outperformed the U.S. stock market for three consecutive years now, as real estate offers a safer capital haven than equities. But many wonder how long that will continue.

Since 2000, REIT year-end returns have beat the Standard & Poor’s 500 index, according to the National Association of Real Estate Investment Trusts, or NAREIT. For year-end 2000, 2001 and 2002, REITs posted returns of 25.9, 15.5 and 5.2 percent, respectively. The S&P, meanwhile, posted returns of Ð9.1, Ð11.9 and Ð22.1 percent for the same years.

But now the industry shows fundamental signs of weakness, and analysts voice growing suspicions that REIT stock performance is near a peak. If certain circumstances align, they say, a downturn might not be far off.

“There is no doubt that overall REIT returns will go down,” said Arthur Milston, senior vice president of research at Granite Partners, a New York City real estate investment bank. “All of the underlying fundamentals of real estate leasing markets are in decline.”

In particular, vacancy, sales and funds from operations, or FFO, have concerned analysts for more than 18 months. They are all in retreat, leading some to wonder whether stock performance will start to cool this year.

Some of real estate’s strength has come from the weakness of the stock market, but that, too, might be about to change.

“When the equity business recovers and shows some signs of life, I think it will slow down some of the fever, and [other investment] returns will be competitive again,” said Michael A. Torres, CEO of Lend Lease Rosen, Berkeley, Calif., a company that manages a $2 billion REIT fund on behalf of institutional and individual investors.

Some erosion of real estate’s status as a safe investment haven has already taken place, with the undermining of fundamentals in the nonretail sectors. Vacancies in the office sector increased to 16 percent nationwide for the fourth quarter of 2002, compared with 13.7 percent a year earlier, said Tom Dwyer, manager of retail solutions at New York CityÐbased real estate research firm Reis.com. The vacancy rate for apartments was more than 6 percent in the fourth quarter. Landlords in some markets are making lease concessions to coax tenants into their units, and there is some risk that rents will begin to fall in the next 12 months, said Anthony J. Pierson, a managing director at Hartford, Conn.Ðbased fund manager TimesSquare Real Estate Investors, at a Mortgage Bankers Association of America conference in San Diego in February.

Growth in net operating income, or NOI, for the third quarter of 2002, the most recent numbers available, had been negative for apartment, office and industrial REITs. They posted negative NOI growth of 6.1 percent, 2.4 percent and 1.2 percent, respectively, said Jay Habermann, a REIT analyst for Credit Suisse First Boston, New York City. As for FFO, Boston-based equity and fixed-income research firm Thomson First Call predicted at press time a 1 percent drop for all REITs by the end of 2003 over 2002. In 2001 and 2002 FFO growth was 1 percent, according to Thomson, which pools analysts’ opinions to form a consensus.

Retail REITs have eluded all this so far. They posted same-center NOI growth of 2 percent for the third quarter of 2002 — the latest available date at press time — while comp-store sales growth was down 1 percent, said Habermann. As of that quarter, the latest data available at press time, malls had an average occupancy of 90.9 percent, up from 89.9 percent in the year-earlier quarter.

Community and neighborhood centers have held up well, too, despite the Ames Discount Stores and Kmart Corp. bankruptcies last year. Occupancy slipped a few notches to 91.8 percent from 92.1 percent, but NOI for those properties grew 1 percent, he said.

Still, retail’s position is precarious, some note, because the industry has failed to produce enough sales to sustain successful numbers. According to ICSC’s monthly mall merchandise index, sales per square foot for nonanchor mall tenants were flat at 0.1 percent in December 2002, on a year-over-year basis.

Neighborhood and community centers account for more than 70 percent of all retail space and more than 90 percent of all centers, said Dwyer. And they have two thorns in the side: a possible Kmart liquidation and Wal-Mart’s dominance in food sales. These centers will take about 18 months to work through the Kmart bankruptcy, while balancing the risk of its total liquidation, said Habermann.

“One more large bankruptcy like that could hurt the sector,” he said. Analysts estimate that if Kmart goes out of business, about 150 million square feet of retail space will be dumped back onto the retail real estate market.

Second, Wal-Mart continues to take market share from traditional grocers, the other major anchor of neighborhood and community centers.

“Our sense is the stocks have done extraordinarily well,” said David Shulman, a REIT analyst at Lehman Bros. “They are expensive and do not reflect the fundamental risk posed by Wal-Mart.”

But what about that low vacancy rate? That may be for the wrong reasons, said Dwyer. Retailers are signing leases and adding store units despite lackluster sales. They open more stores to battle each other for a larger share of the consumer dollar, he explains. That tactic will decrease vacancies in the short term, but might spell disaster in the long run.

Based on completion dates for projects now under way, about 30.4 million square feet of new retail space should arrive on the market in 2003, surpassing the annual average amount of new retail space of 25.1 million, according to Reis.com.

“We just don’t believe the market can take all that in,” Dwyer said. “Sales will not be able to sustain the number of stores opening up.”

But despite these challenges, some say the REIT industry is not overpriced. The industry currently gives investors an initial yield of 9 percent, which is favorable, compared with lower cap rates in the private market that hover at about 8 to 9 percent.

Underscoring that, Merrill Lynch noted in a December report that the REIT sector is trading at 96 percent of its net asset value, slightly below its long-term average of 100 percent.

Most agree that real estate runs the risk of losing investors to other equities if the overall U.S. economy improves. Institutional investors, who are dedicated long-term holders, own about 50 percent of REIT stocks, said Habermann. The other portion may be short-term investors. There is the risk that some capital will leave real estate once these stocks lose their competitiveness, he acknowledged.

“Are we at a peak this moment in time? I don’t know,” said Lend Lease Rosen’s Torres. “However, I do think expectations for returns have tempered.”

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