Commercial Property: The Other Shoe

AMERICANS IN THE PAST TWO YEARS have been closely watching residential real estate, as TV commentators breathlessly relate each downward tick in home prices and upward move in foreclosures. But all the while, another important part of the real-estate market has been quietly cratering, all but ignored by the general press. Since peaking in early 2007, the value of the nation's commercial property has fallen an estimated 30% to 40%.

You can get a good idea of the pain being suffered by looking at an index of real-estate investment trusts, the publicly traded entities that investors use to play the commercial real-estate sector. The MSCI REIT Index fell 77% from a high of 1233 in February 2007 to the low of 287 hit in March. Since then, it has rebounded 45%, to 420, as investors seek opportunities and the economy seems to be improving.

But the commercial-property sector remains fraught with peril. Some REITs will be strong enough to snap up buildings at bargain prices, while other REITs may go bust or need to raise gobs of new equity to bolster their debt-heavy balance sheets. The commercial real-estate problem has become a focus of federal regulators in recent weeks as they stress-tested the 19 largest U.S. banks to see where losses could pop up if the economy, rather than recovering, worsens.

Why has the value of REITs tumbled an average of 65%, while the value of their properties has slid more like 35%? REITs tend to rely on borrowed money. That boosted profits in the good times, from 2002 to 2007, but has magnified problems ever since.

Optimism about REITs has increased lately, in part because the economy might be bottoming and because $7 billion of common equity has been raised this year by more than a dozen realty companies, including leaders such as Simon Property Group (SPG), a big mall operator, and Vornado Realty Trust (VNO), a major New York office-building owner. This signals that much of the industry can pare its debt, but sometimes at the cost of significant dilution to existing shareholders.

"The REIT rally has more to do with excitement over the equity sales and the move to stocks than any sudden turn in the fundamentals," says Alexander Goldfarb, a REIT analyst at Sandler O'Neill. It is expected that industry net operating income, a key financial measure for the realty trusts, will be down in the low-to-mid single digits for 2009 and 2010, thanks to declining rents for office buildings, apartments and shopping malls.

Other major challenges lie ahead. Goldfarb expects what he calls the "re-equitization" of REITs to continue, with potentially tens of billions of dollars of capital left to be raised. There is pressure to build equity because REITs took on excessive debt during the 2005-2007 property boom. The total value of the country's more than 100 property-owning trusts has shrunk to $160 billion from a high of $400 billion, while debt stands at about $260 billion. The average leverage ratio among REITs is 60%, meaning debt accounts for 60% of their total equity and debt.

IN THE EARLY 1990S, DEBT ACCOUNTED for just a third of REIT's balance sheets. Like many executives in other industries during the boom years, some real-estate investment trust managers thought the good times would linger and that the capital markets would always be welcoming. Rather than sell shares to pay for acquisitions, they piled on what seemed to be cheap debt. Now, they are issuing stock at a fraction of the price they could have gotten two years ago.

"How many times do real-estate guys have to learn the lesson that leverage can burn you?" asks Mike Kirby, director of research at Green Street Advisors in Newport Beach, Calif. "It happened in 1990 and 1991, and it is happening again now. The industry is going to pay a dear price to re-equitize its balance sheet."

Kirby adds that REIT executives -- many of them aggressive types who turned family businesses into big public companies -- must change their mindsets. "Real-estate guys can't help themselves. Instead of asking, 'How much debt should I have,' they ask, 'How much debt can I get?' " Kirby argues that the trusts need little or no debt.

A good chunk of REITs' debt is maturing during the next few years. It may be tough to refinance all of it, owing to lower property values and the cost of new borrowing, which is apt to be higher than the 5% to 6% annual rates of the boom years. Traditional lenders such as life insurers want 7.5% to 8% for secured loans. Unsecured debt can cost 9% or more -- if it is available.

Investors in the volatile REIT sector should stick with the biggest, best-capitalized outfits, including Simon and Vornado; Taubman Properties (TCO), which runs upscale malls; Boston Properties (BXP), an owner of prime office buildings in New York and Washington; Public Storage (PSA), the top owner of self-storage facilities, and AvalonBay Communities (AVB), a high-end apartment owner.

They all have good balance sheets and can either raise equity to trim debt or don't need to do so. The average REIT dividend yield is about 7%, although some companies, such as Simon and Vornado, are paying most of their dividends in stock, which is of little benefit to investors who own realty-trust shares for reliable cash payouts.

Kirby considers the sector "fairly priced" after the gains since March and says "the one defining feature of REIT performance is that companies with less leverage have dramatically outperformed the ones with high leverage." He points to the strong standing of Public Storage, which has the industry's second-highest market value at $11 billion, after Simon's $13 billion. Public Storage has almost no debt; preferred stock accounts for about 25% of its capitalization. It is REITland's closest thing to a Berkshire Hathaway.

There are a bunch of REIT funds, including Vanguard REIT Index (VGSIX). Then there are exchange-traded funds, including iShares DJ U.S. Real Estate (IYR), which yields 7%. Investors also can play preferred shares issued by Public Storage and other realty trusts that yield 8% to 11%. The REIT-preferred market, totaling about $10 billion, is much smaller than the bank-preferred sector, making it better suited to individuals than institutional buyers.

There also are REIT-oriented closed-end funds, including Cohen & Steers REIT & Preferred Income (RNP), which trades near $6, a 15% discount to its net asset value. It yields 15%-plus, thanks in part to leverage. The market also features unsecured corporate debt, issued by REITs such as Simon, Vornado and Equity Residential (EQR), that often yields 9% or more.

Real-estate pros focus on a financial measure called the capitalization, or cap, rate -- calculated by dividing annual net operating income by total equity and debt. For REITs, this rate currently averages about 9%. Cap rates hit a low of 5% to 6% in 2007, with some deals, like Tishman Speyer's $22 billion leveraged buyout that year of high-end apartment REIT Archstone-Smith, done at a 4% cap rate. The cap rate is like a bond yield. The higher it is, the better the return to the investor.

In August 2005, Barron's warned the REIT market looked rich ("Pop! The Other Real-Estate Bubble"). We were 18 months early. The MSCI REIT index rose another 50% to the 2007 high. But the index is more than 40% below where it was in August 2005.

The vicious REIT selloff over the past 1½ years has brought belated vindication to former bear David Shulman, a REIT analyst at Lehman Brothers from 2000 to 2005. After his departure from the investment house, Shulman was mocked by Steve Roth, Vornado's longtime CEO, for having "a three-year sell on Vornado with a $43 average target" at a time when the stock was in the 80s. Vornado peaked at $133 in 2007, but plunged as low as $29 in March and now is in the high 40s. It recently sold $741 million of common stock at $43, Shulman's old price target. Roth hasn't apologized in print.

"REITs are a lot more attractive now than they were at the highs in 2007," Shulman said last week from his New Jersey home. "But compared with the rest of the stock market, they don't look so cheap." He notes that most real-estate investment trusts change hands at 10 to 16 times pretax cash flow, while a quality stock such as Johnson & Johnson, which has a triple-A credit rating, fetches 12 times after-tax earnings and seven times pretax cash flow.

In addition, the debt of major REITs often is equal to eight to 10 times annual cash flow, way above the three-to-one ratio most investment-grade companies in other industries strive to maintain.

Shulman, who is now an academic, says one of the big issues for Vornado is the future of Wall Street, because Vornado gets 30% of its operating income from Manhattan office buildings. Prime midtown Manhattan rents, which topped $100 per square foot in 2007 and early 2008, are in the $70 to $75 range now, according to the real-estate advisory firm Newmark Knight Frank. The Midtown vacancy rate hit 14.2% in the first quarter, the highest in 15 years.