REITs’ Days Darkened in ‘98, but Some See a Bright Side

For real estate investment trusts, 1998 was humbling.

REITs began the year as the darlings of the real estate world and favorites in the stock market, buying what seemed like every property in sight while enjoying an unlimited flow of capital from Wall Street. By the end of the year, REITs had nearly disappeared from the acquisition arena as investors backed away from their stocks and Wall Street shut off the easy capital that had flowed to many REITs through initial and secondary public stock offerings.

Predicting what REITs are likely to do in 1999 and beyond requires an understanding of what happened in 1998, according to Jim Sullivan, a senior analyst with Green Street Advisors in Newport Beach.

“In 1998 REITs hit a big bump in the road,” Sullivan said.

A key factor against REITs was the decline in returns they could expect from the buildings they bought.

“A couple of years ago, REITs could still buy properties at substantial discounts to their replacement costs, so they could expect outsized returns from their acquisitions,” Sullivan said. “Today they can’t get those returns just from buying a building.”

Replacement costs, or construction costs, are an important barometer in estimating the returns a property is likely to deliver. In general, if the price paid for a commercial property is less than the cost of building a new one, it means the buyer stands a better chance of making a profit on the rent stream generated by the building.

Up until about the end of 1997, Sullivan explained, REITs were able to buy properties at bargain rates because real estate values had been driven down during the recession. But as prices climbed throughout the end of 1997 and the first part of this year--largely because of the acquisition frenzy fueled by REITs--the REITs’ acquisitions produced steadily declining returns.

The diminishing returns were reflected in REIT stock prices.

“At the beginning of this year, REIT stocks were trading at a 22% premium to their net asset value [the value of the REITs’ underlying assets],” Sullivan said. “Today, the average REIT is trading at a price approximately equal to its net asset value. This means investors today are not willing to pay the big premiums they were willing to pay previously.” According to this formula, he said, REIT stocks peaked in October 1997, when they were trading at 30% above their net asset value.

One of the peculiarities of this decline in REIT prices is that it doesn’t signal a decline in the commercial real estate markets, said Kenneth B. Roath, chairman and chief executive of Newport Beach-based Health Care Property Investors and past chairman of the National Assn. of Real Estate Investment Trusts.

“The fundamentals are still there,” Roath said. But he pointed out that REIT stocks, even if they’re performing well, can pale in comparison to highflying Internet issues.

“How does an investor look favorably on something as mundane as the health-care REIT segment, which historically does quite well in producing 12% to 14% annual returns, when you have a superheated stock market where tech stocks are producing bigger returns than that every quarter?” Roath asked.

But Roath and others believe the REITs’ fall from favor may bode well for a business historically prone to economic peaks and valleys.

“Investors’ lack of interest in REIT stocks has caused a shortage of capital in the real estate industry that has slowed down what was a very hot market,” Roath said.

Eric Lohmeier, an analyst with Everen Securities in Chicago, said the capital crunch put the brakes on both acquisitions and construction.

“The good part of this is that it has really staunched development. We believe the capital shortage will prevent overdevelopment,” Lohmeier said. In the lodging industry, Lohmeier pointed out, 1997 was “a huge development year”; the industry seemed headed for overdevelopment in 1998 and 1999 until the capital shortage forced builders to slow down.

Howard Sadowsky, an executive vice president with commercial brokerage Julien J. Studley in West Los Angeles, said the capital crunch “has created a more honest market in terms of prices” for commercial properties.

“The market was beginning to get into a frenzy in the first two quarters of this year,” Sadowsky said. “Bidding wars were erupting and prices were beginning to surpass the replacement values of the buildings. It was starting to look like 1989 or 1990, with property prices based on the future, not on today’s reality, and there’s no way that you can continue to pay for properties on that type of future basis.”

According to analyst Sullivan, Wall Street demonstrated the “greater discipline” that many real estate experts had counted on to prevent a repetition of the overdevelopment and sky-high prices of the late 1980s that preceded the crash of the early 1990s.

“Wall Street tends to be perhaps much more forward-looking than the traditional sources of real estate capital, such as banks and pension funds and insurance companies,” Sullivan said.

Analyst Lohmeier believes REITs will remain out of the acquisition market for 12 to 18 months, with a few exceptions, after which they will begin buying again--but not at the breakneck pace of past years.

“In at least two-thirds of the cases, the REITs have some plans for more acquisitions at some time in the future, but not at all in the immediate future. The assets have to get cheaper before that can happen,” Lohmeier said.

For assets to get cheaper, sellers must accept lower prices, analysts say.

“We’re still in a period of adjustment, where sellers have to realize that buyers’ cost of money has gone up, so they can’t pay as much for properties,” Roath said. He described 1999 as a “wait-and-see” year for Health Care Property Investors in terms of acquisitions.

“We still have fairly good financial resources to continue acquiring properties. However, we don’t have that indefinitely. I think the entire real estate industry is hoping for some easing of the credit markets after the first of the year,” Roath said.

REITs that don’t buy new properties still have the potential to grow internally during 1999 by raising rents and managing their properties more profitably, according to Roath.

“Whether they can grow internally is a case-by-case question,” he said. “If they bought their properties at the right prices, they still have the potential to raise rents because the economy is still going quite well.”

Analyst Sullivan foresees 1999 as a year in which Wall Street will begin to distinguish between the better-performing and poorer-performing REITs. Differences in management teams will become more critical.

“When any REIT could go out and buy any property and have it appreciate in value almost automatically, every company looked great,” Sullivan said. “We’re in a different part of the cycle now, and it’s going to be the better and smarter REITs with better management teams that will shine.”