Publicly-traded REITs have

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1 sponsored by The Next Phase With commercial real estate seemingly at its cyclical peak, what are REITs to do? By David Bodamer Publicly-traded REITs have enjoyed a robust recovery since the last recession. It s a far cry from the days of plummeting stock prices, middling total returns and balance sheet woes. But there are increasing signs that the current cycle has begun to run its course. Sentiment is pointing to commercial real estate having reached a peak. And recent property price indexes give further fuel to that argument, flat-lining or beginning to recede in recent months. As part of NREI s research in the past two years, we ve been asking respondents to estimate where we are within the cycle. In the beginning of 215, three quarters of respondents said we were in the expansion/recovery phase. Only 12 percent said the market had peaked and less than 1 percent said we were past the peak and into a recession or trough phase. Fast forward to May 216 and sentiment has shifted mightily. Nearly half of respondents in this most recent survey (47 percent) said the cycle has peaked and now just 35 percent say we are in a recovery or expansion phase. (But less than 1 percent say we are in a recession or trough phase.) What does that portend for REITs themselves? As one respondent encapsulated the situation, The lack of other asset classes with good investment returns puts REITs in a good place. Another wrote, It remains a challenge to place large mandates in the real estate market. REITs can be an attractive option for immediate deployment of capital. Survey respondents do see continued opportunities for REITs in Most Wanted Multifamily (37 percent) was the most popular pick on respondents publicly-traded REIT sector buy lists for 216. Multifamily Industrial Student Housing Office Net Lease Retail Hoispitality Mortgage 5% 1% 15% 2% 25% 3% 35% 4% 216, including balancing portfolios through strategic acquisitions and dispositions, expansion into secondary and tertiary markets and potential consolidation of players. As one respondent wrote, REITs could be divesting those assets purchased through bulk deals that do not meet their parameters for core operations. Another said that larger REITs should be looking at buying smaller, private REITs over the next 12 to 24 months. Yet another noted that REITs could take out competitors that are underperforming. Yet in the survey there wasn t clear sentiment on whether it s a good time for REIT mergers and acquisitions. Overall, 45 percent of respondents indicated that it is a good time for REITs to pursue tie-ups. But more than two fifths of respondents (41 percent) said they weren t sure. In addition, only 14 percent said it was a bad time for mergers. And REITs do face challenges as well, including some created by their own track records of success. As one respondent pinpointed, it will be difficult for REITs to continue to generate free cash flow and increase dividends. That will require having the expertise to work their existing portfolios to squeeze out more NOI. Another commonly-named challenge REITs face is finding quality assets at reasonable cap rates. High demand and competition from other buyers has made it difficult to buy at cap rates that work for REITs. 1 NREI June 216

2 Preferred sectors Respondents were asked to rank what sectors would be at the top of their buy and sell list and were able to select up to three property types on each question. The questions generated conflicting responses. For example, multifamily topped the buy list, being named on 37 percent of the surveys. However, multifamily also finished second in the sell list and was on 35 percent of surveys. It was the only property type to appear with that high of a frequency on both lists. The industrial sector generated the strongest net positive response. It ranked second on the buy list, being named on 34 percent of surveys. And it only appeared on 14 percent of respondents sell lists. Another sector that had stronger buy than sell ratings was student housing (23 percent buy, 12 percent sell ). On the flip side, retail received the strongest net negative response. It topped the sell list. Overall, 42 percent of respondents marked retail as a sell. Only 17 percent listed it as a buy. sectors with relatively higher sell ratings than buy ratings included office (19 percent buy, 32 percent sell ) and hospitality (15 percent buy, 27 percent sell ). Healthy balance sheets A majority of respondents indicated that they think REITs have been good at managing their balance sheets. Overall, 6 percent said that REIT balance sheets are balanced and another 13 percent said they have room to take on more debt. Only 27 percent said they felt that REIT balance sheets are highly levered. Respondents also see stability in the capital markets. Roughly one third of respondents said the availability of both equity (34 percent) and debt (37 percent) was unchanged from a year ago. About one fourth of respondents said equity (27 percent) and debt (25 percent) was more widely available. A roughly equal number said equity (25 percent) and debt (24 percent) was less widely available than 12 months ago. In terms of raising capital, respondents endorsed property-level debt (51 percent) as the best avenue for REITs given current market conditions. Another 34 percent endorsed equity issuance, while only 13 percent said secondary debt issuance was the best avenue. In recent months, REITs looking for capital have turned to joint venture partners to help finance growth. The dollar volume of REIT joint venture activity surged 5 percent in 215, according to a recent EY research report. One of the key drivers behind the spike in joint venture activity is the current climate for REITs on Wall Street. Many REITs are trading below their net asset values (NAV), which makes accessing capital in public markets more expensive. REITs are also sensitive to taking on more debt, which can impact their credit ratings. It is not an issue of whether there is access to capital for REITs in this environment. I think it is really a question of whether it is access to the right Second Thoughts Retail REITs (42 percent) appeared on the greatest number of respondents sell lists for 216. Retail Multifamily Office Hospitality Mortgage Net Lease Industrial Student Housing Medical Office industrial sector generated The the strongest net positive response. It ranked second on the buy list, being named on 34 percent of surveys. 5% 1% 15% 2% 25% 3% 35% 4% 45% NREI June 216 2

3 capital, says Mark Kaspar, REIT sector leader at EY. There has been a notable decline in the amount of common equity that REITs are raising in the public market. The total common equity capital raised by U.S. equity REITs dropped sharply from $1 billion during first quarter of 215 to just slightly more than $2 billion in the first quarter of 216, notes Kaspar. That decline could be due to a variety of factors, such as less acquisition activity. We believe a large part of it is because of the disconnect between NAV and share price, he says. Although perhaps not dollar for dollar, joint ventures are definitely helping to fill that gap, he adds. Those REITs that are more actively pursuing joint venture capital are generally in the mall, office or industrial sectors, which are trading at greater discounts to NAV, notes Kaspar. For them, accessing the public equity markets really isn t the best alternative when they can get lower cost of capital and higher private market pricing on their properties through a joint venture structure, he says. One of the most notable joint venture announcements this year includes Welltower s joint venture with the Canada Pension Plan Investment What to Do? Respondents were split on whether REITs should be net acquirers or net sellers. Board. The two entities are teaming up to buy a 97.5 percent stake in six Florida-based seniors housing properties for a combined price of $555 million. Forest City Realty Trust also announced in early April that it had completed the second of three previously announced regional mall joint ventures with QIC, one of the largest institutional investment managers in Australia. Combined, QIC will invest $9 million in the three Forest City projects. QIC has acquired a 49 percent equity interest in Ballston Quarter, a 578,-sq.-ft. regional mall in Arlington, Va. that Forest City is redeveloping. The joint venture also includes QIC s investment in Ridge Hill mall in Westchester, N.Y. and a still pending investment in the Shops at Wiregrass near Tampa, Fla. There also can be some downside to REITs use of joint ventures. Bringing in a joint venture partner does not offer the same opportunity to achieve maximum pricing as compared to a competitive bid situation. Another risk for REITs is that they become too dependent on the joint venture structure, notes Edward Mui, a REIT equity analyst at Morningstar. Such structures can become a problem with transparency in 26% Net Acquirers 3% Flat 17% Not Sure 26% Net Sellers financial reporting. It makes it tough for an analyst or investor looking at financial statements to be able to extract the relevant information depending on the level of disclosure that each REIT chooses to practice, he says. When it comes to deploying capital that REITs have built up, just more than half of respondents (51 percent) said redeveloping or repositioning assets was what REITs should be doing with their cash. top responses included paying off debt (44 percent), acquiring assets (32 percent) and investing in core operations (24 percent). Wait and see In terms of managing portfolios, there is not much clarity in the market on what REITs will do. About 3 percent of respondents said they expect REIT portfolios to remain stable. And then about a quarter of respondents (26 percent) said REITs would be net acquirers, but an equal number (26 percent) said they would be net sellers. Additionally, 17 percent admitted they weren t sure what REITs would do with their portfolios. Overall, REITs have been net sellers in 216. In the the first quarter, REITs sold more than $15 billion in properties and bought less than $6 billion, according to CoStar. The volume in the quarter was greater than in any of the four quarters in 215. For example, in the multifamily sector, top REITs like Camden Property Trust continue to sell large portfolios of properties and trophy assets in primary markets. The largest three multifamily REITs are buying assets selectively, if they buy at all, mostly in strong secondary markets in prime metropolitan areas, and are selling significantly more than they buy. Take Equity Residential, which was the largest apartment REIT in the U.S. with 19,54 apartments, according to the Top 5 Owners list released in April by the National Multifamily Housing 5 NREI June 216

4 Council (NMHC). The REIT is likely to have significantly fewer apartments on next year s list. Equity Residential sold 23,262 apartments to affiliates of Starwood Capital Group for $5.365 billion in the first quarter. The price is much higher than Equity paid for the properties the sale generated an economic gain of approximately $2. billion and an unlevered internal rate of return of 11.3 percent. Equity Residential also cashed in by selling two properties in East Palo Alto, Calif., and New York City, for hundreds of millions of dollars more than it spent to buy them in 21 and 211. The REIT used the proceeds to retire $2 billion in debt and improve the company s already strong credit metrics. Equity Residential also bought a handful of properties in markets including Seattle, Los Angeles and Brooklyn, N.Y. recently, totaling $24.1 million. The second largest apartment REIT in the county is also selling properties, though AvalonBay Communities also bought several communities and has invested in new development. AvalonBay sold a 34-apartment community in Trumbell, Conn. for $7 million in the first quarter. In addition, AvalonBay Value Added Fund II, which is partly owned by the REIT, sold 676 apartments for $158 million. Another fund partially owned by the REIT, Multifamily Partners AC, sold 461 apartments for $229 million. In total, that s nearly a half-billion dollars in sales. In projecting performance for the rest of the year, respondents do not expect much movement in publicly-traded REIT stock prices for the balance of 216. Overall, 46 percent of respondents said they expect publicly-traded REIT stock prices to increase. Another 28 percent said prices would be flat. And 24 percent said they would decrease. However, of those that expect an increase, 88 percent expect prices to rise by 5 basis points or less. The picture is similar for total returns. Just over half of respondents (51 percent) expect total returns to increase for the balance of 216. Another 27 percent said total returns would be flat and 2 percent expect a decrease. But 94 percent of respondents that expect an increase in total returns said the increase would be by 5 basis points or less. n Bendix Anderson and Beth Mattson-Teig contributed to this story. Methodology: The NREI research report on REITs was completed via online surveys distributed to readers of National Real Estate Investor in May. The survey yielded 35 responses. Recipients were asked what regions they operated in (and were allowed to select multiple regions). Overall, 49 percent said they operated in the East, followed by the South (48 percent), West (45 percent) and Midwest (43 percent). Half of respondents (51 percent) hold the titles of owner, partner, president, chairman, CEO or CFO. Approximately half of respondents are investors or developers. Deploying Cash Just more than half of respondents said that REITs should spend their capital on redeveloping or repositioning assets. Redeveloping/Repositioning Assets Paying off debt Acquiring assets Investing in core operations Share buybacks 1% also can be some There downside to REITs use of joint ventures. Bringing in a joint venture partner does not offer the same opportunity to achieve maximum pricing as compared to a competitive bid situation. 2% 3% 4% 5% 6% NREI June 216 4

5 We went from a six-month quarterly forecast process to an eight-week process, and our accuracy is vastly improved. ARTHUR NELSON Vice President of Global Business Systems, Prologis SOCIAL. MOBILE. SMART. YARDI Suites TM REITs can operate more efficiently with solutions from the Yardi Suites that support marketing, leasing, operations, accounting, budgeting, forecasting, valuations, investment management and business intelligence. To learn more, call or visit