The events of October took everyone by surprise, showing that you cannot rely on experience or intuition in this market. Stephanie Schwartz Driver looks for some pointers
A lot can happen in a few weeks. At the end of September, real estate investment trusts (REITs) were reporting positive results, in stark contrast to the broader equity market. But by the end of the October, REITs, too, had plunged, and dramatically. While there are some lessons to be had from previous downturns, the current market conditions are in many ways without precedent. So where will REITs go from here?
At the end of the third quarter this year, REIT investors had reason to be pleased. The FTSE NAREIT Equity REIT Index was up 1.76% for the year through 30 September, and the FTSE NAREIT All REIT Index was down only 1.25%. This was in sharp contrast to broader market trends, with indices showing marked declines - the S&P 500 was down around 19%, the NASDAQ composite down 21%, and the Russell 2000 down more than 10%.
It seemed, at the end of September, that the REIT market had hit bottom in February and that it was on its way back up - in fact, REITs overall were up 6.6% from what seemed to have been the end of the downturn in February to the end of September.
Some sectors were showing particularly strong performance - healthcare REITs were up more than 18% for the year to date, and self-storage was up a whopping 33.8% for the first nine months of the year. There was hope that REITs recovery was a harbinger of better things to come for the economy at large, even though the underlying property values were following a different trajectory.
Everything changed in October, however. By the end of the third week in October, the FTSE NAREIT All REIT index was down 38% for the year. In October's carnage no REIT sectors were immune: industrial/office was down 44% for the month so far, retail down 45%, residential down 32%, and lodging/resorts down 45%.
Healthcare and self storage continued their relatively stronger performance, both down only around 25% for the first three weeks of October; year to date, both showed the least negative performance, with self-storage registering an overall decline of only 3%.
The fact that October's market shock infected REITs put paid to one of their major benefits in an equities portfolio. Traditionally, the correlation between REITs and the broader equity markets has been quite low, but this time REITs have plummeted along with the rest of the market. In the current market environment, historical precedent has been blown away.
"What happened in October I can't make sense of," says Brad Case, vice-president, research and industry information, at NAREIT. For those investors looking for whatever defensive play they might be able to make, Case notes that REITs might offer a little more downside protection than other classes of equities, because REITs may well be closer to their bottom than the rest of the stock market.
He also points out that REIT dividends are by and large protected: while a non-REIT company in financial trouble does not have to make any distributions, REITs dividends are guaranteed. "For people looking at total return, this is some protection," notes Case.
However, REITs are expected to look at cutting their dividends in order to bolster their capital base, especially if the current economic downturn seems as if it is going to last. The market isn't recognising the dividend protection offered by REITs as an advantage and valuing it in their pricing.
LaSalle Hotel Properties, for one, announced along with its third-quarter results that it was cutting its annual dividend by 51% to provide liquidity over the next two years, foreseeing that tough times are set to continue through 2009.
The cut means it will benefit from $100m (€79m) of extra liquidity over the next 26 months, according to a statement released with its third-quarter results. The annualised dividend equates to $1.02 per common share, approximately a 9% yield.
So where does the current market downturn leave REITs? Case looks back at previous downturns to see whether they give any indication and notes that in the late 1980s - an economic downturn similar in its severity to the current one - REITs lost 24% of their value, but this loss was then followed by a seven-year bull market with average returns of 20% annually.
He also notes that REITs seemed to hit rock bottom in February 2008, just as commercial property values hit their peak. Such a lag in commercial property values suggested that commercial property would continue its decline.
REITs are selling at a discount to net asset value (NAV), a good sign for bargain hunters. Historically, REITs have tended to trade at a slight premium to NAV - in 2007, in fact, they were selling at a significant premium, leading many investors to look at this valuation gap and judge them overvalued. They hit equilibrium at the beginning of 2008 and have since headed into undervalued territory.
Case has found heartening historical trends here. "When REITs are selling at a discount to NAV, they do roughly 9% better than you would expect against the broad stock market," he says. "And when they are selling at a big discount to NAV, they do roughly 13% better."
Today, REITs are trading at a sizeable discount to NAV, notes Thomas Kirtland, managing director, PricewaterhouseCoopers in New York. "That means that the market is forward-looking, trying to anticipate what is down the road.
It might possibly be that the public markets may be saying that, given the way that REIT stocks are trading, commercial real estate prices have a way to fall yet." To return to equilibrium, either share prices will have to rise, or property prices will drop. "The likely outcome is probably somewhere in between."
Uncertainty is the order of the day, however. "I do not think you can rely on experience or intuition in this market," says Kirtland.
However, the fact that you can value REITs on the basis of NAV is something of an advantage in these tumultuous times, he points out. "Most of their value is in their real estate. We can value that. If other companies could do that, they would."
Because REITs are backed by a tangible asset, they can be valued with a level of assurance not found with other equity types. "It is harder to overvalue REITs," says Case, who also points out that there is a large community of analysts as well as property appraisers behind the valuations offered.
REITs are suffering now in part because their underlying real estate is declining in value. "October's drop is the result of several factors," says Kirtland, "but fundamentally, it's real estate and it's leverage. Has the market overshot the mark? Who's to say?"
Case offers another reason for the reversal of fortune experienced by REITs.
He attributes part of the problem to the fact that REITs are generally classed as financial stocks, a historical legacy that no longer reflects reality. "The name ‘trust' conveys an idea of something that has not been true for 15 years now - but it remains the accepted industry classification."
This is despite the fact that mortgage REITs, the only category that merits the financial classification, account for only 4% of the total US REIT universe. In practical terms, this classification means that a mutual fund or an ETF that invests in financials will also include REITs - and if it is spooked and unloads, REITs are also unloaded.