Difficult Real Estate Markets Mean Bad News For Reit Investors

Real estate has at some times been a terrific investment and, at other times, a terrible investment. Right now, all available information suggests that real estate, as an asset class, will fare reasonably well through the rest of the decade.

A favorite observation among stock traders, after a long bear market that has finally turned around and moved up strongly, is "The easy money has already been made." Despite weak real estate markets from 2001 through 2004, property values held up well due to real estate's popularity as an asset class. And now, although a recovery is under way, it is unlikely that in most sectors of the real estate industry, property owners will be able to generate growth in rental rates and operating income much in excess of the rate of inflation, which is 2-3 percent annually. Some pockets of opportunity will always surface from time to time, but today most real estate is in "strong hands," and distressed sellers are scarce. Thus, the easy money has been made here, too.

The rapid industrialization and intense competition occurring today in North America, Europe, Asia, and Latin America seem to be major and perhaps long-lasting phenomena. U.S. companies must now go toe-to-toe with foreign competitors virtually everywhere in the world. This, in turn, requires U.S. businesses to be very cost-efficient. Downsizings, restructurings, outsourcing of jobs, and layoffs have been the result. Companies are finding it difficult to raise prices, and employees are finding it equally difficult to get significantly higher wages. The bottom line for real estate investors is that, as long as these competitive trends continue, and if excessive supplies of new developments do not trash real estate prices and create opportunities for bargain hunters, it will be difficult for them to generate returns above long-term norms.

Nevertheless, if real estate investors can obtain initial investment returns of 5-7 percent from property acquisitions and enjoy operating income growth in line with inflation, REITs should remain very solid investments—competitive with other asset classes. Furthermore, many REITS may, at times, be able to take advantage of opportunities presented by challenging real estate environments, just as they take advantage of opportunities in favorable environments.

Excellent managements view difficult conditions and tenant bankruptcies as opportunities. United Dominion went on a buying spree during the apartment depression of the late 1980s and early 1990s, while Apartment Investment and Management and Equity Residential bought huge amounts of undermanaged apartment communities several years later and spread their operating costs over a much larger number of units. Nationwide Health and Health Care Property bought defaulted nursing-home loans from the Resolution Trust Corporation (RTC) at 16-18 percent yields. Kimco Realty bought the properties, and even the leases, of troubled retailers and found new tenants willing to pay higher rents. A number of years ago, Weingarten Realty actually increased its occupancy rates during the Texas oil bust, as many tenants vacated half-empty locations and migrated to Weingarten's attractive shopping centers. More recently, in 1999 Cousins Properties bought The Inforum, a 50 percent-leased office building in downtown Atlanta, for approximately $70 million. It invested an additional $15 million in improvements and signed a new lease for about 30 percent of the building. Within approximately two years, it was earning a return of about 12.5 percent on the total investment. These are but a few examples of how lemons can be turned into lemonade by imaginative and capable real estate organizations with access to capital.

Conversely, it can also happen that a great real estate market is bad for REITs. For example, many REITs saw their profit growth "hit the wall" in the mid-1980s, when real estate prices were skyrocketing. Not only were properties simply not available at prices that would provide acceptable returns, but owners were also facing competition from new construction. Before anyone realized what was happening, the cycle moved into the overbuilt phase and cash flow growth slowed markedly.

As we'll see in more detail later, REITs can grow their profits both internally, through rising operating income, and externally, through property acquisitions and new developments. Poor real estate markets may create external growth opportunities if distressed sellers are numerous, but it doesn't always happen this way; there were few distressed sellers during the last real estate recession, and there were numerous buyers. One never knows how any particular real estate or capital market cycle will play out, but the point here is that strong REIT organizations with access to ample capital may be able to take advantage of opportunities often created by tough real estate markets. While cash flow growth would slow temporarily in response to such difficult rental markets, these REITs' ability, at certain times, to buy sound properties at cheap prices enables them to create substantial value for their shareholders.

mm lll'i The extent to which a well-managed REIT can avail itself of the opportunities presented in a down market depends upon the amount and cost of available capital, the depth of the market weakness, and the extent of competition from other buyers.

Some of the best investment opportunities arise when a company or even an entire industry is overlooked or misunderstood by the great mass of investors. Legendary investors Warren Buffett and Peter Lynch made their reputations not by buying the growth stocks that everyone else was buying, but rather by taking advantage of solid companies with undervalued stocks, often caused by investors' lack of patience or foresight. Buffett's investment in Wells Fargo Bank some years ago was but one example among many.

The same principle applies to REITs. REIT stocks are "all-weather" investments for diversified portfolios, but are particularly attractive when nobody wants to own them. Investors' past fears and hesitations had, for a long time, left these lucrative investments largely undiscovered and, therefore, undervalued. REITs have become more popular in recent years, but myths and misconceptions die hard, and one never knows when investors will again trash them for all the wrong reasons. Those who understand them are unlikely to follow scared sellers to the exits.

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