The Modern REIT Odyssey: Act 2

In the 1984 film "2010," the supercomputer Hal 9000 famously declares, "I'm completely operational, and all my circuits are functioning perfectly." As the U.S. REIT industry closes the door on 2009 and heads into 2010 things certainly seem to be fully operational, even if all circuits aren't functioning perfectly just yet.

Regardless, there is an enthusiasm surrounding the industry that is a complete reversal of the mood heading into 2009. There is a sense that one of the toughest years in REIT history is about to be over, and that publicly traded REITs will have come through it in reasonably strong shape.

Nonetheless, 2010 will present some significant hurdles for REITs, namely a tough operating environment and continuing challenges related to strengthening balance sheets, says Jeremy Anagnos, co-chief investment officer of CBRE Investors LLC. Also, some REITs may be able to take advantage of increasing distress and declining valuations in the commercial real estate market by acquiring other REITs or private portfolios.

Tough Operating Environment
Heading into 2010, REITs are dealing with the same difficult operating environment that all commercial property owners are facing. Job losses, coupled with decreased GDP, weak consumer spending, and minimal business and leisure travel, are negatively affecting the commercial real estate market, according to RREEF's most recent U.S. Property Cycle Monitor. The firm expects fundamentals to worsen through 2010 as rent declines reflect diminishing demand.

Even though REIT fundamentals have held up decently this year as the economy struggled, it might take several years to recover from the recession. "REITs can't escape from the deteriorating fundamentals," Anagnos points out, adding that REITs will likely see weakness in their net operating incomes not only in 2010, but also in 2011.

Nearly 7 million jobs have been lost since January 2008, while consumer purchases were down 5.3 percent from August 2008 to August 2009. All this adds up to a difficult environment for commercial property owners across all sectors, even health care, student housing and seniors housing.

RREEF predicts that recovery will come soonest to apartments, which tend to respond most quickly to growing labor markets. Meanwhile, industrial properties are expected to be the next sector to recover, with office and retail properties underperforming through the near-term. Although longer, less volatile lease terms and initial low vacancy allowed retail to outperform the other sectors during the first stage of the downturn, the trend is quickly changing.

Declining NOI means that REIT dividends will still be under pressure, according to Keven Lindemann, director of SNL Financial's real estate group. Throughout 2008 and 2009, most REITs cut their dividends and some issued stock partially in lieu of cash dividends in an effort to preserve capital. Some REITs were forced to suspend their dividends.

"It's rarely viewed as a positive thing when a company cuts its dividend, but there was a fairly broad recognition that these companies needed the cash and by preserving it, they were positioning themselves for the long term," Lindemann says.

Lindemann doubts that REITs will be forced to cut their dividends further, but is skeptical that many will be able to increase their dividends. "The ability to raise the dividend depends on whether properties can generate the appropriate amount of cash flow," he explains. "If fundamentals are still weakening, the ability to generate the cash flow to pay the dividend is impacted, and dividends can't increase."

Ongoing Focus on Balance Sheets
It's not enough that REITs must contend with a difficult operating environment in 2010; they'll also have to deal with capital markets that are still not functioning properly.
When REITs saw their stock values drop significantly earlier this year, their debt-to-equity ratios were pushed out of whack and their balance sheets were weakened. With the credit markets frozen and REITs unable to refinance much of their mortgage debt, it seemed that many REITs were on the verge of financial disaster.

As the capital markets have thawed slowly, REITs have tapped both the equity and unsecured bond markets, and in doing so, they've strengthened their balance sheets and convinced investors that they'll be able to survive the credit crisis and the recession. As of the end of September, U.S. listed REITs had raised nearly $20 billion in equity offerings and issued almost $7 billion of unsecured debt.

But, Anagnos says, the capital markets remain REITs' biggest challenge. "The markets will remain touch and go," he predicts. "There are companies that have not addressed the liabilities on their balance sheets—either partially or fully—and there is pressure on them to continue to resolve that."

In fact, industry experts expect that REITs will continue to tap the capital markets in 2010 because the sector remains levered. Anywhere from $50 billion to $100 billion of new equity needs to be raised to recapitalize the sector, according to Sheila McGrath, an analyst with Keefe, Bruyette & Woods. With sector average debt/EBITDA levels still north of 7x, there is clearly more equity to be raised to bring leverage ratios lower, she notes.

While some REITs will need to issue equity to repair their balance sheets, many REITs have already shored up their balance sheets and will continue to raise equity in 2010 to grow their businesses.

"The market is going to be bisected between the haves and the have-nots, and the gulf is getting bigger day by day," Anagnos says. With their access to the public markets, listed REITs, in general, have a tremendous advantage over private equity firms. "The companies that are appropriately positioning themselves for opportunities in the future will be the ones that have the most interest from investors."

The REIT equity issuances in 2009 were successful and well subscribed because investors saw tremendous value in what they were buying—essentially they were getting quality real estate on the cheap, Anagnos says.

Next year, the REIT sector will continue to see significant investor interest, especially as concerns about inflation become more serious and pervasive. "If you presume that inflation is going to spike over the next three years, REITs are in an enviable position because they are widely considered to be inflation hedges," according to Ettore Santucci, a partner and chair of Goodwin Procter LLP's securities and corporate finance practice, and its REIT practice.

The REIT issuances in 2009 that improved the capital condition of the sector also pushed stock prices up—something that future offerings may not be able to achieve. "As REITs' stock prices improve, future offerings may no longer be such a slam dunk because investors will start to differentiate investments between the companies that have great opportunities to invest the proceeds versus further repair the balance sheet," Anagnos says.

Increased M&A Activity
While investors have rewarded listed REITs, on the whole, for their ability to survive the credit crisis and raise equity, now is the time for companies to start refining their strategic vision, says Cedrik Lachance, a senior analyst with Green Street Advisors.

"This could be a golden era for REIT investing, but to be able to take advantage of it, REIT balance sheets need to be even stronger than they are today," Lachance says, adding that REITs need to focus on tapping the capital markets to make acquisitions.

Today, experts agree that few REITs are in the position to make acquisitions—either through the asset or company route. Not only do their balance sheets still need some bulk, but also there are concerns that property values have not fully corrected.

But, there is little doubt that owners—particularly private owners—and properties across the U.S. will be distressed in the coming months and years, putting REITs in the driver's seat.
"There will be more distress on the private side because those owners don't have access to the public markets," Lachance says. "REITs are more likely to feast on private distress first before they look to other REITs."

However, there might be some opportunities for stronger REITs to acquire weaker REITs that are in trouble because they have either failed to raise equity or have been unable to raise enough to take care of their debt maturities. "It's difficult for smaller public companies to survive in this kind of an environment, and there certainly could be some additional pressures that could lead weaker, smaller REITs to merge with stronger REITs," says Jeffrey Baker, senior managing director of Savills Granite, a New York City-based real estate investment bank and services firm.

Anagnos points to recent M&A activity in the United Kingdom's REIT sector as a possible predictor of U.S. REIT activity. In January 2009, the U.K. REIT sector went through a painful recapitalization period in which new shares were priced at 40 to 80 percent discounts. However, the companies that were able to raise equity are much stronger today, and some have even begun to digest smaller real estate companies that weren't able to issue new stock.

London-based SEGRO PLC (LSE: SGRO), for example, raised equity in March 2009 at one of the most discounted rates. However, the capital positioned the diversified REIT to make a play for Brixton plc, a highly-leveraged REIT that had been unable raise equity to pay off its debt.

SEGRO did a second offering that raised enough equity (roughly £250 million) to finance one-third of the acquisition cost of Brixton, which owned a portfolio of quality industrial assets near London's Heathrow Airport. SEGRO's second offering and acquisition were well received by the market—SEGRO's stock was trading at £3.79 per share in late September, when it issued equity at £2.30 per share.

"The market cheered a REIT that invested the money it raised, and I think that type of activity in the U.S. would be well received by investors," Anagnos says. "Because REITs have access to capital through the public markets, they are very well positioned to act as consolidators over the next two to three years."

Many U.S. REITs also are raising money through joint venture partnerships. In fact, Baker says global institutional investors, private equity firms, and sovereign wealth funds are increasingly interested in coming back into the U.S. real estate market. Multifamily REIT UDR, Inc. (NYSE: UDR), for example, recently announced a $450 million joint venture with Kuwait Finance House, while mall REIT Macerich (NYSE: MAC) raised $116 million by selling off 75 percent of a 1.4-million-square-foot mall in Broomfield, Colo., to London-based GI Partners.

"These transactions will be completed in very select cases where REITs have highly desirable assets," Anagnos says. "For the REIT, it solves part of their capital problem in a way that might be beneficial to investors."

Jennifer D. Duell is a regular contributor to Real Estate Portfolio.

Editor's Note: This article originally appeared in the November/December 2009 edition of Real Estate Portfolio magazine.