Sing A Long with REITS...
Like a bolt out of the blue
Fate steps in and sees you through
When you wish upon a star
Your dreams come true
By A.D. Pruitt
The Wall Street Journal
10/19/10
As earnings season gets under way for real estate investment trusts (REITS), analysts are warning it isn't going to be pretty.
High vacancy rates and low market rents are continuing to drain cash flows from office, retail and industrial buildings even as many analysts and economists predict an industry bottom will emerge this year. Hotel and apartment companies are expected to be the strongest performers given an increase in corporate and leisure travel and a growing population of renters.
"I think earnings will be weak. The idea we're going to have robust earnings is just not going to happen in most property sectors," says Mike Kirby, director of research for Green Street Advisors, a firm based in Newport Beach, Calif., that closely tracks REITs.
But the tepid earnings represent a disconnect from the performance of REIT stocks this year, which have outshone the broader market.
For instance, The Dow Jones All Equity REIT index, which tracks 155 REITs, was up 12.8% for the third quarter compared with returns of roughly 10% for the Standard & Poor's 500-stock index and the Dow Jones Industrial Average.
The reason: Investors are looking past the current weak fundamentals and into next year, where a strong recovery is expected to take root.
REITs also are benefiting from the greater availability of credit in commercial real estate and the hunger of investors for higher yields.
Most REITs pay substantial dividends because of the rule that they must pay at least 90% of their taxable income out as dividends.
But dividends at some REITs may come under pressure if rents and occupancy rates continue to fall.
Mr. Kirby anticipates weakness in both property-level earnings and funds from operations, a key profitability measure for REITs that translates into earnings before depreciation and amortization.
"In most property sectors, vacancy rates remain very high and rents are staying quite low," Mr. Kirby said. He said, in general, fundamentals are bouncing along the bottom and cash flows are still declining, albeit slightly.
The office vacancy rate was 17.6% for the third quarter, a 17-year high, according to research firm Reis Inc. The firm noted effective rents have declined 12% to $22.04 a square foot from the peak in 2008. But the rate of deterioration slowed in the third quarter in a sign the market is stabilizing.
Richard Anderson, an analyst at BMO Capital Markets, says the earnings releases for Boston Properties Inc. and Vornado Realty Trust will serve as bellwethers for the market.
"There are pockets of optimism, [but] as a general rule, the office business remains weak," Mr. Anderson says. "It remains a tenant's market for the most part. They are negotiating better deals for themselves [and] are reluctant to make long-term commitments to their space, as the economy remains in a state of flux."
For retail, the vacancy rate hit 10.9% for the third quarter, close to the historic high of 11% in 1990, and the firm projects the national warehouse vacancy rate to reach 11.7% by the end of 2010, a 0.3-percentage-point-increase from the end of 2009, according to Reis.
Earnings from hotels and apartment operators are expected to come in relatively stronger compared with other sectors, although they will likely be far from robust.
Host Hotels and Resorts Inc. last week said third-quarter funds from operations were flat on a per-share basis at 11 cents, but revenue rose 11% to $1 billion. The lodging sector, one of the hardest-hit during the economic downturn, has been on the mend as steep cuts in rates draw in more corporate and leisure travel.
Haendel St. Juste, an apartment REIT analyst at Keefe, Bruyette & Woods, said earnings by apartment operators should improve sharply because demand for rentals has surged amid the housing crisis.
"People don't want to buy, they want to rent these days," said Mr. St. Juste, referring to the wave of national foreclosures and perceived disincentives to buy new homes. He noted that every 1% decline in home ownership adds 1 million to 1.5 million new renters to the market.
His firm expects average funds from operations for apartment operators to decline about 3% during the third quarter from the same period last year.
The national apartment vacancy rate stood at 7.2% at the end of third quarter, according to Reis. That was down from the second quarter's 7.8% and 7.9% at the end of the third quarter a year ago.
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