Are we there yet?

In each of the past five years REITs have outperformed the broader stock market. And for about the last three years pundits and observers have been saying that it can't go on much longer. Yet the REIT rally has proved unusually stubborn, shaking off brief dips and ultimately delivering rich returns on a year-in, year-out basis. Within that, retail REITs consistently have been even stronger than other REITs.

So when both the NAREIT index and Morgan Stanley REIT index took a spill in early April, the immediate reaction by most was to see it as another momentary blip.

“The fundamentals in our business continue to be strong,” says Bill Taubman, executive vice president for Taubman Centers. “Often, choppiness in the market has to do with overall capital flows rather than fundamentals in the business itself.”

Yet, today more than ever, there are new signs that the REIT rise will at least slow, if not fall some during the balance of 2006.

Most ominous for REITs is the fact that for the first time since 2001, yields on 10-year Treasuries are more than 5 percent. As a result, returns on Treasuries deliver a more attractive yield than REIT dividends. REIT dividends have delivered a positive spread in comparison to Treasuries for nearly a decade, all the way back to 1997.

The spread peaked at just over 350 basis points in 2003, but has been steadily creeping down every since. Today, it is nearly 100 basis points in the other direction — the biggest margin in favor of Treasuries since at least late 1992, which is as far back as Citigroup Investment Research has tracked the figure. Moreover, the spread between REIT cap rates and the 10-year Treasury — roughly 150 basis points — is also a cyclical low.

A lack of attractive alternatives has buoyed REIT stocks during their five-year long rally. The rise in Treasuries means there's now even more competition for investors who are searching for yield.

The fall back on REITs came after a torrid first quarter. During the first three months of the year, the Morgan Stanley index rose 16.3 percent — well ahead of how the index performed in 2005 when it increased 8.8 percent for the whole year. The first quarter was more in line with 2003 and 2004, when REITs rose about 40 percent each year. The index seemed poised to crest the 1,000 mark for the first time, exceeding most analysts' anticipations.

But in early April REITs took a tumble, spurred in part by weaker-than-expected retail sales in March. At the same time, Standard & Poor's Equity Research Services warned investors to expect a decline in its own REIT index based on what, it said, were high valuations.

“While we like the group's technicals from a long-term perspective, we do see the probability of an up-to-15 percent correction over the next six months,” says Mark Arbeter, chief technical analyst at S&P's Equity Research Services.

Almost immediately after S&P issued the warning, the correction had begun. The Morgan Stanley index fell all the way down to 887.86 — a 9 percent drop in value in less than a month. At press time, the index was regaining ground, back up to 924.62.

Strips lead

Within that, retail REITs matched that pattern, up big through the first quarter, contracting heavily in early April and up again as the month went out. At the end up April, retail REITs were up about 8 percent for the year. Strip centers have been the leading sector, with returns of 11.6 percent followed by freestanding retail at 6.4 percent and lastly regional malls — traditionally the strongest segment — coming in at just 5.3 percent.

To be sure, the regional mall sector has been dragged down in part because of Mills Corp.'s well-documented woes. But the performance of REITs raises the question of whether the sector's fundamentals warrant the pull-back to which they've been subjected to of late.

The biggest point in retail owners' favor is that with occupancies near record highs and retailers clamoring for space, rents have been skyrocketing and so most companies are still posting healthy net occupancy income gains. On the regional mall front, Taubman Centers for example, said rents increased 2 percent in the first quarter and its NOI was up 3 percent.

On the strip center side, Pan Pacific Realty Trust's results have been even more dramatic. For 2005 its rents on new leases and renewals rose 18 percent, the highest the company had reported since going public. Chairman, President and CEO Stuart Tanz expects similar results in 2006.

“We see no weaknesses in the fundamentals of our business,” Tanz says. “Tenant demand is as strong as it's ever been. … We're seeing some of the lowest default rates in our tenants that we've ever seen. That tells a big story. If no one is leaving and if no one is defaulting, that tells me the tenant base is very strong.”

So what are REITs doing with these riches? The public merger market within the retail sector came to an abrupt halt in early 2005

Some think that potential exists for more consolidation in the industry, but — beyond picking up the choice pieces of whatever emerges from the Mills mess — there's no consensus on who might be bought and who might be sold.

In the broader REIT universe, a series of larger privatizations — 15 since January 2004 — have fueled interest in the sector. For investors it created a scenario where you could buy a REIT stock one day and the next see a pricey offer come in as one after another, private equity buyers have come in and snapped up REITs and taken them off the market.

There have also been a wave of REIT joint ventures with fund managers. Many retail REITs have sold off majority stakes in portions of their portfolios to such funds holding on to minority interests. Most are also taking in management and leasing fees on these portfolios.

Even with high stock valuations, high income and private equity and joint venture capital coming in, REITs are holding off on acquisitions for the time being.

Instead most REITs have put capital into development and redevelopment. That, though, seems under control.

“What we look at is whether the development pipeline is worth more than 10 percent of the existing assets. If anybody goes past that, we ask, can they handle it,” says Merrie Frankel, vice president and senior credit officer with Moody's Investors Service. “Right now, no one is going past that mark.”

Most companies are undergoing a heavy regime of redevelopment or expansion at their existing centers, which Frankel thinks is the right strategy in this market.

“It's so difficult to buy good assets at logical cap rates that it's more efficient to redevelop,” she says.

Moreover, on the debt side, the picture is also healthy. There's been a slight decrease in fixed-charge coverage — from 2.62 percent to 2.55 percent — but Frankel doesn't think it's enough of a drop to be worried about. “As far as debt goes, I'm OK,” she says.

Volcanic volatility

Part of the problem is that observers who have followed the REIT industry for years are used to the sector being stable. The new reality, though, is that REITs are now just as volatile, if not more so, than the broader stock market. The volatility today may simply be the result of the sector's success.

The pool of investors who dabble in REITs has grown significantly in recent years. Specifically, the rise in REIT volatility has coincided with the rising number of REIT exchange traded funds. Volumes of trading on REITs is also as high as it's ever been. Moreover, 11 REITs in all have been added to the S&P 500 since the first were added in 2001. Most recently, Boston Properties and Kimco Realty Corp. were added to the index in late March. As a result, for the first time in its history, the Morgan Stanley REIT index is actually experiencing greater volatility than the S&P 500.

The churning leads to greater ups and downs and not necessarily connected to fundamentals. Moreover, the fact that the REIT rally has gone on so long has investors jumpy. So when things begin to fall, there's a binge of selling as investors try to get out just in case the business doesn't rebound. However, since the REIT rally began in earnest in 2000, the market has seen at least five corrections, by the reckoning of Barry Vinocur, editor of Realty Stock Review. In each instance, when the Morgan Stanley REIT index has fallen, it has eventually regained its footing and continued its upward trajectory.

“Spring 2004 was the worst. It was down 18.6 percent at its low point, but REITs rebounded for that and ended the year up more than 30 percent,” Vinocur says. The most recent drop, before April's plunge, was October. The Morgan Stanley Index fell 8.1 percent, but regained its footing by year's end.

So does that mean it's time to buy?

“You would have made a lot of money by buying on the dips,” he says. “But that's definitely not something to base one's investment thesis on.”

Composite REIT Index 1994 Total 1995 Total 1996 Total 1997 Total 1998 Total 1999 Total 2000 Total 2001 Total 2002 Total 2003 Total 2004 Total 2005 Total 2006 (Thru 4/20) Total
Retail 3.19 5.10 34.65 16.99 -4.94 -11.77 17.97 30.42 21.07 46.77 40.23 11.80 8.03
Strip Centers 1.75 7.36 33.55 21.44 -6.99 -10.71 15.10 29.89 17.72 43.12 36.25 9.27 11.60
Regional Malls 8.77 3.00 45.27 13.69 -2.62 -14.58 23.50 31.88 24.56 52.24 45.01 16.54 5.27
Free Standing -5.49 31.59 30.77 17.77 -6.25 -4.89 8.95 23.95 21.76 35.91 32.87 -0.49 6.42
Source: NAREIT
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 (Q1) Total
No. of days Less than 1% 247 246 237 211 234 223 219 193 209 173 178 44 2414
+/- 1% 5 7 14 26 16 25 27 49 40 63 59 17 348
+/- 2% 0 1 1 11 0 4 1 6 4 10 11 1 50
+/- 3% or more 0 0 1 4 2 0 1 4 0 6 4 0 22
Percent of days Less than 1% 98 97 94 84 93 88 88 77 83 69 71 71 85.2
+/- 1% 2 3 6 10 6 10 11 19 16 25 23 27 12.3
+/- 2% 0 0 0 4 0 2 0 2 2 4 4 2 1.8
+/- 3% or more 0 0 0 2 1 0 0 2 0 2 2 0 0.8
moves of > 1 % 2 3 6 16 7 12 12 24 17 31 29 29 14.8
Source: Wachovia Capital Markets LLC