US REITs have taken a battering. With historically low share prices, do they represent a rare buying opportunity or are their problems permanent? Stephanie Schwartz-Driver reports

The FTSE NAREIT All REIT Index was down more than 32% in the first two months of 2009, on top of 2008's 47% decline. Not only have real estate investment trusts (REITs) plummeted in value, but these normally stable equities have been demonstrating sometimes extreme volatility. Their non-correlation, one of their selling points, is no longer holding true. And some REITs have been cutting their dividends in order to retain capital for development. However, this is not all bad news.

Correlation and volatility are not entirely unexpected, says Brad Case, vice-president, research and industry information at the National Association of Real Estate Trusts (NAREIT). "The last time anything like this happened, in 1987, correlation shot up and volatility shot up," he explains.

"Volatility returned almost immediately to pre-crash levels. Correlation went down as well, although not as rapidly, but it did go down to way below what it had been pre-crash."

In addition, much of the volatility is due to a market peculiarity, notes Al Otero, portfolio manager and managing director at European Investors, which advises Schroders on two global REIT products. "Over the last 18-24 months, the volatility of REITs has been up more than general equities," he admits.

However, one reason for this is the fact that REITs are characterised as financials for S&P purposes: up to 12% of financial services exchange traded funds are made up of REITs. "In the frenzy to attack the financial services sector, REITs have been a casualty," Otero says.

In the case of dividend substitution, investors have tended to view dividend announcement favourably, according to Case. In tracking companies that have made such announcements, NAREIT has noted that prior to the announcement, the REIT would have been as buffeted by the market as any other. But post-announcement, the market responded positively, allowing the REIT to make up lost ground, relative to the rest of the industry.

"Many investors think that dividend substitutions are an appropriate defensive response," suggests Case.

Dividend substitutions are a response to the unprecedented liquidity crisis rather than a change of direction, believes Otero. "This is not a change in philosophy by REIT managements, but a response to the capital environment," he says.

For example, Simon, the mall REIT, has made it clear it is taking dividend decisions on a quarter-by-quarter basis.

Otero believes dividend substitution will become more common. "We will see more REITs reduce their dividend or pay in common stock until capital markets come back," he maintains.

"REITs become more disadvantaged when capital is scarce," Otero says. "There is criticism that they should have seen this coming, that they are over-levered. But it was only in 2006 that they were criticised for being under-levered." At the end of February, equity REITs had a debt ratio (total debt divided by total market capitalisation) of 66.3%; the complete REIT universe had a debt ratio of 72%.

Professor Bernhard Funk, chair for real estate finance and real estate investments at HAWK University in Germany, says: "There are two ways to generate growth: tap the equity and tap the debt markets, or merge with other REITs or property companies. If financing remains a bottleneck, it will become increasingly difficult for REITs to sustain their growth patterns."

He continues: "The message is clear. If the credit crunch continues, investors should look for REITs that have both strong portfolios and conservative debt burdens, mitigating refinancing risks."

"I anticipate there is a market cycle ahead where REIT pricings may go up steeply - the only open question is when exactly," Funk says.

"Valuation of REIT stocks will continue to be impacted by weakening commercial real estate fundamentals in 2009. However, as REIT stocks tend to anticipate future developments, REIT stocks trading at discounts to NAV of approximately 30% cannot be considered a permanent trend," Funk says.

Speaking at the Pension Real Estate Association (PREA) conference in March, David Sherman, president at Metropolitan Real Estate Equity Management, asked: "Should REITs be priced at a premium or a discount to underlying asset value? In my view, they should be priced at a discount, and for some time now." Sherman questions whether, and how, REITs create value, saying: "Only one or two dozen do, some through development, some through overhead. They are less efficient."

The only reason why pricings may remain at this level is if history reveals US commercial real estate as completely overpriced. "This is a rare worst-case scenario," says Funk. "We should be ready to acknowledge that there is a huge potential for upside in REIT pricings, after the worst storm has gone through in the credit markets."

When looking for good bets, buyers have to be discriminating, said David O'Connor, president at High Rise Capital Management, who also attended the PREA conference.

"There's not a lot of thought right now into [separating] which companies will make it and which will not. Short sellers are dominating the market."

In his view, REITs ought to be down around 40%, "because the economy is horrible. The public market is different than what is going on with the underlying real estate."

However, investors interested in going into the market today might well look at REITs. "In the public market, there are no legacy issues," noted O'Connor. In fact, 70% of the delegates at the PREA conference agreed that 2009 is a good year to create or raise a REIT allocation.

In addition, there are some indications that REITs are at or near their bottom, Brad Case explains. Preliminary results of an academic study conducted by David Geltner, director of research at MIT's Center for Real Estate, suggest this is the case. Analysing trading in swaps based on the NACREIF property index reveals that investors think values of properties will go down around 35% and will reach bottom at the end of 2012.

The silver lining in this for REIT investors is that taking this 35% decline in property values with leverage predicts a 69% decline in value - REITs have already seen a 70% decline. In addition, REITs have a history of coming out of downturns before the underlying property values hit bottom.

 "The kind of analyses I'm hearing from researchers and investment managers are making me feel better about the future," says Case.

"As capital markets start to function and settle out, and as we can rely again on an income component, REITs will start to show their expected characteristics," says Otero.

"One positive which is hard to focus on right now, going back to 1995-96 after the real estate recession, there was a great buying opportunity for REITs. But you have to look forward."