The bear market has produced a two-year bull market for real estate investment trusts (REITs). That makes sense, given the non-correlation between real estate and equities. Although it's too early to call a solid bottom to the stock market, real estate experts and analysts generally agree that in the near term REIT shares are going to be fighting headwinds due to deteriorating real estate fundamentals and waning investor enthusiasm.

Equity REIT share prices, which rose 16.51% in 2000 and 5.85% in 2001, have headed in the other direction this year. Through Oct. 10, equity REIT share prices posted a return of negative 9.21%, according to the National Association of Real Estate Investment Trusts (NAREIT).

The sharp drop in total returns — which includes stock appreciation/depreciation plus reinvested dividends — is even more striking. In 2000, total returns for REIT stocks registered 26.37%, reports NAREIT. In 2001, that figure was still a hefty 13.93%. But through Oct. 10 of this year, total returns in the equity REIT sector are a negative 4.4%.

Similarly, the Morgan Stanley REIT Index shows that total returns fell 9% in the third quarter. And the early indications are that the fourth quarter might not fare much better. Returns dropped 6.8% through Oct. 10, reports Jonathan Litt, senior real estate analyst at Salomon Smith Barney.

“The third quarter was the first really big negative quarter we've had in terms of total returns in the REIT market since 1999,” stated Litt during an Oct. 10 quarterly conference call hosted by NAREIT.

Such a dramatic swing, Litt said, was bound to occur given the strong run-up in REIT prices and total returns in 2000 and 2001. “It was almost a self-fulfilling prophecy,” he said, “because we had arguably the weakest fundamentals of the past decade in the past year or two, and yet the stocks continued to motor ahead.”

It is precisely those weak real estate fundamentals that remain a cause for concern. The national office vacancy rate for all classes of space in the central business districts (CBDs) rose to 14.4% in the third quarter, up from 10.6% during the third quarter of 2001, according to New York-based Cushman & Wakefield. Meanwhile, the suburban vacancy rate rose from 15.3% to 20% during the same period.

REIT Returns vs. Investment Alternatives
(Domestic returns are listed in annual percentage changes. Figures for 2002 are year-to-date through Oct. 10.)
S&P 500 Dow Jones Industrial Russell 2000 Total Return Indexes NAREIT Composite (Total Returns)
2000 -9.10% -6.18% -3.02% 25.89%**
2001 -11.89% -7.09% 2.49% 15.50%
2002 -29.10% -24.82% -30.46% -3.61%
*Price only returns
**The NAREIT Composite is an index of all publicly traded REITs (equity, hybrid and mortgage). About 95% of all REITs are equity REITs. In this case, total return is share price appreciation/depreciation plus reinvested dividends.
Source: NAREIT


Equity REIT Returns By Property Sector
(Percentage change in total returns*)
Y-T-D
(Oct. 10, 2002)
One Year Totals
(Oct. 2001-Sept. 30,2002)
RETAIL 10.09% 31.34%
•Regional Malls 13.54% 43.70%
•Shopping Centers 6.45% 22.28%
•Freestanding 13.11% 22.40%
OFFICE -11.90% -4.79%
INDUSTRIAL 8.82% 24.97%
APARTMENTS -14.06% -5.66%
LODGING/RESORTS -12.72% 19.78%
* Total return is share price appreciation/depreciation, plus reinvested dividends.
Source: NAREIT


The trend on rents has been much the same. Class-A rents in the CBDs dropped from $32.24 per sq. ft. to $30.50 per sq. ft. while rents in the suburbs dropped from $27.71 per sq. ft. to $25.90 per sq. ft., according to Cushman & Wakefield.

In an analyst's report from Salomon Smith Barney, titled “The REIT Screen Is Red — wish we had something good to say,” Litt writes that regional malls and the warehouse REITs will likely suffer the least over the next six months, while the multifamily and office sectors will come under the most pressure.

If there is a positive, it is that the REIT group sports a 7.7% dividend yield and is trading at a 13% discount to net asset value, according to Litt, an indication that the stocks may be undervalued.

Swift Reversal of Fortune

SNL Financial, a real estate data services firm based in Charlottesville, Va., reports that during a six-week period from Aug. 30 to Oct. 11, the stock price of the 158 equity REITs it tracks dropped an average of 10.3%. Total returns dropped 9.4% during the same period. Meanwhile, the market cap fell from $159.8 billion to $143.5 billion, according to SNL.

“I would expect continued sogginess in REIT performance,” says Paul Reeder, director of SNL Financial. “The third-quarter earnings season is going to be nasty for many REITs.”

For example, on Oct. 7, Alexandria, Va.-based apartment REIT AvalonBay Communities Inc. (NYSE: AVB) announced that it expects third-quarter funds from operations (FFO) of 86 cents to 88 cents a share compared with its previous guidance of 93 cents to 97 cents a share. FFO is a common measure of REIT performance. AvalonBay cited economic weakness and the negative effects of record-low mortgage rates that enable renters to purchase homes. At the close of business on Friday, Oct. 18, Avalon's price per share was $38.15, down from its 52-week high of $52.65 in April.

Changes in capital flows and investor sentiment also are not working in REITs' favor at the moment. Early this year, as the broader equities market headed south, investors fled to real estate. Arcata, Calif.-based AMG Data Services reports that $3.5 billion flowed into open-end mutual funds through Oct. 11 of this year compared with only about $400 million for all of 2001.

But over the next several months, the capital flows into open-end REIT mutual funds and closed-end funds are expected to remain flat or diminish, says Litt. Combined, these funds have accounted for $6 billion to $7 billion of positive flows into the sector this year alone. And so-called momentum investors, those who look for a quick fix before moving on to opportunities in other asset classes, are rotating out of the REIT sector, according to Litt.

“If we see the dedicated investors (which include dedicated mutual funds, closed-end funds and pension funds) having negative outflows, and if we see that the fast money and maybe even the value and income-oriented investors are lowering their allocations, there's not a lot of cash coming into the group to pick up the pieces,” explained Litt during the conference call.

Publicly held REITs may be hitting a wall, but private investors are still placing money in real estate, says David Rabin, director of investments for PM Realty Advisors, a Newport Beach, Calif.-based pension fund advisor. So far, he says, the deteriorating fundamentals have not been an impediment to private capital sources, which are still aggressively chasing real estate.

Not Everyone's Running for the Exits

Still, some investors continue to predict good things for REITs. Mike Acton, director of research for Boston-based AEW Capital Management, says his firm's institutional clients remain high on real estate, and REITs in particular. AEW manages $7 billion in pension fund and endowment money and has invested about $2 billion of that in real estate.

“We've seen more capital from institutional investors going toward REITs,” emphasizes Acton. “By putting it in securities, they're getting broad exposure.” The funds, he says, are buying REIT shares of preferred property types to diversify their portfolios. It's also a way to invest without being a direct owner of real estate.

Over the long term, Acton adds, the demographics point to more money flowing into REITs, if only to exploit the cash dividends. Most REITs are paying between 6% and 8% dividends per year, says NAREIT, which are the kind of returns that retirees would love to see.

“Once the Baby Boomers start to retire, these pension plans that have promises to all of these beneficiaries are going to have to shift their capital to asset classes that generate income,” Acton says. “I would think more capital would have to be in real estate. It's a $4 trillion market. It can absorb more capital.”

Top Ten Office REITs Ranked by Equity Market Cap*
(As of Sept. 30, 2002)
Company Symbol Market Cap (in millions) Market Cap Percentage of Total Subsector
Equity Office Properties Trust EOP $10,820 37.5%
Boston Properties Inc. BXP $3,544 12.3%
Mack-Cali Realty Corp. CLI $1,853 6.4%
Trizec Properties Inc. TRZ $1,703 5.9%
Arden Realty Group ARI $1,529 5.3%
CarrAmerica Realty Corp. CRE $1,334 4.6%
Highwoods Properties Inc. HIW $1,250 4.33%
Prentiss Properties Trust PP $1,239 4.3%
HRPT Properties Trust HRP $1,063 3.7%
SL Green Realty Corp. SLG $932 3.2%
*The combined equity market cap of the Top 20 office REITs is approximately $28.9 billion, of which Equity Office Properties Trust accounts for 37.5%, making it by far the largest office REIT.
Source: NAREIT


Office in the Eye of the Storm

Office REITs have clearly felt the effects of retrenchment by recession-ravaged companies that are downsizing and giving up space. The office REITs registered a minus 11.4% in total returns through Oct. 10, according to NAREIT.

An announcement by Equity Office Properties Trust (EOP) in October that it plans to save $50 million in operating expenses by centralizing building management operations and cutting non-essential tenant services provides the strongest evidence yet that the weak fundamentals are putting a strain on operations. The Chicago-based REIT also indicated that it is not seeking any acquisitions and that its primary focus is on boosting occupancy across its portfolio.

Richard Kincaid, CFO at Equity Office, says the best-case scenario for the office market right now is stabilization. “With the office REITs, the sense is that it's not getting worse but it is also not clearly improving at this stage,” Kincaid says.

The share price for EOP closed at $25.21 on Oct. 18, down from its 52-week high of $31.36.

Recent statistics provide a glimmer of hope for office REITs, however. In the second quarter, Boston-based Torto Wheaton Research reported a net gain in absorption nationally of 7.7 million sq. ft., the first positive absorption since fourth- quarter 2000.

And the vacancy rate, while still climbing, may be nearing a peak. According to New York-based Reis Inc.'s survey of the top 50 office markets, the vacancy rate grew by 0.4% to 15.7% in the third quarter, compared with a 0.6% increase in the second quarter and a 1% jump in the first quarter.

Indianapolis-based Duke Realty Corp., which owns both office and industrial properties, has maintained a strong balance sheet by selling $1.5 billion in assets since early 2000. “We sold more assets than we needed [to raise capital] for new projects,” says Tom Peck, senior vice president of investor relations for Duke. Peck says the move put a little pressure on the company's earnings but it also drove its percentage of debt down significantly.

Meanwhile, the economy still isn't creating new jobs. In September, payroll employment dropped by 43,000 jobs from the previous month, according to the U.S. Department of Labor. And until there is significant improvement, the office market will not be able to absorb its excess space.

Acton of AEW believes it could be 2004 or even 2005 before office vacancy rates return to 10%, or the point of equilibrium. Kincaid agrees the recovery could be slow, but adds that wise investors might want to grab REITs while they are poised to grow. “I'd argue that if you have a three- to five-year outlook, you can buy office companies, get them cheaply and you're going to ride that wave up,” he says.

But REITs must pay close attention to the creditworthiness of tenants to preserve dividends, says Bruce Schonbraun, managing partner of Roseland, N.J.-based consulting firm Schonbraun Safris McCann Bekritsky & Co. “When the market becomes more selective, each company has its own credit profile, and that will be a key consideration in the stability of the dividend,” Schonbraun says.

It is precisely those steady returns that keep long-term investors interested in REITs. “Momentum investors (those just trying to realize gains when REIT stocks were hot) were unhealthy. You don't have them like you did before,” says Schonbraun. “What we have now are institutions and individuals that are yield oriented.”

Retail Rolls Along

Compared with the depressed office market, the retail sector is a ray of sunshine. In fact, retail REITs have been the darlings on Wall Street. Consumer spending has held up well, sparing retail real estate the kind of damage that this jobless recovery has dealt to office, multifamily and hotel sectors.

Regional mall REITs and shopping center REITs have posted healthy returns this year. Total returns on mall REITs jumped 13.54% through Oct. 10 of this year. Meanwhile, total returns for shopping center REITs, which include grocery-anchored centers, climbed 6.45% during the same period, according to NAREIT.

The steady, if unspectacular, showing among shopping centers is easy to understand, says Gary Widett, COO of Heritage Property Investment Trust, a Boston-based shopping center REIT. “People still have to go to the grocery store,” he says.

Widett believes the fundamentals for shopping centers are still relatively sound, and that investors have realized grocery-anchored centers are a good, recession-resistant investment.

Michael McCarty, senior vice president at Indianapolis-based Simon Property Group, says retailers are in better financial shape than most industry observers might think. “They are surviving a weak sales environment by focusing on maximizing efficiencies” in the supply chain and store operations.

Retailers can benefit by those efficiencies in the short term, but if the economy doesn't turn around in the next year or so, retailers may have a hard time maintaining their bottom lines, McCarty says.

Both Heritage and Simon Property Group report strong institutional interest in their stocks. Widett says his firm, which began publicly trading in April, is approximately 70% owned by institutions. That has led to a stable stock price this year because the institutions seem to have a long-term investment horizon.

Top Five Regional Mall REITs
(Ranked by equity market cap as of Sept. 30, 2002*)
Company Symbol Market Cap (in millions) Market Cap Percentage of Total Subsector
Simon Property Group Inc. SPG $6,629 38%
General Growth Properties Inc. GGP $3,205 18.1%
The Rouse Co. RSE $2,768 15.7%
CBL & Associates Properties CBL $1,150 6.51%
The Mills Corp. MLS $1,146 6.49%
* Regional malls are typically enclosed centers and range from 400,000 sq. ft. to 800,000 sq. ft. with two or more anchor tenants. The total equity market cap of the nine regional mall REITs in the sector is $17.7 billion, of which Simon Property Group represents 38%.
Source: National Association of Real Estate Investment Trusts (NAREIT)


McCarty says Simon Property Group's inclusion in the Standard and Poor's 500 Index earlier this year resulted in a flood of institutional interest in his firm's stock. “We saw a tremendous influx of mutual funds buying the stock, and we ended up on the radar scope for a whole other set of institutional buyers,” he says. “Reasonably, we believe that's one of the significant reasons for stock growth.”

Cap rates for retail properties have shown only slight movement over the past year. According to second-quarter statistics provided by Chicago-based Real Estate Research Corp., going-in cap rates for neighborhood centers have dropped from 9.4% to 9.3% over the past year, while regional mall cap rates have actually ticked up 10 basis points from 8.9% to 9%. (The higher the cap rate, the lower the purchase price.) Power centers have shown a little more movement, falling from 9.9% a year ago to 9.7% at the end of the second quarter.

Renee Csuhran, national sales manager of institutional real estate finance for Cleveland-based Key Commercial Real Estate, says she expects cap rates for retail could fall significantly in the near term.

Industrial Keeping Pace

If the outlook for retail weakens, industrial REITs are poised to become the preferred category for investors. Total returns in the industrial sector registered 8.82% year-to-date as of Oct. 10, and were up nearly 25% for the 12-month period beginning October 2001 and ending September 2002, according to NAREIT.

While the sector has endured an increase in vacancies and some softness in rents, the overall fundamentals remain much better than the office market.

AMB Property Corp. of San Francisco has tried to stay ahead of the game by focusing on occupancy, says Bruce Freedman, executive vice president of real estate operations for the company. “In early 2001, we began being very aggressive in renewing tenants,” Freedman says, adding that AMB closed below-market deals at the time, but the rental rates the firm was able to negotiate were more favorable than today's market.

As for financing, AMB has not gone back to the public market since its IPO in 1997, choosing to access private capital through partnerships and creating property funds. Its most recent fund, the $200 million Alliance Fund II, counts the Citigroup Pension Plan among its investors. It recently purchased 1 million sq. ft. in Seattle and 400,000 sq. ft. in New Jersey.

Mike Brennan, president and CEO of Chicago-based First Industrial Realty Trust, says his company sees indications that investors are coming back to quality industrial product. First Industrial has sold a number of properties with cap rates ranging from 7.5% to 8.5%, indicating that investors see the strength and potential upside to owning industrial property as the economy recovers.

Mixed Signals from Multifamily

Apartment REITs continue to feel the effects of a soft rental market. Occupancy rates have been falling as low-cost financing turns more renters into homeowners. Meanwhile, landlords are paying more to find tenants and accepting lower rents. Atlanta-based Post Properties, for example, began offering free rent and other concessions and pushed occupancy from 89% to 93% by fall 2002, says Dave Stockert, CEO of Post Properties.

The softness in the multifamily sector has had little effect on cap rates, however. Real Capital Analytics reports that cap rates for garden apartments were 8.5% in the second quarter of this year vs. 8.3% last year. For high-rise apartments, cap rates registered 8.1% at mid-year vs. 8.0% at the same time last year.

An economic recovery would give the multifamily market a quick boost, says AEW's Acton. “As soon as the economy starts moving again, interest rates will creep up, jobs will be formed for the 22- to 28-year-old group and rental rates will pick up for apartments.”

Hotels Still Limping

No REIT sector has been harder hit by the Sept. 11 terrorist attacks than hotels. Business and leisure traffic plummeted, and the recovery in revenue per available room (RevPAR) has been gradual. Total returns for hotels were a negative 12.72% year-to-date as of Oct. 10, according to NAREIT.

Washington D.C.-based MeriStar Hospitality Corp., which owns hotels under the Hilton, Sheraton and Marriott flags, noticed a precipitous drop in the number of business and convention guests. Paul Whetsell, MeriStar's chairman and CEO, says that corporate cutbacks are his biggest problem now.

“Look at the things that get cut in a down environment — training, recruiting, consulting — these are huge businesses for hotels,” he says. Both MeriStar and Irving, Texas-based FelCor Lodging Trust issued third-quarter earnings warnings in September, bracing the market for yet another bad quarter.

Top Five Shopping Center REITs
(Ranked by equity market cap as of Sept. 30, 2002*)
Company Symbol Market Cap (in millions) Market Cap Percentage of Total Subsector
Kimco Realty Corp. KIM $3,252 17.7%
Weingarten Realty Investors WRI $1,896 10.3%
New Plan Excel Realty Trust Inc. NXL $1,786 9.7%
Regency Centers Corp. REG $1,782 9.7%
Developers Diversified Realty Corp. DDR $1,429 7.8%
* Shopping center REITs include grocery-anchored shopping centers and power centers. The combined equity market cap of the 26 REITs tracked in the sector is $18.36 billion, of which Kimco represents 17.7%.
Source: National Association of Real Estate Investment Trusts (NAREIT)


Matt Gove is an Atlanta-based writer. Matt Valley is the editor of NREI.