REIT stocks have been under pressure for the past few months, and some analysts say a nasty short-term correction could be in order, especially if Treasury yields continue to rise. But bulls, when asked why they like the sector, often offer a very simple reason: "It's the dedicated pension fund money, stupid!" Glenn Mueller, a real estate investment strategist with Legg Mason and endowed chair of real estate at Colorado State University, hammered this message home, although a tad more eloquently, at the recent National Association of Real Estate Investment Trusts convention in Chicago. On a panel that was supposed to consist of bulls and bears, Mueller found himself as the lone REIT bull. Mueller argued that there is $50 billion of pension fund money sitting on the sidelines ready to be invested in direct commercial real estate properties and REITs. Because of this "dedicated" money, there is a floor for REIT prices -- meaning they can't drop too low, he said. "With $50 billion of capital standing ready to invest in private direct real estate, I believe there is a floor under REIT prices, as the private market will buy any REIT whose price drops below its net asset value," Mueller explained in a follow-up interview after the conference. (Net asset value, or NAV, is a method of determining the underlying value of a REIT's real estate portfolio based on real estate transactions in the private market. If a stock trades below the NAV estimates that sell-side analysts publish, then some argue it's cheap, and vice versa.) The overall money that goes into commercial real estate helps drive up prices and drive down property yields, helping the market think REITs' valuations are cheap based on their current NAVs. Mueller's idea is that if REITs look too cheap, then institutions will come in and either take companies private or buy up shares, providing a floor under pricing. Mueller's argument, which comes at a time where
more and more analysts on turning bearish on REITs for the short term, rests on certain propositions. One of the larger ones is that a privatization trend will continue to help the sector in the face of so much bearish sentiment.
This year, five public REITs have been taken private, with private equity groups and pension fund money paying premiums for the stocks. In the case of apartment REIT AMLI Residential Properties Trust ( AML), Morgan Stanley's Prime Property Fund paid a 21% premium to where the stock was trading, which suggests that the public markets were undervaluing AMLI's real estate assets. Mueller and other industry watchers believe this privatization trend will continue so long as REITs look cheap vs. what they would fetch if their assets were sold in the real estate market. Mueller is probably right about this privatization trend to a point. But some REIT watchers, like Barry Vinocur, longtime editor of Realty Stock Review, think it is absurd to suggest that every REIT that trades below NAV will be bought out. Not every piece of REIT-owned real estate is valuable, and some management teams have done a poor job of creating value. Another issue altogether is whether the $50 billion figure Mueller cites as money sitting on the sidelines is reliable, given that it's a number that's difficult to gauge. Mueller was unavailable to clarify how he derived that figure. This year, pension funds are projected to invest $51 billion into commercial real estate, according to a survey of funds conducted earlier this year by Institutional Real Estate, a Walnut Creek, Calif.-based consulting and publishing company. Of that, $3 billion is projected to flow directly into REITs. Unfortunately, there's no good data that shows much has actually been invested so far. Recently, there have been some big votes of confidence in REITs. For example, the Los Angeles Police & Fire Pension System is edging toward allocating up to 15% of its real estate allocation (roughly $180 million) to REITs, Vinocur said. Today, the average pension fund has an 8% target allocation for real estate in its portfolio, with 16.6% of the real estate portion invested in REITs and the remainder in direct properties, according to the research firm. Going back to 1997, the target allocations have been in the 7% to 8% range every year, with the exception of 1999, which saw a drop-off to 5.8% as pension funds flocked to booming tech stocks.
Because not all of the target allocations have been invested, there is always money sitting on the sidelines. Lately, more and more money seems to be sitting it out, since finding attractive yields in real estate is difficult given all the money that is chasing the sector. However, trying to get an exact handle on the amount of money waiting to be invested at any given time also is a tricky task, says Doug Poutasse, chief investment strategist with AEW Capital Management, one of the largest real estate investment advisers for pension funds. Another difficulty is figuring out whether this money is really "dedicated" or not. "I think all estimates of the 'on the sidelines' amount are highly subjective," Poutasse wrote in an email. However, he said it is true that considerable funds have been "hard committed" through closed-end funds that gather money to invest in direct properties, and that money will stay in the market almost regardless of relative opportunities. "A lot more is targeted but not legally committed, and I think it is pure guesswork as to how this will move. The stock market (U.S. at least) is not exactly lighting anyone's fire this year," he wrote. So in the end, even though pension funds have a good track record of committing money to REITs in the past, perhaps this money shouldn't be fully relied upon, given where the market might be heading. As Jonathan Litt, a Citigroup analyst also present on the NAREIT panel, reminded the audience in Chicago, all the money chasing Internet and tech stocks in the late 1990s looked pretty dedicated too, at the time. However, Litt did grant that there is also some floor under REIT pricing, but didn't estimate how low. Sure, there might be some more takeouts of public REITs in coming months. Arden Realty ( ARI), an office REIT focused on the Southern California market, has been mentioned as a company that could be soon bought out around $50 a share, representing about a 10% premium to where it trades now. Post Properties ( PPS), an apartment REIT, has also had its name thrown around as a takeover candidate. But with the two-year Treasury note yielding around 4.4%, REITs will continue to be under pressure as a yield investment. Some REIT watchers, like Ken Rosen of the Rosen Real Estate Securities, are
predicting REITs could decline as much as 20% next year if the yield on the 10-year note pushes above 5.5%. If that's the case, it's hard to see how much of a cushion pension funds could provide to the sector.