Ahh, the first week in January. When the lights come down, the resolutions are first broken, and we bask in predictions of the future. So not to disappoint, it's time to look for the four trends that should shape the real-estate industry in 1999.
Look for an Early Rally
Look for a REIT rally early in 1999, thanks to the compelling value many REITs sell for following the bloodbath of 1998. Don't believe me? Consider the facts: The average REIT is trading at about 10 times its 1999 funds from operations (or FFO, a REIT measure of earnings), versus a multiple of 32 times earnings for the
That's a bit of an "apples to oranges" comparison, I admit, because FFO is a measure of cash flow, while earnings are not (look for a discussion of the comparison of FFO for REITs to the cash flow of the S&P 500 in an upcoming Building Blocks column). But Eric Hemel, director of REIT research at
, recently calculated that the S&P trades at 2.8 times the multiple of REITs. That's high compared to the average spread between the broader market and REITs over the past five years of just 1.6 times. "REITs are cheaper relative to the S&P 500 than at any point in time over the last five years," Hemel wrote in a recent report.
Not only that, but they're still growing: Analyst consensus earnings estimates for 1999 predict EPS growth in the low teens. In the meantime, the average REIT yields around 8%.
An early rally could test the REITs' maturity, however. There is a real risk that REIT managements are waiting for another opportunity to flood the market with more equity -- shares that investors have shown they are unwilling to absorb. If companies perceive a rally as heavenly authority to indiscriminately issue new equity, expect the rally to fade and the wrecking ball to return.
How much is too much? REITs will have to make compelling arguments that the equity is committed to accretive projects. Issuing shares for the sake of all-too-vague "future opportunities," like those issued by
Prison Realty Trust
last week, are likely to be critically scrutinized by investors. A plethora of secondaries and gimmicks like UITs will signal the top. Hopefully REITs have learned, making 1999 a pleasant surprise.
All REITs Are Not Created Equal
This past year was the year that saw indiscriminate selling by the market, the result of congressional action limiting the advantages of paired-share REITs. As
Chris Marinac put it, "A few bad apples ruined the whole bushel."
"There was a lot of confusion in the industry that other changes were afoot," said Marinac, suggesting the perception of additional punitive legislation hurt all REITs. Combined with poor capital management and the threat of overbuilding, growth investors fled the sector in droves.
By late 1998, however, the contrast between winners and losers was restored, a trend likely to continue in 1999. Winners will include companies with solid management, a conservative capital and growth strategy, and deal candidly with their shareholders. While there are scores of potential "turnaround" candidates in the beleaguered sector, look for companies like
to deliver pleasant surprises in the coming year. That includes companies like
, which are refocusing their efforts on their core competencies and taking a more conservative approach toward real-estate management.
Inevitably, some REITs will struggle. Companies like
and Prison Realty are likely to face continued challenges from past missteps. Others like
, with heavy debt loads and second-tier properties, are likely to be laggards as investors continue to prize asset quality.
Surprisingly, the slip in REIT prices in 1998 didn't spur significant consolidation. The dearth of deals was not due to a lack of interest, but rather a lack of capital.
However, as stock prices pick up in early 1999, and capital becomes more available, look for the "urge to merge" to be rekindled. There are simply too many small REITs that lack the economies of scale to compete. Deals among residential and retail REITs are likely to lead the parade.
Price parameters are likely to be defined early in 1999 as the deal to acquire
by a partnership of
Crescent Real Estate
plays out. The fact that Crescent returned to the table, after pulling out of the original deal, provides anecdotal evidence of a more favorable merger environment in 1999.
As REIT stock prices have drooped, they are bound to catch the eyes of more active investors. As Marinac said, "It is truly cheaper to purchase real estate on Wall Street via REITs than on Main Street through direct investment."
If I hear the word "millennium" one more time, I'm likely to puke. However, the Y2K issue is serious and deserves mention. While better off than many, REITs do have work ahead to prepare for the tick of the clock that carries us toward the next century.
Many REITs have made
disclosures suggesting the Y2K phenomenon will not create "material" costs. However, they do face issues. For example, elevators run by computers must be reprogrammed, keycard locks in hotels and offices will have to be compliant, and security gates in apartment communities and self-storage facilities will have to work. Imagine ushering in Y2K on the top floor of a Manhattan hotel only to find the elevators won't take you down to your room and, once you have walked down 20 flights, your keycard won't open the door.
Some REITs have already had to deal with the Y2K issue. Office, retail and apartment REITs have already promised that their leasing software is capable of managing lease payments and accounting issues. Certainly, more on the nuts and bolts of Y2K and REITs will surface as the date draws near.
In short, 1999 will be
interesting. Next week, a look at your 1999 picks and those of the
REIT Roundtable. It's not too late: Get your best 1999 REIT ideas to me soon. Shoot me an
email with your picks and pans. You'll take center stage next week.
Christopher S. Edmonds is the president of Resource Dynamics, a private financial consulting firm based in Atlanta. At the time of publication, his firm owned shares of Starwood and Prime Retail, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.