PRINT THIS STORY:

CHANGE TEXT SIZE:

Could a downturn have upside for REITs?

By Kevin Kenyon

"REITs will be in a position, as prices decrease, to pick up properties."

-- William G. Cornely, COO, Glimcher Realty Trust

With some industry observers predicting that a downturn in the real estate cycle could occur anywhere from 12 to 18 months from now, speculation has already begun as to how things will be different "this time."

For instance, although conventional wisdom suggests a downturn would spell trouble for nearly all segments of the retail industry, some believe real estate investment trusts (REITs) could actually benefit.

Others say a downturn could put more pressure on private developers, forcing some to sell off assets to well-capitalized REITs.

While REITs have generally fared well since 1993, when the current real estate cycle began, they have done so in an extremely positive environment. By emerging at the bottom of the last cycle, experts say, REITs with strong balance sheets were able to buy assets fairly cheaply and then benefit as those assets recovered.

Now, with some predicting that the industry is getting closer to the peak of the current cycle, questions abound about what the future holds: How will REITs fare in an environment that is less than ideal? Will the presence of well-managed REITs prevent the wholesale fallout that occurred in the late '80s and early '90s? What effect would a downturn have on the current trend of consolidation? And how would it affect private companies?

REITs could very well be the beneficiaries, rather than the victims, of the real estate cycle, according to James Sullivan, managing director, senior real estate analyst for New York-based Prudential Securities.

A downturn could accelerate the current consolidation trend by allowing REITs to acquire assets at very attractive cap rates, said Mr. Sullivan, who shared his thoughts in Prudential's recently released annual forecast, "Future Shocks 1998."

"We've seen a great deal of transactions by REITs already, and I think if we were to have a downturn in the market, my guess is that you would see a quick spurt in acquisition activity," he said. "I also believe that REITs would be ideally positioned to take advantage of that part of the cycle."

With thoughts of what happened in the late '80s still fresh in the minds of many private developers, Mr. Sullivan said a quick pullback on the lending front would force some to seriously consider making deals with REITs.

"The alternative might be to be totally cut off from funding and lose all their equity -- which of course happened back in the '80s -- and people are going to want to avoid that," he said.

The existence of hungry REITs may turn out to be a blessing for private developers, he added, considering that they didn't have a REIT universe of substantial size to turn to when things went south last time.

"The presence of such a large number of fairly well-capitalized REITs with diverse portfolios will be a very compelling attraction to them [private developers], and it would be a way for them to hold on to some portion of their equity value," he explained.

Many REITs also have the advantage of turning to lower cost financing, which will allow them to benefit simply by re-financing privately owned real estate, he added.

Mr. Sullivan said he doesn't foresee the wholesale fallout that occurred in the late '80s, because today's well-managed REITs can now access a variety of different capital sources, and almost half have investment grade ratings -- a "positive strength in a recessionary environment."

He said he also expects that any downturn this time around would be much shorter in duration -- another benefit for REITs.

"The imbalance of supply and demand is not likely to be as severe, thus the pressure on internal growth rates could be less than some people might expect," he explained.

Perry Gruber, vice president, director of investor relations for Developers Diversified Realty Corp., a Cleveland-based REIT, agreed that REITs might have some competitive advantages in the event of a downturn.

"Most REITs will be, from a financial standpoint, in a far better position at the trough of the cycle," he said. "They'll have more flexibility because they'll still be able to efficiently access capital, which will allow them to take advantage of opportunities," he said.

The acquisition environment would also improve, considering the fact that today's narrow margins make it difficult to acquire properties accretively, a situation that would change during a downturn -- when the spread between the multiples of better and poorer-faring centers increases, he added.

That said, Mr. Gruber noted he doesn't expect REITs to start "blindly" acquiring other companies just for the sake of it.

"In my opinion, a downturn in the cycle won't cause wholesale consolidation, unless there's a good fit between portfolios and operating standards between the companies," he explained. "The best-managed companies are still going to make sound and disciplined judgments about how portfolios fit -- even if there might be a short-term economic benefit."

William G. Cornely, COO of Glimcher Realty Trust, a Columbus, Ohio-based REIT, concurred that REITs could thrive in a recessionary environment.

"Being a public company may provide a competitive advantage over a non-public company from a cost of capital and access to capital standpoint," he explained. "Consequently, I think REITs will be in a position, as prices decrease, to step in and pick up properties."

And while Mr. Cornely also believes that a downturn would spur further consolidation, he predicts that the majority will occur on the upswing of the cycle, not on the way down.

"I'm not so sure how much access to capital REITs will have, either," he said. "I think what you may see is that consolidation will be more likely to occur in the early stages of the uptick much like we've seen the last three to four years."

Echoing thoughts expressed by Prudential's Mr. Sullivan, Mr. Cornell agreed that any downturn would probably not be as severe this time around. "I think it will neither be as deep nor as long, only because I think the brakes will come on a little sooner with all the public companies," he said.

Expressing a very different outlook, however, Damian Zamias, president of Zamias Services, a Johnstown, Pa.-based private mall developer, predicted that private firms would be no worse off than REITs in the event of a downturn.

"Provided that a privately held company has a solid balance sheet, it would really be in the very same position and perhaps a better position when the economy turns the other way," he said.

Private firms, he explained, don't have to report to Wall Street every quarter, and can make long-term decisions without worrying about their stock crashing.

"In theory at least, most privately held companies have an intermediate to long-term view, and that's just not how REITs are structured -- they get crucified if they miss a projection," Mr. Zamias said.

Aligned with the proper capital sources, private firms will also have opportunities for acquisitions, he said.

And don't forget, he added, that all real estate is inherently local, and companies that actively manage their assets "will do just fine."

Private firms of size may also be in a good position to hold mini-auctions to growth-minded REITs, he explained.

"The fact that there are a number of REITs that have an appetite to acquire is not a bad thing for private developers," Mr. Zamias said.

Another thing to keep an eye on in the event of a downturn, is the premium -- anywhere from 15% to 20% -- that the market is currently giving to REITs over net asset value (NAV), he said. "The next time we have a downturn, it will be interesting to see just what happens to that premium."

Perhaps most important of all, according to Mr. Zamias, is the fact that about 80%-85% of all capital invested in commercial real estate is still private capital, not public.

Michael Pappagallo, CFO for Kimco Realty Corp., a New Hyde Park, N.Y.-based REIT, said that while REITs may benefit in some respects in a downturn, they, like everyone else, will eventually suffer.

"People in the industry always debate whether it will be different 'the next time,' but I don't think anyone is insulated from the effects of a downturn, including REITs," he explained.

"The issue with a REIT is that it continually needs to find new ways to grow and go to the markets for capital, and in the event capital begins to dry up, just like anyone else REITs will have a more difficult time," Mr. Pappagallo said.

Consequently, he added, there may even be some shakeout within the REIT universe, as weaker REITs who may have overpaid for assets start to struggle.

Realizing that capital may not be as abundant as it is today, Mr. Pappagallo said Kimco's

strategy involves focusing on internal growth and finding miss-priced assets.

"Whether we're insulated completely, who knows, but we stick with our strategy of a longer term view, so over the long haul we'll be able to withstand the ebbs and flows of the market."

So while predictions may vary as to what will happen down the line, the fact remains that today's operating environment is still one of the healthiest the industry has ever experienced, and no one is in a hurry just yet to discover what the future holds.

As the old saying goes, "only time will tell," and developers of all kinds do agree about one thing -- that time can wait.

"This is the best economy I've seen in my 22 years in the business," Mr. Zamias said. "Let's hope it has legs."