REITs rally on cheap valuations and improved balance sheets

In a down market like today, it’s easy for me to take notice of the one green area of my Bloomberg screen – REITs.

REITs have been reporting second-quarter results, many of which have been weighed down by rising expenses that are a result of landlords putting more money into their properties to maintain occupancy – a natural occurrence when demand is weaker than supply. But, it is the encouraging progress on raising capital and deleveraging balance sheets that is sending REITs higher.

REITs were beaten down worse than other asset classes as the credit crunch made it difficult to refinance coming debt maturities. At their peak, REITs average leverage ratio was over 60%, significantly higher than in the early 1990s when debt accounted for just one-third of REITs’ balance sheets. Such high debt levels were a result of REIT managers assuming that the capital markets would always be welcoming. As a result, REITs piled on what seemed to be cheap debt rather than sell shares to pay for acquisitions.

After their market values got pummeled, many REITs began slashing dividend payments to bolster their capital levels at the beginning of 2009. Investors cheered.

It wasn’t long before REITs tapped equity markets to take advantage of surging prices to raise capital. According to the National Association of Real Estate Investment Trusts, REITs raised roughly $15 billion through common stock offerings during the first half of 2009. Investors cheered.

Even more, REITs have been buying back their public bonds at steep discounts – in essence using $1 to retire $2 of debt. In some cases, cheap buybacks create an arbitrage opportunity if a REIT sells properties at a smaller discount than that in which it is buying back bonds. Investors cheered.

In raising all of this capital, some REITs are preparing themselves for the hundreds of billion in debt coming due in the next few years. Others, however, are preparing to unleash their billion-dollar war chests to fund acquisitions of troubled properties on the cheap. With an estimated $90 billion in commercial real estate in the U.S. alone that is “distressed,” there is no shortage of opportunities.

One particularly big opportunity many REITs are watching closely is the portfolio of General Growth Properties, the real estate giant that filed for Chapter 11 in April, taking more than 160 properties with it, including such trophies as Faneuil Hall Marketplace in Boston and South Street Seaport in New York City.

The point I’m trying to make is that financially strong REITs have offered attractive yields for several months, but now some REITs with stronger balance sheets are looking to move from defense to offense. The risk-adjusted returns these offensive REITs can achieve in this environment has fueled the recent rally.

REITs are lagging most other asset classes year-to-date, and investors still seem to be shying away because of the slowly deteriorating commercial real estate market. However, the massive oversupply that existed during the late 1980s and 1990s in the commercial real estate market does not exist today, suggesting prices could have a decent recovery once demand improves. Of course, this could also be a sign that the worst is yet to come.

Either way, the aftermath of an intense sell-off and massive capital raising has left REITs reasonably priced – which explains the buying fury of the past few weeks – and investors should stop fearing the sector.
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Peter J. Lazaroff, Investment Analyst