A House of Twigs?
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By Barry Vinocur
Real-estate investment trusts have offered investors a haven for much of the past two years. After a lengthy stay in the stock market's doghouse, the Morgan Stanley REIT index broke its lease in 2000, posting a 26.8% total return. This year, too, the sector's benchmark index has outpaced most broad market measures, rising nearly 7% despite some early stumbles. But when Standard & Poor's recently reversed its long-standing ban on the stocks' inclusion in its equity indexes, REITs rightly felt that they'd finally arrived. S&P added Equity Office Properties to its flagship S&P 500 index following the close of trading October 9, while five other REITs were welcomed into the S&P MidCap 400 or the S&P SmallCap 600.
Yet this long-sought seal of approval may be laced with irony, as S&P's warm embrace proves no antidote to investors' cold shoulder. Since midsummer, real-estate fundamentals have been weakening, as Barron's noted in "Realty Check" (July 9). And concerns about REITs, in particular, have only multiplied since the September 11 terrorist attacks. Goldman Sachs cut earnings estimates for six REITs Friday morning.
Table: REIT Round-Up
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In a recent report on real-estate company earnings, the REIT research team at Merrill wrote that 2001 likely would be the weakest year for growth since the early 1990s. "Since real estate is a lagging economic indicator, we are not surprised our FFO [funds from operations] per-share growth rate continues to decline," analyst Steve Sakwa and his colleagues wrote. (Funds from operations, a standard industry measure, are roughly equivalent to earnings.)
"We now expect the REIT sector to post FFO per-share growth of 6.6% this year, which is 120 basis points [1.2 percentage points] below our projected growth rate calculated in early July," Sakwa's report said.
Although REITs are facing their slowest earnings growth in roughly a decade, analysts insist that earnings will climb in both 2001 and 2002. But with REIT shares trading near historic multiples of cash flow -- the stocks now sport an average price-to-cash-flow ratio of around 10 -- Sakwa and his team do not expect any multiple expansion in the next 12 months. "It is quite possible the sector could experience some multiple contraction during 2002," Merrill's report states.
Indeed, shares of apartment REITs already are showing signs of such contraction. For every multifamily REIT such as Houston-based Camden Property Trust, which has confirmed its earnings guidance for this year, there are others that have preannounced shortfalls for 2001, 2002 or both. These include Summit Properties, Mid-America Apartment Communities, Gables Residential, Apartment Investment & Management and Equity Residential Properties Trust.
Morgan Stanley's REIT research team is cautious about multifamily REITs, noting that their so-called defensive characteristics have been anything but that. The stocks were bid up sharply in the past year on the theory that "everyone has to live somewhere," but many have been among the worst performers in the past few weeks in terms of both earnings and shares. Wrote Greg Whyte, the firm's senior REIT analyst, "With our meetings at NAREIT [the National Association of Real Estate Investment Trusts] providing further confirmation of declining foot-traffic levels and occupancies, as well as increasing delinquencies [in rental payments], even the most positive of management teams now seem convinced the weak operating environment will persist well into 2002, and we agree."
Lodging REITs, however, have been hit hardest. The sector's fundamentals were softening before September 11, and have spiraled downward since. At the recent NAREIT convention in Chicago, a number of lodging-REIT CEOs tried to put the best face on what is already the industry's worst downturn since the Gulf War. But investors aren't buying it. "Occupancies have improved since the days immediately following the terrorist attacks, but it's way too soon to be talking about a turnaround," one money manager said. "Our best guess is that it could be two to three years, or longer, before the lodging industry rebounds to levels seen before this year's dramatic slowdown."
One of the biggest issues facing lodging REITs is their ability to continue paying hefty dividends. The stocks, on average, yield about 13.65%. Although a number of lodging REITs have signaled they might be forced to cut or suspend their payouts, none has done so to date. In a recent research note, Jim Sullivan, head of Prudential Securities' REIT research team, noted that he and his colleagues believe some companies are likely to skip their fourth-quarter dividends in order to conserve cash and protect their balance sheets.
Mike Kirby, co-founder and principal of Green Street Advisors, a real-estate research boutique in Newport Beach, California, says REIT dividends generally are "safe," with the notable exception of the lodging sector. Kirby and his colleagues argue that lodging-REIT dividends have to be cut, in light of dramatic declines in occupancy levels, room rates and the sector's earnings, and that delaying the inevitable only creates additional downward pressure on the stocks. "The argument that dividend cuts are already in the stock prices is incorrect," he says. "Lodging prices have fallen because of sharply deteriorating fundamentals. But when the cuts come the stocks will drop further."
Kirby and others argue that most REIT dividends generally are rock solid. Payout ratios, at an average 73.1%, are at their lowest levels since the dawn of the modern REIT era in the early 1990s. Sure, there will be some dividend cuts, not limited to the lodging sector. Crescent Real Estate Equities last week slashed its payout by more than 30%, to $1.50 a share.
But Crescent is the exception, Kirby stresses, noting that just a few REITs are overpaying investors. These funds' payout ratios exceed their adjusted funds from operations (AFFO), or recurring cash flows after deducting normalized capitalized expenditures and backing out "straightlined" rents. (Generally accepted accounting principles require landlords to average a tenant's rent over the life of a lease. Since rents tend to escalate over a lease's lifetime, straightlining leads companies to book higher-than-actual rent in a lease's early years, and lower-than-actual rent in the lease's later years.)
If returns on equity generally decline, perhaps to 8% from a historic 10%-11%, REITs may become more popular with individual investors, notwithstanding the sector's current woes. After all, the ability to book returns of 6%-7% from dividends alone is an increasing rarity in the current market.
A case in point is Chicago-based Equity Office Properties, the largest publicly traded office real-estate company and aforementioned S&P newcomer. Although the company recently lowered its earnings guidance for next year to $3.40-$3.50 a share from $3.57-$3.62, it will still deliver earnings growth in 2002 of more than 8%.
Equity Office recently hiked its dividend more than 11%; last week, the stock was yielding roughly 6.7%. The company owns a high-quality portfolio of office assets nationwide, and its management team, led by Tim Callahan, is considered among the best in the business.
"Will Equity Office raise its dividend by 11% next year? Probably not," Kirby says. But he doesn't rule out a smaller increase. Moreover, Equity Office's dividend is well-covered by the underlying properties' recurring cash flow. Based on next year's estimated AFFO, he adds, the company's payout ratio is a conservative 68.2%.
Put another way, there's approximately $1.47 of cash flow backing every dollar in dividends. Even in an otherwise deteriorating market, that's the sort of ratio likely to calm investors.
Barry Vinocur edits Realty Stock Review and Property magazine in Ocean, New Jersey. E-mail: bvinocur@rainmaker-media.com |
