Thursday, October 25, 2007

REITs See Biggest Drop Since 1998 as U.S. Rout Grows (Update1)

By Dan Levy and Hui-yong Yu

Oct. 25 (Bloomberg) -- U.S. real estate investment trusts are poised for their biggest decline in almost a decade as higher borrowing costs curb takeovers and reduce property values.

After outperforming the Standard & Poor's 500 Index every year from 2000 to 2006, REIT stocks may drop as much as 20 percent in the next 12 months, according to University of California economist Kenneth Rosen.

``REITs are overvalued by 25 to 40 percent relative to stocks and bonds,'' and cash flow yields are too low, said Rosen, who also runs a $480 million hedge fund from Berkeley, California, that invests in real estate securities.

Property trusts that own office buildings, apartment complexes, hotels and shopping centers are losing value as banks and investors shun bonds and loans backed by subprime and commercial mortgages. That's going to drive down REIT prices, said American Century Investments fund manager Jeffrey Tyler. Morgan Stanley analysts said last month that REIT returns could decline 10 percent.

The Chicago-based National Association of Realtors said yesterday that sales of previously owned U.S. homes fell more than economists forecast in September as higher mortgage rates made it more difficult for potential buyers to get financing. Sales were down 19 percent from September 2006 and the median home price dropped.

Index Slumps

The 128-member Bloomberg REIT Index returned 78 percent with dividends in the two years prior to its Feb. 8 peak, the day before New York-based Blackstone Group LP bought Equity Office Properties Trust for $23 billion, or $39 billion including debt, the real estate industry's biggest leveraged buyout.

Since then, the index has fallen 16.5 percent after dividends as commercial mortgage rates climbed as much as 2 percentage points above the 10-year Treasury note. The last time the REIT index declined more than 10 percent in total return was in 1998 when investors were diverting funds to high-flying Internet stocks.

International Returns

REITs outside the U.S. also declined. The 40-company Tokyo Stock Exchange REIT Index, led by Nippon Building Fund Inc. and Japan Real Estate Investment Corp., is down 28 percent from its high last May. The 14-member Bloomberg Europe Real Estate Index, led by Unibail-Rodamco SA, is down 33 percent from its February peak.

Warehouse and industrial REITs are the only group in the Bloomberg U.S. index that hasn't lost value this year, gaining 11.5 percent as U.S. imports of raw materials and consumer products increased. Public storage REITs dropped the most, down 19 percent. Apartment REITs decreased 13 percent and office stocks declined 12 percent. All returns include dividends.

American Century, the Kansas City, Missouri-based money management firm with about $100 billion of assets, sold about 40 percent of its REIT holdings in May 2006 because prices, driven up by hedge funds and takeovers, ``exceeded the underlying fundamentals,'' Tyler said. Now, with rents flattening and vacancies rising, ``the picture isn't getting better,'' he said.

The U.S. office vacancy rate increased to 9.8 percent at the end of September from 9.7 percent in the second quarter, and rents in Manhattan and San Francisco climbed at the slowest pace in more than a year in the third quarter, according to real estate brokers Cushman & Wakefield Inc. and Studley Inc. in New York and Chicago-based Grubb & Ellis Co.

`More Shakeout'

``There is plenty more shakeout to go in the REIT market,'' Tyler said. ``Property values are going to be under pressure, and by extension that will move to REITs.''

Sam Lieber, who oversees $5.5 billion in real estate stocks as president of Alpine Mutual Funds in Purchase, New York, sold ``lesser-quality'' REITs as prices climbed starting in the fourth quarter of 2006. ``They got very expensive,'' Lieber said, declining to identify specific companies. He expects higher growth from REITs outside the U.S.

``International has greater growth and there have been significant currency benefits as well'' as the dollar weakened against the euro and other currencies this year, Lieber said.

The Alpine Global Premier Properties Fund, with a market value of about $1.6 billion, has about 28 percent of its assets in the U.S., compared with about 40 percent to 45 percent for the majority of similar funds that invest in real estate worldwide, Lieber said.

`Volatile' Prices

Lieber bought shares of Unibail-Rodamco, Europe's largest REIT, after it fell as low as 161.22 euros on Aug. 1, two months after the company was created in June through the merger of France's Unibail Holding SA with Dutch shopping-center owner Rodamco Europe NV. He had previously sold shares of Unibail for a four-fold gain in the run-up prior to the takeover.

``There are still some opportunities here in the U.S. so I wouldn't discount it,'' Lieber said. ``The trick for us is to manage through this difficult period of volatile share prices.'' He recently bought shares of Los Angeles-based Kilroy Realty Corp., an office and industrial REIT, after it fell more than 30 percent from its February high.

Drag on Growth?

Morgan Stanley, the second-biggest U.S. securities firm by market value, told clients on Oct. 18 that weak credit markets and a shutdown of the commercial mortgage-backed bond market may mean ``downside stock price risks'' for REITs and lower property prices.

The New York-based company said in a Sept. 21 report that returns could fall 10 percent in a ``mild recession'' and by as much as 32 percent in ``a low-probability stagflation scenario.''

Economists and Federal Reserve officials are predicting the real estate slump will curb economic growth. Fed Chairman Ben S. Bernanke said last week that housing ``is likely to be a significant drag on growth in the current quarter and through early next year.'' It's ``too early'' to assess whether the drop will slow consumer spending and business investment, Bernanke said.

Wachovia Corp. analysts reduced 2008 earnings estimates for apartment, hotel, retail, office, diversified and specialty REITs in an Oct. 17 report.

``REIT valuations are not factoring in a more significant slowdown of the economy,'' said Christopher Haley, an analyst at Charlotte, North Carolina-based Wachovia, which has an overall investment rating for the industry of ``underweight.''

Decline in Takeovers

Takeovers fell 72 percent in the third quarter from the prior quarter, data compiled by Bloomberg show. While the pace of deals slowed, the value of U.S. REIT acquisitions totaled $59 billion in 2007, up from $7 billion in 2005, according to New York-based industry research firm Real Capital Analytics Inc.

This year's transactions include the buyout of Chicago- based Equity Office; the $22.2 billion purchase of apartment REIT Archstone-Smith Trust of Englewood, Colorado, by Tishman Speyer Properties LP and Lehman Brothers Holdings Inc.; and Morgan Stanley's $6.5 billion takeover of Crescent Real Estate Equities Co., the Fort Worth, Texas-based office, residential and resort REIT.

The REIT market got its start in 1960 when the U.S. Congress created property trusts. That led to a wave of initial public offerings beginning in 1991 with Kimco Realty Corp. of New Hyde Park, New York. Kimco is now the largest U.S. owner of community shopping centers, with a market value of $10.5 billion.

REIT IPOs

More than 200 REITs went public since 1991. Today, their combined market value is about $357 billion, according to the National Association of Real Estate Investment Trusts in Washington.

REITs have attracted investors because they are required to pay out at least 90 percent of their income as dividends, avoiding corporate taxes, and their dividend yields have historically exceeded those of Treasury securities. Assets in real estate mutual funds rose to $82 billion as of Sept. 30 from $12.5 billion a decade ago, accounting for almost 1 percent of mutual fund assets tracked by Chicago-based Morningstar Inc.

Yields Narrow

Almost half of the 128 stocks in the Bloomberg REIT Index yield less than the 10-year Treasury note's 4.34 percent, making them expensive relative to government bonds, according to Bloomberg data. Nine of the 10 largest U.S. REITs by market value have dividend yields of less than 4 percent.

Confidence in REITs will return once banks resume making loans to finance acquisitions, said James Corl, chief investment officer at New York-based Cohen & Steers Inc., which manages more than $25 billion of real estate stocks. That will show investors that properties have retained their values, he said.

``Six months from now, a lot of this stuff will have been flushed out,'' Corl said.

Publicly traded real estate companies that own office assets in markets such as Tokyo, Hong Kong and London offer potentially higher returns than U.S. stocks, said Ted Bigman, a managing director at Morgan Stanley who invests $25 billion in real estate stocks on behalf of pension funds and endowments.

U.S. REITs are trading at a discount to net asset value as investors anticipate declines in property values; historically, these stocks traded at a premium to the value of the underlying real estate, Bigman said.

``Over time, asset values will settle out and the shares are likely to trade at a premium again,'' said Bigman. ``The process of property prices settling out is not likely to happen before the end of 2007.''

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