Real Estate Investment Trusts (REIT)

Equity REITs rebounded nicely in the 2nd quarter, when equity REITs posted total returns of 29% (total return FTSE NAREIT Index), vs. a 15% gain for the S&P and an 11% gain for the Dow. So far in July, REITs are down about 8%; the worst performing sectors in July have been Regional Malls (-10.9%), Industrial (-9.8%), office/industrial (-9.6%) and apartments (-9.7%). Overall, REITs are still down 19% YTD in 2009 and 43% over the past year.

OPPORTUNITIES

Many REITs are still trading at discounts to NAV (net asset value), a good buy signal. Historically, over the past seven or so years, REITs have traded near or in excess of NAV.

Even with dividend cuts and share price gains, the average yield for equity REITs is still near 6%. Yields are well in excess (280 bps) of the 10-year Treasury, although the spread has narrowed considerably over the past quarter.

Most companies have been shoring up balance sheets by raising cash through equity and asset sales, with the proceeds being used to pay down debt.

• The credit freeze will have a positive effect on commercial real estate down the road; new office, apartment and retail construction has slowed considerably which will benefit owners in a couple of years. Many companies that we cover have ceased all new construction.

In this environment, we like well-capitalized companies that have adequate liquidity to fund maturing debt at least through 2010. One name we still have a Buy on is Avalon Bay Communities, Inc. (AVB - Analyst Report), an apartment REIT with low debt and assets in infill markets where little new supply will be coming on board. Fannie Mae (FNM - Snapshot Report) and Freddie Mac (FRE - Analyst Report) are still heavy lenders for apartments, which gives buyers and sellers access to capital; as such, transaction volumes in multifamily are not as depressed as other sectors.

In addition, we like Vornado Realty Trust (VNO - Analyst Report), another company with low comparative debt, lots of cash and class-A office assets in some good long-term, heavily supply-constrained areas.

WEAKNESSES

REITs still depend on access to capital to fund growth, and with the credit markets still tight, it is difficult to raise money for new developments/acquisitions.

• Going forward, many REITs will raise capital through property level debt, dividend reductions, and equity offerings. Property level debt is harder to obtain and more expensive as commercial real estate prices continue to plummet. Many companies are writing down the value of assets. Share offerings are generally dilutive at low prices, which will depress near-term earnings.
• Dividend cuts make the sector less attractive to income-oriented investors. Many REITs cut their dividends in 2009, and the pain is not over. We expect more cuts as 2009 progresses.

A few companies are now paying a large portion of their dividends in new shares, which we view as a negative. This could become more common over the next few quarters if fundamentals decline and bank lending does not increase.

REITs will be dependent on asset sales to raise cash. Overall commercial sales volumes have decreased dramatically this year. There is still a large bid-ask spread between sellers and buyers and sales will be low throughout 2009.

Expect share prices to be volatile over the next two quarters. Job growth and consumer spending patterns have been dismal so far this year, and there is no evidence that either are improving. Declining fundamentals will continue to weigh on the sector. Specifically, we are negative on suburban office and industrial going forward. Suburban office and industrial vacancies are ticking up at a rapid pace, and absent job growth, filling space will be difficult.

We still have sell ratings on Liberty Properties Trust (LRY - Analyst Report), a suburban office/industrial REIT and Post Properties (PPS - Snapshot Report), an apartment REIT. While both companies have addressed balance sheet concerns, operationally, we think they will lag peers throughout 2009.