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The Speculator
9
reasons REITs are about to get rocked
Real estate trusts beat the market in
2000 and 2001, but a storm is gathering that will blow that trend
away. Here's how we'll play it.
By
Victor
Niederhoffer and Laurel Kenner
What emerged was pent-up supply. It came out of
left field.
-- Justin Stein of Grubb & Ellis,
quoted in Crain’s about the unexpected softness of the Manhattan
real estate market in 2002
Somber black storm clouds are
gathering over real estate investment trusts (REITs). REITs gained
26% in 2000 and 16% in 2001. The margin of superiority over the
S&P 500 ($INX)
-- some 100 percentage points over the two-year period -- was by far
the greatest in at least 30 years. The Y2K numbers are particularly
troubling because there is a strong tendency for large gains in
REITs in any one year to be followed by below-average performance
two years later. We consequently are planning to buy some S&P
500 shares and to take a small short position in five REIT stocks to
take advantage of the divergence.
We
see a vast number of early warning signs that REITs are heading for
a decline. Here are eight that are particularly troubling to
us:
Vacancy rates. National and local vacancy rates in
the office, apartment and hotel sectors are expected to rise sharply
in 2002. The rise will put pressure on rental rates. Already,
tenants are negotiating better deals. The best research we know of
on real estate cycles, a truly comprehensive PricewaterhouseCoopers
study based on 20 years of prices for every major metropolitan
statistical area broken down by type -- i.e., office, apartment,
industrial, residential, hotel and warehouse -- indicates that
rising vacancy rates are the most accurate signals of a decline in
prices. And vacancy rates are rising, especially in commercial real
estate such as offices and apartments. (Note that we're not talking
about direct investment in single-family homes, which tend to hold
their value barring a giant run-up in interest rates or a regional
economic downturn, such as what defense cuts did to real estate in
California and Connecticut in the early
1990s.)
Downgrades. More and more well-connected,
highly respected firms with every reason to be as friendly as
possible to the REIT industry are beginning to lower their opinions
of real estate’s prospects in 2002. Morgan Stanley analysts were
quoted Dec. 17 in The Wall Street Journal as seeing “negative
earnings momentum” and “no real catalyst for earnings expansion,”
while Merrill Lynch, in a Dec. 19 research comment, saw “muted price
appreciation” in “this late-cycle sector.” If brilliant analysts
covering the industry full time, with many tempting reasons to be
bullish at all times, are this cautious, we can almost see the
lightning ready to strike.
Fuzzy accounting. A recent
report from Green Street Advisers, the most scholarly and studious
firm of all we have encountered in the field, found evidence that
REIT funds for operations, the measure most investors look at, were
lower in 2001 than in 2000, but that companies are obfuscating the
picture with non-recurring write-offs and extraordinary charges --
an all-too-familiar practice these days. (A REIT is a special
corporate form that provides a lucrative tax break: it pays no
income taxes so long as 90% of its taxable income is distributed to
shareholders as dividends.)
Popular books. The
hottest growth area in the financial publishing industry is real
estate. "Investing In Real Estate" by Gary Eldred and Andrew McLean
and "J.K. Lasser’s Real Estate Investing" by Michael Thomsett are
selling particularly well. Book sales tend to be a lagging indicator
of what’s likely to make money. Recall the rash of day-trading and
Dow 40,000 books that proliferated at the millennium, just before
the stock market’s debacle.
Slow economy. Real estate
is driven by income and employment. We are in a recession now, but
it hasn’t affected real estate...yet.
S&P 500
membership. The arbiters of Standard & Poor’s, after
intensive lobbying from the industry, added three REITs to the
S&P 500 Index at the end of 2001 and beginning of 2002:
Equity Office Properties (EOP,
news,
msgs)
on Oct. 10; Equity Residential Properties (EQR,
news,
msgs)
on Dec. 3; and Plum Creek Timber Co. (PCL,
news,
msgs)
on Jan. 16. As our colleague and editor Jon Markman has shown,
stocks that are removed from the index outperform the ones that are
added. (Equity Office and Equity Residential are the top two REITS
ranked by market cap. We should note both are controlled by Sam
Zell, the Chicago investor famed for swooping in on distressed real
estate.)
Doc Greenspan. The venerable Fed chairman,
who saw irrational exuberance in the stock market in December 1996
at Dow 6,437 and excessive inflation in late 2000 when he
spearheaded repeated increases in the federal funds rate, is now
sounding the horn for the great stability of real estate prices.
(The inflation rate in the last quarter of 2000 was actually 3.4%.)
He is pleased that the wealth effect from rising residential real
estate values has cushioned us from the violent declines in consumer
spending often triggered by layoffs and the drop in the stock
market. Why does this remind us of a dying man clutching at straws?
Luck. REITs have had an excess of good luck recently.
In July 2001, privately held Silverstein Properties, one of New
York’s biggest property owners, beat our three top office REITs --
Vornado Realty Trust (VNO,
news,
msgs),
Brookfield Properties (BPO,
news,
msgs)
and Boston Properties (BXP,
news,
msgs)
-- to buy the Twin Towers of the World Trade Center for $3.2 billion
in the city’s largest real estate transaction ever. It is
regrettable that good luck tends to be mean-reverting, with
expectations for future good luck remaining constant regardless of
the past path. But stock market values over time tend to reflect
good luck’s continuity.
And one more
reason…
All that we need to add the final nail to the
coffin, as far as we’re concerned, is a cover story in a major
magazine extolling REITs’ great future prospects and current
dividend yields. Such an article did appear in the Dec. 29, 1997,
issue of Forbes, titled: “The Unstoppable REIT Juggernaut. Forget
Industrial Stocks. For the next few years, real estate is where the
action will be.”
There was action, but not the sort
contemplated by Forbes; $100 invested in industrial stocks at
year-end 1997 resulted in a final sum of $150 by the end of 1999,
some 100% higher than the same sum invested in REITs. This despite
the many advantages of REITs cited in the article, including vastly
improved earnings visibility, cheaper cost of capital,
diversification and the high likelihood of takeovers. The article
concluded with words just as true today as when written four years
ago: “Could something go wrong and stop the REIT juggernaut? Long
run, it is unstoppable, and big fortunes are being -- and will be --
made here.”
But not by us in 2002.
There is one
overriding positive for REITs that everyone who’s bullish on the
industry holds out as a rudder. Dividends of REITs are currently
running at 7% a year, and those dividends have managed to increase
for those that survived hard times through the economic cycle. These
dividends obviously look very good compared with alternative yields
of about 1.5% on stocks and 2% on Treasury bills. And yet, these
same arguments on REITs held in 1987 when REITs underperformed the
S&P 500 by some 50%. The dividend yields from REITs are
consistently above reported funds from operations. Thus, they
represent to us returns on capital, and these, as we know from our
personal and financial lives, cannot continue without ultimately
paying the piper.
Excessive optimism would be troubling
enough in any industry. But in real estate, the sector with the most
notorious boom-and-bust cycle of all, it’s terrifying.
We
nevertheless resorted to our trusty pencils and backs of envelopes
to support or refute our theory before we could consider unloading
it on our faithful readers. Happily, the test bore us out. We found,
going back to 1971, a --0.35 correlation between the return in REIT
prices in one year and the change two years later. Thus, the change
in 2000 inversely predicts the change in 2002. The chart below
illustrates the terrible story of cyclicality just in the last 10
years. Results show total return, with reinvested dividends and
capital appreciation.
| REIT returns vs. S&P 500 since
1991 |
| Year |
REIT returns |
S&P 500 return |
| 2001 |
15.50% |
-13.04% |
| 2000 |
25.89% |
-10.14% |
| 1999 |
-6.48% |
19.53% |
| 1998 |
-18.82% |
26.67% |
| 1997 |
18.86% |
31.01% |
| 1996 |
35.75% |
20.26% |
| 1995 |
18.31% |
34.11% |
| 1994 |
0.81% |
-1.54% |
| 1993 |
18.55% |
7.06% |
| 1992 |
12.18% |
4.46% | |
Source: National Association of Real Estate
Investment Trusts
When REITs gained 25% or more in a
year, the gain falls to an average 8% two years later.
The
beautiful thing about cycles is that they work both ways. In
aggregate, there were eight declines in REIT prices during the
period, and the REITs returned 24%, on average, two years later. But
as explained above, we believe we are far from being at the bottom
of the cycle.
Granted that we have enumerated a witch’s brew
of reasons that REITs look bad. How can we play it? Normally, we are
ready to put our money where our mouths are. But not here. The
correlations we found are too unstable. And we are reluctant to sell
individual stocks short in any circumstances, particularly those
that pay a high dividend yield. The friction involved in selling
such issues short is particularly unpalatable to us. We are
therefore merely listing the REITs rated 4 or worse for timeliness
by Value Line, with 5 being the worst rating. They are:
- Archstone Smith (ASN,
news,
msgs),
a Denver REIT that owns and operates 78,000 apartments nationally.
- Crescent Real Estate (CEI,
news,
msgs),
a Fort Worth REIT organized by a group headed by Richard Rainwater
that owns office buildings and hotels and resort developments.
- Equity Residential Properties (EQR,
news,
msgs),
the Chicago REIT controlled by Sam Zell. It owns 1,100 complexes
with 200,000 units in 36 states.
- Penn REIT (PEI,
news,
msgs),
a Philadelphia REIT that owns apartments and shopping centers.
- Prologis Trust (PLD,
news,
msgs),
a Denver company that owns industrial and cold storage facilities.
All seem to have that trademarked combination of declining
quarterly financial comparisons that is a key negative in Value
Line’s tested system. We plan to sell a very small number of shares
of these short (let’s say about 1% as much as we have long on our
biotech recommendations) and to hedge that with a comparable long
position in a Vanguard index fund or S&P Spyder.
Final notes:
In our Jan. 10 article, we
mentioned that we were bullish on stocks but were waiting for a nice
drop to become 150% invested in biotechs. “Bullish on stocks??? You
must be joking,” was the harsh response we received from Lena Valdes
and many other readers. Similarly, on those rare occasions we turn
bearish, we are sure to hear, “It’s people like you, with your
short-term, spastic buy-and-sell mentality, who ruin the trends for
long-term types like me.” Fortunately we are accustomed to abuse, as
the market is a harsh taskmistress who never allows easy money to be
made for long.
We did get 150% invested in stocks at the
close last Friday. Not only did we buy all our recommended biotechs,
but we also bought IBM (IBM,
news,
msgs)
because it was down 3% that day, in accord with our tested system.
We also took a speculation by buying a large quantity of General
Electric (GE,
news,
msgs),
the world’s biggest stock by market value. We intend to opine on GE
in our next column. Kindly send laudatory or disparaging responses
to this address and we’ll
send you an update on the IBM system and more.
For insight
on how real estate cycles might be predicted, we read thousands of
articles. Many of the articles were worthless because they used
retrospective data or very small samples. An exception was a
mid-2001 PricewaterhouseCoopers report, “Real Estate Value Cycles,”
which contained 20 years of data on all categories of real estate.
The report’s authors observed that improved information on vacancy
rates has resulted in much faster cycles in recent years; rents fall
more quickly when vacancies increase. At present, vacancy rates are
increasing dramatically in numerous regions and geographic areas, a
key sign of a downtrend.
By far the best article we found in
our search for work on the relation of REITs and stocks was a 1995
study covering the years 1970-1995, “The Historic Performance of
Real Estate Investment Trusts,” by Jun Han and Youguo Liang in the
Journal of Real Estate Research. Han and Liang showed that equity
REITs -- those that own property -- performed three times better
than mortgage REITs -- those that invest in loans. Equity REIT
returns were comparable to stocks. The study’s data, which was
adjusted for survivor bias, led us to conclude that big REITs
perform better than small ones. Han and Liang pegged the effect at
almost three times better for the big ones than the average for
REITs. The biggest REITs by market value as of Feb. 1 are Equity
Office Properties, Residential Properties and Starwood Hotels and
Resorts (HOT,
news,
msgs).
At the time of publication, Victor Niederhoffer and
Laurel Kenner owned or controlled shares in the following equities
mentioned in this column: IBM and General
Electric.
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