Residential REITs are the subject of much institutional investor interest - indeed some pension funds are increasing their positions, as Stephanie Schwartz-Driver reports

Although the commercial real estate universe is being battered by current economic conditions, second quarter results showed a little bright light, when residential REITs showed a year-to-date increase in total returns of nearly 16%. Apartments led the charge, rising 16.74%, offsetting a small decline by manufactured homes of -0.34%.Overall, REIT returns continued their significant outperformance in 2008. Although the FTSE NAREIT All-REIT Index posted a double-digit decline in June, it was up 2.8% in July; the FTSE NAREIT Equity REIT Index was up 3.5% for July."Most of 2008 has been tough for most of the industry," said Brad Case, vice president, research and industry information, at NAREIT. "Equity REITs overall are down for the year, but self-storage and residential are both up." In Case's view, residential REITs are faring well in terms of the supply and demand balance. "Investors are optimistic about the demand for apartments and the supply of apartment stock. In terms of the other REIT sectors, investors are optimistic about supply but less so about demand."There are several reasons for the early recovery of residential REITs, in Case's view. One is the simple fact that residential REITs hit their bottom earlier than other sectors - while residential hit bottom in December 2007, the other sectors did not reach their lowest point until February 2008.
This early decline is partly attributable to an over-reaction to the residential housing crisis. Keith Guericke, president and chief executive officer of Essex Property Trust, laid out the scenario. Some 18 months ago, Essex was trading with a share price of around $140 (€96) . "Then sub-prime hit the news, and everybody panicked. They painted everything called residential with the same brush, and our share price fell to $88," he said. "Around nine months ago, we started talking to our investors, beginning an education process, and our share price has corrected to more than $120."
This process of correction is not necessarily a bad thing, Guericke believes, insofar as it is cooling off the effects of an overheated market. "At one point, our multiple was 26 or 27, whereas historically it stood at 16 or 17. We got too expensive on the up side," he said. "Now we are holding at a multiple of around 19 or 20, closer to the historical averages."

Although it is said that the recovery in REITs precedes a recovery in the general market, there are no historical precedents to suggest this is the case. "I'd like to point to other examples in the past when residential has led a recovery - for some reason the sector is leading this time," said Case.There is one significant historical pattern that Case does nod to as a source of optimism. "The REIT industry as a whole has been in a downturn. Previous downturns have not been as severe - but they were followed by seven years of outperformance by REITs compared to the broader market," he explained. "So this downturn is likely also to be followed by a significant period of outperformance."
Multifamily sector has been buoyant as it has been buffered from the credit crunch afflicting real estate development. Capital has continued to flow into multifamily development, provided by Fannie Mae and Freddie Mac - it is part of the charter of both agencies to support affordable housing initiatives.While transactions are down across all property sectors, multifamily has declined less than other sectors, according to Real Capital Analytics. For example, in the first quarter of 2008, office sales fell by 80% and retail by around 70%, against a decline of only 40% in multifamily. Some of these deals have been facilitated by Fannie Mae and Freddie Mac.
However, residential REITs are having to ride out some market uncertainty about the future of Fannie Mae and Freddie Mac. The agencies, which are government-sponsored enterprises, owned by shareholders and publicly traded, have been hit hard by rising delinquencies in the residential mortgage space.
Fannie Mae was founded in 1938, an initiative of Franklin Roosevelt's New Deal to move the country out of the Depression, with the goal of providing liquidity to the mortgage market. It had a virtual monopoly on the secondary mortgage market until Freddie Mac was established in 1970 following Fannie Mae's privatisation. Freddie Mac was intended both to expand the secondary mortgage market and to eliminate Fannie Mae's monopoly.

Fannie Mae and Freddie Mac have been hard hit by the sub-prime crisis. Together they guarantee or own around half the outstanding home loans in the US. While investors have long believed that their government charter meant that Fannie Mae and Freddie Mac had government backing, this is not explicitly the case. In July, however, as their share prices were rocked by market uncertainty, the government did step in to pledge government funds to keep the two agencies operational, offering lines of credit or the possibility of a US government equity investment.This government intervention is significant to the multifamily sector because it has focused public attention on Fannie Mae's and Freddie Mac's ambiguous status. Rumours have circulated that the Federal Reserve is looking at possibilities of regularising their status, either fully privatising or nationalising the two agencies or even breaking them up. Any change in their operational status could threaten their affordable lending programmes, which have traditionally focused on the multifamily space and which have kept this real estate sector positive.

Ric Campo, chairman of the board and chief executive office of Camden Property Trust, sees the recent government moves to support the two agencies, including July's housing bill, as "a guarantee" that Freddie Mac and Fannie Mae will continue with business as usual. In the first two quarters of 2008, Fannie Mae invested some $20bn in the multifamily sector. "The recent turmoil with Fannie Mae and Freddie Mac is about their shareholders, not about their lending programmes," said Campo.
Guericke is also confident that Fannie Mae and Freddie Mac will continue to provide financing to the multifamily sector. "We do a lot of business with Fannie Mae and Freddie Mac and we talk frequently to the officials there." He stressed that the troubles the two agencies face are with residential mortgages, not with their multifamily operations. "If you disaggregate their portfolios, there is very little default in the multifamily sector - it is a very profitable part of their business." In 2007, defaults on multifamily loans sponsored by Fannie Mae were at 0.08% and sponsored by Freddie Mac were at 0.02%, according to the Mortgage Bankers Association. Any injection of profitability is significant as the agencies struggle to control their bottom lines. In August, both Fannie Mae and Freddie Mac announced that they would be scaling back their purchases of mortgage securities. Fannie Mae also noted that it would be focusing more on jumbo loans - bigger loans to more financially stable buyers - rather than on the conforming loans that had been its regular target, in order to improve its profitability. These moves seem to conflict with the mandate to protect the market for ordinary homebuyers and may be perceived as threatening the two agency's special status.Despite the rumours, Guericke does not anticipate a change in their status. "They will only change if Congress comes in to change them, and I do not know why Congress would want to," he said.
 In current market conditions, apartment REITs in particular are benefiting form the interaction between the rental apartment market and owner-occupier markets, said Case. "People are hesitant to buy, so instead they are renting."
Guericke has seen this trend in action. "Historically, 20% of our tenant turnover was because people were leaving to buy new homes. Today, home buyers account for only eight to 12% of turnover," he said. Essex has also seen a decline in total annual turnover from around 60% down to 52%. Campo has seen a similar pattern. "At its peak, around 24% of tenants who moved out were buying their own homes; today buyers account for only around 14%."Essex attributes its own good fortunes partly to its geographical focus. All its properties are on the West Coast, tending to stick within 30 or 40 miles of the coast in areas of high population density.While there have been some job losses in certain southern Californian sub-markets, northern California, Washington and around Seattle have remained strong job markets. "Our performance has been driven by markets with positive job growth," said Guericke. In 2008, Essex has experienced 96.5% occupancy, with rent growth of 7-8% in northern California and Washington and 2-3% in southern California.
 

Guericke anticipates that overall strong performance is sustainable through to the end of this year, after which growth will tail off somewhat in northern California and Seattle. In 12-18 months, he expects that southern California will start to pick up again.
Two other companies in the residential REIT sector - American Campus and Education Realty Trust - specialise in student housing, a growing sector. These two REITs have returned more than 10% each year to date as they seek to capitalise on a new market in quality student housing. The developments run by these operators provide amenities more typical of luxury apartment complexes than college dorms, with new and well-maintained buildings, private rooms and bathrooms, and leisure facilities such as pools and basketball courts.While most developments to date have been off-campus in nearby locations with good transportation connection, some universities have been moving to privatise their dormitory provision, offering long-term ground leases to developers who will fund building on campus and manage the properties.
In order to weather the turmoil in the immediate term, Campo is undertaking a conservative three-pronged strategy. "The first is to make sure that we have adequate liquidity. Second, we are being very cautious on development starts, and right now we have a $2.5bn development pipeline. In some markets it is better to slow down. And the third is that we are focusing on the basics."This caution does not mean that Camden is avoiding more opportunistic strategies when they are appropriate. For example, the firm is engaged in buying back its own stock, when it finds that it can buy back from hedge funds at 90 cents on the dollar at current valuations. Camden has also raised a $375m multifamily value fund, which can be leveraged up to 70%. "We are now deciding how to deploy this," said Campo, adding that he also sees some opportunities in mezzanine financing.Unlike other REIT sectors, residential REITs attract significant institutional investor interest: Campo reports that Camden is around 85% institutionally held, and Essex Property Trust is around 90% institutionally held. "The top companies in the sector have significant institutional appeal," said Guericke, "particularly those companies that have always shown strong performance.""We have a lot of institutional investors increasing their positions," notes Campo, who  adds that "investors are nervous about everything, but we have not felt any investor jitters."
 

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