Why REIT Earnings Look Set to Slow

Some analysts think the recent REIT rally could be at risk. Plus, more troubles for Prison Realty.
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Sometimes just one quarter can mark a significant turnaround for a sector. After tumbling in the first three months of the year, REIT shares are on a major rebound. Through Monday, the SNL Securities REIT index was up 6.51% year to date vs. a 4.98% gain for the S&P 500 and 2.96% for the Russell 2000, the index of smaller companies that REIT analysts use as a benchmark to gauge the health of the industry. Some analysts, however, wonder whether the rally is sustainable.

One of them is Larry Raiman of

Donaldson Lufkin & Jenrette

. His concern is earnings: He sees annual growth in funds from operations (or FFO, the industry's way of calculating earnings) continuing to slow -- from 12% in last year's first quarter to 9% in 1999's first quarter and 7% to 8% in 2000. "We've predicted for some time that first-quarter 1998 would be the peak for FFO growth," wrote Raiman in a recent report, "and

recent results confirm that view."

Raiman's track record for predicting industry trends is impressive. Early last year, for example, Raiman was alone in

calling the top of the REIT market.

He bases his forecast on certain trends. A mild slowing in the economy means that demand has most likely plateaued for this cycle. That and the fact that new construction has finally caught up with a shortage of available space over much of the past two years mean that supply and demand have finally come into balance.

Raiman is not the only one to share this view. "Strong demand along with the reopening of debt markets has caused much new construction," says Glenn Mueller of Baltimore-based

Legg Mason Securities

. "That is pushing supply at rates higher than demand."

But Raiman also sees an end to the acquisition strategies that had made REITs such dynamic growth vehicles in years past. That was particularly true in 1997 and early 1998. With REIT stocks trading at all-time highs, acquisitions denominated in shares became downright bargains. In contrast, equity capital became prohibitively expensive last year as stock prices plummeted. At the same time, the prices of underlying real estate trended higher, making property acquisitions all but impractical.

That's why he thinks earnings will continue to slow. "Do I think REITs are going to acquire? Yes. Do I think acquisitions will significantly impact earnings growth? No," says Raiman.

If true, that leaves only internal growth -- via lease rollovers and escalators in existing leases -- to fuel earnings gains, and that internal growth rate generally hovers around the inflation rate. Also, new supply will pressure rent increases downward, according to Legg Mason's Mueller. "Rental growth rates have slowed dramatically in many property types due to new supply."

These realities have yet to be reflected in most analysts' earnings estimates, argues Raiman. "Estimates call for 1990 FFO to grow nearly 10.6%," says the analyst, but "we believe earnings growth of 8% to 9% is more realistic. Hence, further downward revisions appear likely in the near future."

One fund manager agrees. "Larry is on the mark," says Sam Lieber of

Alpine Management

. "Estimates are probably on the high side. Many estimates haven't been purged of acquisition growth, which will be minimal." Lieber thinks that most REITs will post earnings growth of between 5% and 9% this year.

That doesn't bode well for the future of the recent rally in REIT shares, according to Carl Tash of

Cliffwood Partners

, a Los Angeles money manager specializing in REITs. "We thought momentum would carry this market higher," he says. "Now we're not so sure." Tash has seen share prices plateau, as if in sympathy with the earnings slowdown forecasted by DLJ's Raiman. "That REITs haven't been able to sustain new highs is a concern," says the buy-sider.

While the rally may slow, Alpine Management's Leiber doesn't think the stocks will return to their winter lows. "There aren't many screaming bargains now, but the stocks are very reasonably priced," he says.

Adds Raiman, "Earnings revisions won't kill the stocks, but there is a chance for flat REIT shares for awhile."

Jailbreak: More Bad News for Prison Realty

As if last week's

news of

Prison Realty Trust's

(PZN) - Get Report

bailout of its operating company,

Corrections Corp. of America

, wasn't enough to rattle investors over its prospects, a breakout at a CCA-managed prison could put a further chill on the stock. The companies share some officers and directors.

Two inmates -- one of whom was serving 220 years for multiple homicides and assault -- escaped from the

Mason Correctional Facility

in Tennessee Thursday afternoon. The jailbreak is likely to reignite debate about CCA's effectiveness, which came under scrutiny last year after multiple stabbings and an escape from its facility in Youngstown, Ohio. While Prison Realty announced encouraging occupancy increases last Friday, some believe the latest bad news will again dampen the company's growth. "They just can't seem to get it right," says one analyst. "Just when you think they're getting all the bad news behind them, the other shoe drops."

This comes at a time when Prison Realty may face some surprising competition: the very state prison authorities it was supposed to replace. "We're finding we can run these facilities for less than private operators," says one correctional executive from the western U.S. "The trend may become to privatize certain services like medical and transportation, but leave prison control and ownership in public hands." If that trend materializes, Prison Realty may find itself penned in for some time to come.

Boston Properties: First Out of the Secondary Box

As REITs have rallied, we've heard rumblings from many companies about raising equity capital. But while most have just made noise,

Boston Properties

(BXP) - Get Report

jumped into the equity markets with both feet, offering 4 million shares at 36 1/4. The stock traded to 36 3/4 Friday, when it was placed by

Goldman Sachs

.

However, the market may not be as receptive to smaller REITs. "Four million shares for a blue-chip isn't a big deal," says another buy-side manager. "A similar deal from a lesser name wouldn't fare as well."

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback at

invest@cjnetworks.com.