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Low-Leverage REITs Lead To ‘90s-Style RE Revival

Guarded optimism returned to the hallways at NAREIT’s conference last week, replacing the economic gloom and doom that shrouded the last real estate investment trust industry gathering in San Diego last November. But for all the talk of “green shoots” in the credit markets and broader economy and this spring’s stock market rally, it still remains to be seen whether the recent rallies in REIT share prices and the raising of nearly $15 billion through 45 public equity offerings since the beginning of the year will take root in an economic landscape littered with continuing job losses and weak property fundamentals.

Certainly, attendees of the National Association of Real Estate Investment Trusts REITWeek conference were in a less dour mood. And why not — equity REIT share prices, which fell 15.7% in 2007, nearly 38% in 2008 and another 39% in 2009 before reaching a low in 2010,  have since rallied by more than 60% through June 9, according to the MSCI US REIT Index.

The optimism has been fueled by the “re-equitization” of many REITs through secondary offerings over the last few months. NAREIT released an analysis last week predicting that publicly traded REITs will raise $582 billion for acquisitions representing $728 billion in property value, including debt, by the end of 2012. The surplus equity should begin to create acquisition activity by the second quarter of next year.

Just two months ago, analysts said the amount of equity being raised would come nowhere near the need. Citigroup estimated that REITs would need $35 billion in total equity to bring the sector down to 50% leverage at a presumed 8% cap rate. To reduce leverage to 45% would require $57 billion in equity.

While conference panelists agreed that raising the necessary equity will be a tall order, REITs could reduce their average debt from the current 53% to as low as 25% if NAREIT’s prediction comes true. That would free up capital for a reprise of the early 1990s, when investment trusts led the way out of a previous commercial real estate recession by using equity raises to fund massive purchases of distressed assets.

Survival of the Equity-Richest…

Meanwhile, many public companies that went private during the private-equity boom of 2005-07 will likely re-emerge in coming years as REITs, at vastly lower leverage of course. With stepped up IPOs, acquisitions and increased market capitalization, REITs could grow to a 31% share of the broader commercial real estate market by the end of 2012 from roughly 5% at present, according to NAREIT. Firms raising equity capital in recent months include retail and office owner Vornado Properties Trust, mall operators Simon Properties and Kimco, data center developer Digital Office Properties Trust, among numerous others.

A number of entities have filed for initial public offerings, mostly to become mortgage REITs. Most recently, Starwood Capital said in a filing that has launched Starwood Property Trust (SPT), which will register as a REIT and raise as much as $500 million in an IPO to buy distressed commercial and residential real estate. Barry Sternlicht, former chairman of Starwood Hotels, will be the CEO.

The entity will use financing from the government’s Term Asset- Backed Securities Loan Facility (TALF) and Public Private Investment Program (PPIP). Starwood Property said in its filing, “we believe that the next five years will be one of the most attractive real estate investment periods in the past 50 years.”

Access to public markets will separate the REIT “haves” from the “have-nots” over the next three to five years, but will also provide a distinct advantage over their debt-riddled and capital challenged rivals in the private sector, panelists agreed during a session on REITs and investing last week.

“Re-equitization creates a huge opportunity,” said Thomas Carr, former head of CarrAmerica Realty Corp. and current managing partner of Federal Capital Partners, a private REIT specializing in acquiring assets in and near Washington, DC. “This is one of those watershed events like the early ‘90s where the public companies have an opportunity to dominate. Private market fundamentals will continue to deteriorate for at least the next 12 months.”

“Demand for REIT equity has been incredibly robust,” said Debra Cafaro, chairwoman, president and CEO of Ventas, a healthcare REIT, during another session. “The mere act of raising capital by REITs has fueled a virtuous cycle of an improving equity market for REITs that has in turn led to more equity raisers and engendered more investor confidence.”

“With confidence returning to the REIT, debt and equity markets, the REIT picture looks brighter, although certainly not clear,” Cafaro said.

The public markets are likely the only source of capital that can fill the void in the commercial real estate industry’s “huge mess” of maturing debt and weak fundamentals, said Mike Kirby, chairman and director of research at Green Street Advisors.

“There needs to be enormous amounts of new equity coming in to recapitalize the commercial real estate industry,” Knott said. “That number is certainly over $100 billion; it’s probably a multiple of that in terms of total equity capital that real estate needs.”

With private equity mostly unable to raise new funds and pension funds for the most part unwilling to allocate capital to real estate, “the public market will be driving everything. Its cost of capital will be driving real estate pricing,” Knott said.

“It could be a very profitable time because when your cost of capital drives the prices of the assets you’re buying, it’s almost guaranteed to be a pretty good business.”

Recovery: Still a Gleam in the Eye…

Despite the opportunities for REITs, recovery from the worst recession since the 1930s is nowhere on the horizon for either commercial property markets or the broader economy. Job losses will extend well into next year. Occupancy and lease rates continue to deteriorate.

“The fundamentals I think are going to be as big of an issue that the financing issue has been in the last six months,” said Knott’s co-panelist Kenneth Rosen, chairman of Rosen Consulting Group.

The new money that will flood into the system from equity, new Federal Reserve policies and government stimulus could help reverse some of the pain from job losses by next year, Rosen said, “but it’s only going to create a more moderate recession. We’re not going to go into a recovery. We’ve lost 5.8 million jobs, most of them in the last six months. We can’t really say there’s light at the end of the tunnel for the real estate sector.”

Hamid Moghadam, chairman and CEO of industrial owner and developer AMB Property Corp. (NYSE: AMB), said that unlike debt-free companies like Microsoft and Cisco, it’s very difficult for real estate companies to operate without leverage.

“Real estate has this huge private market on the side that is highly levered. I maintain it’s because nobody is prepared to tell their investors that real estate is a low teens return business,” Moghadam said. “Unless you tell people that it’s 25-30%, you can’t raise money. It’s a circle that keeps picking up speed until it hits the wall and everyone gets super conservative again.”

People just got mesmerized by astronomical returns, Rosen noted.

“Core real estate is a 6- 7% return, with growth into the low teens. Anything else is produced by leverage and high risk. That’s enough return. If you want more than that, you’re gambling.”

Carr said one of the main lessons of the last two real estate cycles is “anytime you get too much cheap money in the hands of real estate people, it’s a dangerous moment. You start seeing massive investment at unprecedented levels.”

“The one question I would urge any investor to ask is, ‘what do you have to believe in terms of the future and growth rates, order to think this is a good investment?’”

Zell, Zuckerman Weigh In…

Not surprisingly, two of CRE’s most conspicuous icons, publisher and Boston Properties Chairman Mort Zuckerman and Tribune Company head and Equity Group Investments Chairman Sam Zell, remained bullish on REITs and predicted that companies with strong cash positions will absorb weaker rivals weighed down by maturing debt and troubled assets.

The men differed during an exchange at the conference on such issues as whether a large number of IPOs will be launched or whether government stimulus and the Federal Reserve policies such as the TALF will help the market. But they agreed that REITs have a bright future.

“The REIT model has worked,” Zell said. “17 years is not a very long period of time for an industry. The last 12 months have been a test and the industry has passed. Frankly it has passed with flying colors.”