How to Play REIT Uncertainty

REIT stocks continue to suffer from high volatility, but the sector's troubles are more reflective of investor skittishness over the true value of commercial real estate than actual fundamentals.

Almost every day, business-news outlets are putting out stories about how the commercial real estate market is set to implode. This is creating fear among many investors and leading them to shy away from REIT stocks. The US MSCI REIT index has fallen 24% over the past year, including dividend returns.

"There is a big disconnect with what is going on in commercial real estate and what the market thinks is going on in commercial real estate," says Rich Moore, a REIT analyst with RBC Capital Markets.

Fundamentals remain relatively strong in the commercial real estate market. But REIT stock prices are reflecting two fears: there will be big trouble on the financing front and big trouble for rentals.

Problems in the debt market remain a gloomy cloud over the sector. The effective shutdown of the market for commercial mortgage-backed securities, or CMBS, has drained deal flow. CMBS was a major financing method for property transactions in recent years.

Spreads on AAA-rated CMBS have widened by about 125 basis points since the summer, according to the Markit's CMBX index, which tracks credit default swaps on the securities.

The widened spreads signal increased expectations of defaults and lead to higher debt financing costs. As a result, commercial real estate sales volume has slowed and property values have fallen.

With these issues, it's becoming difficult for professional money managers to determine REITs' net asset values, or NAV, which roughly equate to the private market values of the firm's real estate, as measured by comparable property transactions.

"There is no transparency in the private market," says a real estate buy-side investor, who is also wondering whether the CMBX index is oversold -- meaning debt costs may not have risen as much as the index implies.

An overall lack of deal flow also makes it hard to determine cap rates (or initial yields on acquisition prices) for properties.

"We are not seeing many huge transactions so it's difficult to get a feel as to cap rate compression," says trader who specializes in REIT stocks.

Moreover, worries are circling over whether the few potential buyout deals in the works -- the possible ones for apartment owner Post Properties(PPS Quote) and office landlord Maguire Properties(MPG Quote) -- could even be completed given financing troubles.

Against this backdrop is the additional fear that rent growth will slow as the economy worsens.

However, several well-respected analysts say commercial real estate fundamentals are expected to hold up relatively well over coming years.

Growth prospects for net operating income, or NOI, remain reasonably strong, says Mike Kirby, director of research with Green Street Advisors, an independent real estate research firm.

Most sectors should generate NOI growth of 2.5% to 4% in 2008 and 2009. Office property growth will be even better, averaging about 5% over the next few years, Kirby says.

"These forecasts are predicated on modest, but positive economic growth," he says. "They will obviously be worse if we have a recession, but it is very hard to picture negative NOI growth in most of the major sectors unless things get really ugly."

So how should an investor play the REIT sector? Here are two simple strategies:

Avoid stocks with problematic debt maturities.

Look at the capital position of the company and when debt maturities are coming due. This information can be found in the footnotes of 10-K filings.

In a difficult credit environment, refinancing mortgages is becoming harder. It's best to stay away from companies that have debt maturities they potentially can't cover.

General Growth Properties(GGP Quote), for instance, took on a lot of debt to finance its purchase of Rouse in 2005. While General Growth owns very nice malls, "it's a very bad time to have too much debt," says Moore, the RBC analyst.

General Growth has $2.6 billion of debt maturities coming due in 2008, and $3.2 billion due in 2009, according to the company's latest annual report. It has only $221 million available on its $650 million revolving credit facility.

Although the company has wiggle room today, "if credit markets worsened, GGP might find itself in a bit of a problem," says Moore, who rates the stock underperform.

In contrast, fellow mall giant Simon Property Group(SPG Quote) has $1.1 billion open on its $3.5 billion credit facility that can be used to fund long-term debt maturities as they come due.

Simon has $809.7 million of debt coming due in 2008, and $1.6 billion in 2009. This clean balance sheet is a major reason the stock is a top holding of real estate mutual funds.

Remember that lower-quality retail or apartment owners may have problems with growth.

It's important to look at the quality of earnings streams, and lower-quality REITs may run into trouble on that front.

Think about it conceptually for a moment. Low-quality apartment and retail buildings in general also have worse-quality tenants. Landlords of such buildings, therefore, have lower pricing power, and existing tenants have higher risk of default.

Green Street's Kirby says there is some evidence this year that investors are mistakenly focusing more attention on "junk REITs" -- those that are high dividend-paying, have higher yields on funds from operations, higher leverage and/or lower quality portfolios.

"Many of these REITs have fared better than average over the last couple of months, as unsophisticated investors searching for bargains/yield often pile in to these names first," Kirby says.

But instead of chasing dividend yields, investors should look for a quality earnings steam.

For example, Federal Realty(FRT Quote) is considered to be the highest quality of the shopping center REITs. Federal also has a clean balance sheet and has had some of the highest spreads on new leases of any retail REIT in recent years.

Federal recorded 11.4% growth in funds from operations per share in 2007. Analysts expect another 7.8% FFO per share growth in 2008. There is a good reason why Federal enjoys one of the highest price-to-FFO multiples among REITs.

Growth, combined with safety, are the best way to play REITs today.