Has pricing on retail real estate finally gotten too rich for REITs?

While acquisitions seem to be continuing at a dizzying pace, driven by private equity funds, 1031 and TIC buyers, retail REIT executives have put their wallets back in their pockets and slowly stepped away from the frenzied acquisitions market. Instead, REIT managers — not generally known as the riskiest bunch of executives — are gambling elsewhere.

Kimco Realty Corp. has purchased car dealerships in Canada, while Simon Property Group has started to develop shopping centers in China. REIT executives have also traveled Down Under to form joint ventures with Australian limited property trusts. Seemingly every company is discussing mixed-use and “asset intensification.”

This environment is creating serious challenges for REIT managers and, in fact, altering the game plan for how they deliver returns. In this high cap-rate environment, many REITs have slowed the pace of acquisitions (which have been the lifeblood for increasing FFO and sustaining the REIT rally). Instead, the strategy has turned to taking advantage of the high pricing to sell off non-strategic assets. REITs are employing their massive stores of capital elsewhere.

REIT executives have returned to their developer roots. The pipeline for new projects is at its highest point in years. Many are also going back and spending a lot on redevelopment of current assets.

“It's so tough to buy,” Kimco CEO Milt Cooper says. “We want to buy right. Risk can constitute price if you overpay. This year, we're not finding [deals] with which we can sleep well at night.”

So just about the only thing they haven't been doing is buying their bread-and-butter assets. Retail REITs this year have accounted for just 19 percent of the $6.3 billion in retail property acquisitions, according to Real Capital Analytics Inc. In 2002, by comparison, retail REITs accounted for 62 percent of such deals.

Even consolidation has slowed down. After the General Growth/Rouse deal, speculation mounted as to who would be next. A few deals have occurred: Macerich Co.'s acquired Wilmorite's portfolio, Regency Center's Inc. bought the First Washington/CalPERS portfolio and Centro Watt's acquired Kramont. But most experts think that more consolidation is in the cards and are waiting for the next big deal to come about. However, no one wants to speculate on who will be sold and who will be buying.

Not so fast

This was supposed to be the year that real estate slowed. Federal Reserve Chairman Alan Greenspan's repeated raises of the federal funds rate was intended to push interest rates higher and slow the red-hot residential and commercial real estate markets. Rising rates compress yields, and should encourage borrowers to shift from short-term floating-rate debt to fixed-rate long-term paper. But that's not exactly what's happened.

Instead, the Fed's efforts to push up interest rates have done nothing except compress spreads. The 10-year Treasury is lower now then at the beginning of the year. Cap rates remain at all-time lows. And REIT stock values remain at all-time highs.

The industry was coming off a 2004 in which stock for all public REITs jumped 32 percent. REITs were trading at huge premiums to net asset value — 12 percent for shopping center REITs and 12.9 percent for regional mall REITs. And many real estate funds earlier this year started steering money into alternative investments, such as homebuilding companies and hoteliers not organized as REITs.

But REITs have continued to prosper. For 2005, the Morgan Stanley REIT Index had appreciated 9.3 percent as of late September. (In contrast, the Dow Jones was down 2.3 percent during the same time period.)

In the second quarter, mall REITs generated same-center sales growth of 4.3 percent on average, NOI growth of 3.8 percent and occupancy increases of 0.6 percent, according to Prudential Equity Group LLC. Although all the figures were positive, both sales and NOI grew more slowly than they did in the first quarter. As of mid-September retail REIT stocks had risen 10 percent in 2005 — trailing only the self-storage sector in the REIT universe. Within the retail sector, mall REITs rose 13.7 percent, shopping center REITs were up 7.1 percent and freestanding REITs rose 6.5 percent.

But REITs are trading well above historical norms. According to Prudential analyst Jim Sullivan, mall REITs are trading 14.8 times their FFO. Historically the multiple has been 10 times.

“We believe the REIT industry share prices do not reflect the risks of investing in real estate,” wrote Sullivan, in a September research note. “We believe that share prices for the REIT industry, which include share prices for mall REITs, are unsustainable. We expect pricing pressure over the next 12 months.”

Outside the big box

REITs have been big on non-core activities this year. Rather than spending time hunting for acquisitions in their core-competencies — i.e. shopping centers and malls — many REITs have been developing other businesses. Several REITs have invested directly in retailers or become merchant lenders. Sales of outparcels and non-core assets have also been a big theme. And “mixed-use” has become a rallying cry in board rooms across the country.

“The type of property we're buying has good or great income potential from other uses,” says Doron Valero, president of Equity One Inc.

“Management teams are taking advantage of the hot acquisition market by selling non-core or low-growth assets such as Simon's sale of its office assets, DDR's sale of its industrial portfolio and Weingarten's big ramp up in its dispositions,” says Citigroup REIT analyst Michael Bilerman. In addition, CBL & Associates Properties has sold off some of its community center portfolio.

Weingarten has been selling non-core retail assets, but it also commands a large industrial portfolio, which Merrie Frankel, vice president of real estate finance for Moody's Investors Service, says is the largest collection of non-retail assets in any of the retail REIT portfolios.

“They don't have any intention at the moment of doing anything, but they're the last holdout with a portfolio that's not among their mainstream assets,” Frankel says.

Also, the industry's development pipeline is rapidly swelling with projects. This represents the most new projects that owners have had in the works in years. Many of the projects are not full-fledged regional malls; most are lifestyle centers with a handful of large, hybrid centers and mixed-use projects. There is also considerable ongoing redevelopment and expansion.

According to Citigroup, General Growth has a $2.1 billion, 30-property development pipeline. Simon has an $840 million, 16-property pipeline. Mills has $1.5 billion and 21 projects. And Regency has $1.2 billion earmarked for development.

“I think people are emphasizing development today versus acquisitions because pricing on acquisitions has gotten so expensive,” says Stephen Lebovitz, president of CBL & Associates Properties Inc. “This year will be one of our biggest years ever in terms of development activity.”

CBL has 2.5 million square feet of space coming on line through new development and expansions of existing properties. It has also spent $257 million on acquisitions.

“It's cheaper to develop than it is to buy these days,” Frankel says. “I don't see it out of whack yet. Nobody has much more than two or three projects opening in one year. But there's clearly an uptick.”

REITs have also been eager to dip into public markets to raise both debt and equity. REITs can pay down older facilities and issue new debt at lower rates than their previous arrangements. REITs on the whole are less leveraged than they were five years ago.

“Within overall markets, investors have really been rotating into REITs and commercial real estate,” says Paul McDowell, CEO of Capital Lease Funding. Capital Lease occupies a unique place on the retail REIT spectrum. It began as a net lease financier, but became a public REIT in 2004 and is now building a portfolio of net lease assets — worth about $1 billion to date — to go along with its debt business. The company has nearly used up its IPO capital and is preparing a secondary offering.

REITs on the whole have tapped in to the market for 65 equity offerings and 57 debt offerings, raising about $19 billion total. That's down some from 2004, when they raised $38.8 billion, but still puts 2005 on pace to exceed every year prior, going back to 1998.

Refinancing has left the mall REITs with a weighted average interest rate of 5.9 percent on their debt and exposure to variable-rate debt is 27 percent. Those numbers are actually slightly up, largely because of Macerich's acquisition of Wilmorite's portfolio and General Growth's acquisition of Rouse Co., which has left both companies more highly leveraged than their peers. General Growth, for example, is carrying a 30 percent variable debt load. But both General Growth and Macerich are working to lower their exposure. General Growth's exposure in the first quarter was 38 percent.

The retail REIT market is continuing to broadcast conflicting signals. On one hand, prices for real estate (and REIT stock) seem unsustainable and every metric shows REITs trading at premiums to historic norms. On the other hand, analysts have been saying the same thing for a while and the other shoe still hasn't dropped. In fact, retail REITs are poised to end the year up more than 10 percent, continuing their long-term rally.

One thing is for sure, the series of brutal hurricanes that hit last year and continue in 2005 has put extra strain on an already struggling energy market. With gas prices now at $3 a gallon, some experts think that the Christmas season is in trouble (see story on page 20 in “Traffic Reports”).

The economy as a whole — and retail real estate specifically — has been carried by consumer spending. That now appears to be facing a crisis point. If so, retail REITs may finally be facing what they've long-dreaded: the winding down of their rally. How managers continue to respond and innovate will determine the winners and losers of this coming period.

The answer? Many point back to mixed-use development. It's a way of diversifying an asset and creating a place people can live, work and play.“Real estate is such a valuable product,” Lebovitz says. “I think that a number of companies are exploring mixed-use opportunities as part of mall development.

CBL is adding new amenities to its existing properties. “It's directly integrated rather than on the periphery. I think there's definitely more attention being paid to that,” Lebovitz says.

SAME-CENTER MALL STORE SALES GROWTH

Company Name 4Q01 4Q02 4Q03 4Q04 1Q05 2Q05 Avg.
CBL & Associates 1.50% 1.60% 1.10% 2.80% 4.50% 3.40% 1.10%
Crown American Realty 1.50% 0.30% NA NA NA NA -
General Growth Properties -0.80% 2.10% 0.40% 4.30% 2.70% 3.30% 1.30%
Glimcher Realty Trust -0.40% -0.80% -0.80% 1.50% 2.90% 1.30% 0.20%
JP Realty -1.40% NA NA NA NA NA
Macerich Co. -1.30% -1.60% 1.80% 4.20% 5.80% 4.60% 1.50%
Mills Corp. -3.00% -2.50% 1.60% 6.80% 6.50% 3.10% 0.60%
Pennsylvania REIT - - -0.50% 2.00% 2.80% 1.50% 0.00%
Rouse Company -2.00% 0.00% 1.20% NA NA NA NA
Simon Property Group -0.30% 0.00% 3.00% 6.20% 6.30% 5.50% 2.10%
Taubman Centers -2.10% -1.50% 3.00% 8.00% 7.20% 6.30% 2.50%
Equally Weighted Avg. -1.10% -1.10% 1.20% 4.50% 4.80% 3.60% 1.40%
Market-Cap Weighted Avg. -1.10% -0.90% 1.60% 5.20% 5.10% 4.30% 1.60%
Note: The comparison represents same-center sales for specialty retailers that report sales in Mall REIT portfolios.
Source: Company reports; Prudential Equity Group, LLC

MALL STORE SALES PER SQUARE FOOT

Company Name 4Q01 4Q02 4Q03 4Q04 1Q05 2Q05
CBL & Associates $298 $293 $300 $314 $320 $315
Crown American Realty $268 $270 NA NA NA NA
General Growth Properties $355 $355 $351 $410 $416 $412
Glimcher Realty Trust $293 $300 $304 $323 $331 $334
JP Realty $263 NA NA NA NA NA
Macerich Co. $350 $355 $361 $391 $401 $403
Mills Corp. $330 $326 $337 $368 $371 $375
Pennsylvania REIT - - $305 $324 $329 $328
Rouse Company $421 $411 $426 NA NA NA
Simon Property Group $383 $386 $402 $427 $437 $442
Taubman Centers $456 $456 $468 $477 $485 $507
Equally Weighted Avg. $342 $350 $362 $379 $386 $390
Market-Cap Weighted Avg. $370 $370 $375 $400 $409 $413
Avg. Year-Over-Year Change 2% 0% 1% 7% 6% 5%
Source: Company reports; Prudential Equity Group, LLC

MALL STORE OCCUPANCY

Company Name 4Q01 4Q02 4Q03 4Q04 1Q05 2Q05
CBL & Associates 94.1% 94.1% 94.4% 94.4% 91.5% 92.2%
Crown American Realty 87.0 87.0 -
General Growth Properties 91.0 91.0 91.3 92.1 90.0 90.7
Glimcher Realty Trust 87.2 91.0 90.2 88.5 87.6 88.0
JP Realty 84.0 - -
Macerich Co. 92.4 93.6 93.3 92.5 92.2 92.1
Mills Corp. 93.0 93.8 94.5 96.0 94.8 95.0
Pennsylvania REIT - - 94.5 89.7 90.5 90.5
Rouse Company 95.1 95.1 95.0
Simon Property Group 91.9 92.7 92.4 2.7 91.5 92.2
Taubman Centers 91.8 93.4 90.0 90.5 90.5 90.9
Equally Weighted Avg. 90.8 92.4 92.5 92.2 91.1 91.5
Market-Cap Weighted Avg. 92.0 92.9 92.8 92.8 91.4 91.8
Avg. Year-Over-Year Change -0.7% 0.9% -0.1% 0.0% 0.1% 0.4%
Source: Company reports; Prudential Equity Group, LLC

SAME CENTER NOI GROWTH

Company Name 4Q01 4Q02 4Q03 4Q04 1Q05 2Q05
CBL & Associates 0.1% 3.7% 6% 6.8% 10.7% 2.5%
Crown American Realty 0 3.7
General Growth Properties 4.6 4.1 5.7 7.1 6.1 5.8
Glimcher Realty Trust 1.7 1.7 2.9 0.4 0.6 2.3
JP Realty -1.8
Macerich Co. 2.1 1.4 0.9 4 3.4 2.2
Mills Corp. 2.5 1 10 3.4 1.7 3.6
Pennsylvania REIT 1.7 0.4 2.4 -2.4
Rouse Company 3.5 6.6 2.1
Simon Property Group 4 3 2.5 2.7 3.3 4.1
Taubman Centers 0 4 2 3 3 6
Equally Weighted Avg. 1.5 3.2 3.8 3.5 4.1 2.8
Market-Cap Weighted Avg. 3.1% 3.6% 3.6% 4.1% 4.3% 3.8%
Source: Company reports; Prudential Equity Group, LLC