REITs: The Case for NOW May Be Around the Corner

Transcription

1 INSIGHTS REITs: The Case for NOW May Be Around the Corner April 2009 This year will almost certainly be a dramatic one for REITs, both in the U.S. and abroad. But on a purely quantitative basis, REITs offer compelling valuations, and qualitatively speaking, headwinds are not as intractable as one might think. The intensification of credit and liquidity crises, combined with a growing realization that the current global slowdown will be one of the worst on record, culminated in a precipitous drop in the value of real estate securities. All around the world, during 2007 and 2008, no regional market was spared, with peak-to-trough prices dropping roughly 7. 1 But a hard-nosed analysis of valuation measures, for both U.S. and international real estate securities, reveals the makings of a possible resurgence with truly attractive upside. While headwinds persist namely, falling real estate values, dividend cuts, volatility, and capital availability they are not as distressing as market sentiment suggests. Please visit for access to all of our Insights publications. Reading the yield spreads: evidence of overshooting on the downside? On February 28, 2009 the weighted-average dividend yield for U.S. REITs stood at 10.1%. To put that in perspective, over what we can call the Modern REIT Era ( ), the REIT month-end yield has broken 8% only a few times, and there has only been a single instance of the month-end yield remaining above 8% for longer than a month. Moreover, history shows that in the 12 months after breaking the 8% barrier, REIT returns have been impressive (Exhibit 1). Exhibit 1: REITs 12-month returns after yield breaks 8% 3 25% 2 15% 1 5% U.S. REIT dividend yield Subsequent 12-month returns 17.3% 18.7% 8.2% % 9. Source: NAREIT, J.P. Morgan Asset Management. 23.9% Nov-94 May-95 Sep-99 to Mar-00 (avg) Nov-08 to Feb-09 (avg) 1 Source: MSCI, Global Property Research, J.P. Morgan Asset Management.

2 We can also estimate potential for REIT performance by comparing REIT yields to various fixed income bogies, and the most meaningful comparison can be made to the Baa bond. (Over the Modern REIT Era, the yield correlation to Baa bonds is 0.80, versus only 0.51 for the 10-year Treasury.) 2 This relationship has intriguing implications for REITs current valuation and future potential returns. Assume for a moment that the Baa bond yield stays close to its 20-year average of 7.9% (it was 8.7% as of 2/28/09), giving us a conservative yield run rate of 8% to 9%. That would imply a REIT dividend yield of 7% to 8%, based on the average historical spread of -114 bps (Exhibit 2). Where are REIT yields now? They are sitting above the implied yield even after cuts. Exhibit 2: REIT yield spreads to Baa credit through February % 1% -1% -2% -3% -4% Jan-92 Jul-93 Jan-95 Jul-96 Jan-98 Average spread Jul-99 Source: Barclays Capital, J.P. Morgan Asset Management. Data through February Jan-01 Jul-02 Jan-04 Jul-05 Jan-07 Jul-08 What investors must not miss is the implication of the high correlation between REIT dividend yields and Baa bond yields i.e., the fortunes of credit and REIT equity (the dividend yield is a ROE measure) are generally linked. So what are the markets saying about the fortunes of Baa yields? According to recent estimates from J.P. Morgan Securities, the yields on investment grade corporate bonds were factoring in an estimated cumulative default rate of 14% over five years (assuming 2 recovery rate). That is an aggressively pessimistic assumption given that in the worst cumulative five-year period since 1950 ( ) the default rate only reached 3%. The implication is clear: if bullishness on credit can be equated to bullishness on REITs, then overshooting credit estimates to the downside should equate to overshooting on REITs as well. So, what do current spreads tell us? The current spreads versus Treasuries, for both REITs and Baa bonds, are at exceptional historic highs (Exhibit 3). Given that the correlation of spreads for REIT and Baa yields is a strong 0.80, it would imply that if indeed the market has overshot, as these spreads would indicate, the expected normalization of spreads for both assets should generate significant appreciation. Exhibit 3: REIT and Baa yield spreads to 10-year Treasuries Correlation = % Baa spread to 10-Yr 7% 6% REIT spread to 10-Yr 5% 4% 3% 2% 1% -1% -2% Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Current Baa spread = 572 bps Jan-04 Jan-05 Jan-06 Source: Barclays Capital, NAREIT, Bloomberg, J.P. Morgan Asset Management. Jan-07 Jan-08 Jan-09 2 Source: Barclays Capital, Bloomberg, J.P. Morgan Asset Management. 2 REITs: The Case for NOW May Be Around the Corner

3 Comparative measures indicate compelling value We can also get an idea of value by looking at three real estatedriven REIT valuation measures, all of which currently signal compelling value in REIT shares: Net Asset Value (NAV) Exhibit 4 shows the monthly series of price to current NAV estimates for our REIT coverage. Using forward-looking NAVs, we estimate that REITs were trading at a -38% discount to the value of their real estate on February 28, (Note: The Price to NAV measure is an estimate of where REIT share prices should trade based on the underlying fair value of the real estate asset. Since 1994, the average Price to NAV premium has been 8%.) Implied Capitalization Rate (ICR) ICRs are an estimate of the yield investors expect from the properties held by a REIT as implied by the REIT s market capitalization. At the end of February, ICRs for the REIT asset class approached 1, after peaking at an estimated 10.5% on November 20. (Exhibit 5). J.P. Morgan Asset Management s Real Estate group recently produced a potential worst-case scenario showing going-in cap rates for commercial real estate rising to just over 8%. If that estimate is correct, then REIT share prices, implying a yield of % on the underlying real estate held by REITs, have overshot to the downside. The implication is that ICRs could close to 8%, providing 2 to 3 upside. Price per Pound On a price per pound basis (i.e., dollar value per square foot), the real estate owned by REITs is estimated to be trading at a roughly 45% discount to replacement cost, a gap that will more than likely be closed in the next recovery. 3 Real estate investors have a saying, basis is forever, because buying real estate at such a discount provides the owner the potential for above-average return on capital and a powerful competitive advantage when luring renters, as they can charge lower rent. The ability to buy quality real estate at such a compelling discount should ultimately lure buyers back into the direct market, stabilizing real estate values and providing support for REIT security prices. Exhibit 4: U.S. REITs price to NAV Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Source: J.P. Morgan Asset Management. Historical +8% average premium to NAV Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06-38% discount to NAV Exhibit 5: U.S. REIT implied cap rate versus Direct Real Estate cap rates Yields (%) 11% 1 9% 8% 7% 6% 5% U.S. REIT implied cap rates NCREIF-transactional cap rates Estimated peak on 11/20/08 Dec-97 Jun-98 Dec-98 Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Source: NCREIF, Green Street Advisors, J.P. Morgan Asset Management. Jan-07 Jan-08 Jan-09 3 Source: Barclays Capital, Stifel Nicolaus, J.P. Morgan Asset Management. J.P. Morgan Asset Management 3

4 International REIT securities may present the better value Per our estimates, international real estate securities are offering similar long-term real IRRs (Dividend Discount Rates shown in Exhibit 6a) as U.S. REITs. However, based on the dividend yield spreads to underlying 10-year Treasuries, and our own internal stock-by-stock analysis of the discount to NAV (shown in Exhibits 6b and 7), international real estate securities may actually offer the better value. U.S. underperformance over the beginning of 2009 has its real IRRs moving close to the top of the regions studied here, but NAV discounts still favor international markets. One reason IRRs are lower in Europe is that future cash flow growth in core markets is likely to lag Asia. In Asia/Australia, it is generally accepted that long-term GDP growth, inflation and, therefore, long-term cash flow growth from real estate, should outpace that of Western markets. The combination of that growth and similarly discounted share prices provides compelling long-term IRRs. In general, NAV discounts in the Asia/Australia region are larger as price declines have been generally similar in scope to those in Europe and the U.S. but set against smaller expected declines in real estate values. Headwinds persist, but they are being addressed Though REITs appear ready for a resurgence, based on quantitative analysis, there remain a number of qualitative issues that concern investors, such as: 1. Given the continued downward correction in direct real estate values, won t REIT values continue to fall? 2. Should we be concerned that REITs are cutting dividends and/ or threatening to pay those dividends in stock? 3. Will the current elevated levels of REIT volatility normalize? 4. Won t REITs be hurt by the continuing contraction of capital? As serious as these issues are, they are not as intractable as one might think. Exhibit 6A: Global real estate valuations are attractive globally Real DDRs 16% 14.2% 14% 12% 1 8% 6% 4% 2% Source: J.P. Morgan Asset Management. Exhibit 6B: Global real estate valuations are attractive globally Price to NAVs U.K. Australia Japan Asia ex-japan Source: J.P. Morgan Asset Management. Exhibit 7: Weighted average dividend yield spreads to 10-year Treasury or country equivalent Basis points % -60.8% -60.6% 707 bps % Japan U.S. Asia ex-japan 764 bps % -38.4% U.S. 816 bps U.S. Global International Source: GPR, Bloomberg, Global Property Research, J.P. Morgan Asset Management. 8.3% Australia U.K. Europe -21.7% Europe 4 REITs: The Case for NOW May Be Around the Corner

5 First, falling real estate values do not necessarily predict falling REIT values. Exhibit 8 shows rolling four-quarter capital appreciation returns for direct real estate and REITs. The circles highlight two recessionary periods in which REITs generated positive quarterly rolling annual returns for up to two and a half years while direct real estate was marking itself to market. This is important to comprehend for two reasons: (a) In both highlighted periods, REITs corrected first (ahead of direct real estate) anticipating real estate price declines, and (b) like other forms of equity, REITs respond promptly to short-term factors, e.g., falling interest rates, government intervention. Second, dividend yield cuts by individual REITs do not necessarily equate to dramatic percentage drops at the asset class level. Consider: as of January 31, 2009, 31 REITs out of the 99 in our index (MSCI REIT Total Return Index) had already cut their dividends. It is easy to assume such cuts would cause a very large decrease in the overall asset class yield. The actual result, however, after weighting those cuts by market capitalization, is not nearly as dramatic. We used 2009 consensus yield estimates to forecast the impact of recent and anticipated cuts for the REITs in our benchmark. We found the result to be only a roughly -1 decrease in the percentage yield. Exhibit 8: Rolling four-quarter capital appreciation returns for direct real estate and REITs Dec-78 Dec-80 NAREIT Price Index Dec-82 Dec-84 Dec-86 Dec-88 Dec-90 Dec-92 Dec-94 Source: NAREIT, NCREIF, J.P. Morgan Asset Management. NCREIF-ODCE Price Index Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Third, stock payouts, while not ideal, are not necessarily a disaster for investors. The IRS ruled at the end of 2008 that REITs could pay up to 9 of their dividends in stock with no penalties. Several REITs including bellwether firms like Vornado Realty Trust (VNO) and Simon Property Group (SPG) have announced their intention to take advantage of this ruling to conserve cash. While we certainly don t want to be blindly optimistic about the impact investors lose forever the forgone cash amount, and investors who have to sell their new shares are diluted there are some positives to this tactic: It does not reward new investors at the expense of existing shareholders, as in the case of an equity issuance. It is a one-year ruling by the IRS, thus intended to be temporary. The end result is that forgoing cash dividends allows the REIT to improve its balance sheet until the credit market thaws, and/or enables potentially accretive opportunities, such as purchasing high-yielding properties or paying down heavily-discounted debt. J.P. Morgan Asset Management 5

6 Fourth, the issues of volatility have been a concern. REITs have been more volatile than the S&P 500 since This reality conflicts with the conventional strategic case for REIT investing, which is based on stable returns and low volatility, aided by a large dividend yield. However, there is reason to believe that the REIT volatility premium is not permanent as the dividend yield should, once again, be a stabilizing factor for REIT returns moving forward. Support for this notion can be seen in Exhibit 9, which shows dividend yields as a percent of total returns. Over the Modern REIT Era, dividend yields made up approximately 69% of REIT average cumulative annual returns. However, during the REIT boom years of , when returns averaged 28.6%, the average yield was only 5.1% or a mere 18% of the total return. But the situation now appears to be returning to historical norms. Using our proprietary Dividend Discount Rate (DDR) i.e., an IRR for the REIT space as of 2/28/09 we have seen the relationship of yield to total return come back in line with long-term levels at 74% (DDR of 13.5% with yield of 10.1%). Exhibit 9: Historical and current relationships of dividend yield to total return A: Total return breakdown B. Dividend yield % of total return 35% 3 25% 2 15% 1 5% Exhibit 10: MSCI constituents fixed charge coverage 2.85x Growth Yield 2.9% 6.4% 5.1% Modern REIT era ( ) 23.5% Boom period ( ) Source: NAREIT, J.P. Morgan Asset Management Current DDR (2/09) Finally, while REITs are indeed capital intensive, current debt coverage is good. The fixed charge coverage ratio for U.S. REITs in the MSCI REIT Index is more than reasonable at 2.75x (as of 4Q08). (Exhibit 10) So even though fundamentals are expected to weaken over 2009, the asset class is starting from a strong position. 2.80x 2.75x 2.70x 2.65x 10-yr average = 2.7x International markets are in similar shape, with Asia being a bright spot. In Asia, leverage is not as much a challenge as in the U.S. and Europe, as Asian companies are, in general, less levered (Exhibit 11). The more lowly-levered properties found throughout Asia/Australia enhance the appeal of international 2.60x 2.55x 2.50x Source: SNL, Factset, MSCI, J.P. Morgan Asset Management. Exhibit 11: Debt to enterprise value U.K. U.S. Europe REIT Source: UBS, J.P. Morgan Asset Management. Japan AREIT SREIT Singapore JREIT China HK REIT HK Australia 6 REITs: The Case for NOW May Be Around the Corner

7 REIT investing as these properties make up 66% of the GPR 250 ex-u.s. international securities index, and 41% of the Global 250 real estate securities index (as of 12/31/08). Contrary to popular belief, REITs can secure debt capital. While the news headlines may scream that CMBS markets are closed, and the unsecured market is too expensive, in the midst of it all REITs are quietly accessing substantial amounts of credit. Between November 17th and January 31, 2009 REITs procured an impressive $3.15 billion of secured mortgages at an average coupon of about 6., although coupons of roughly 7% to 8% can be expected for some companies. REITs also have financing or delevering options. They enjoy a decided advantage versus other real estate investors in the form of a flexible capital stack (the breakdown of a company s capital components). For example, REITs can retire their publicly traded debt/preferreds at significant discounts, potentially a short-term accretive use of capital. Signs of a comeback on the horizon? We believe the case for REITs is strong on both quantitative and qualitative grounds. The compelling arguments, outlined in this paper, strengthen the rationale for investing in REITs as current and historical valuation measures appear attractive both in the U.S. and overseas. REITs current 9% to 11% average dividend yield alone (similar to what some bonds are yielding) offers a strong incentive for investors to maintain a REITs allocation in portfolios, or add to them. 4 But there is significant potential upside as well, driven by (a) credit spread normalization and (b) stabilization of both economic and real estate markets, equating to an estimated bps of compression in yields and about 3-75% appreciation. Not only do REITs share some of the appealing characteristics inherent in traditional bonds e.g., coupon payments, price gains driven by spread compression when spreads are too wide but they also offer equity-like appreciation over the long term, driven by the stable cash flow growth (i.e., income) from real estate. Building momentum To win back investor confidence and realize the upside potential outlined in this paper, REITs need to demonstrate significant progress in addressing its financing needs, once and for all. While REITs have previously taken impressive steps, including cutting dividends to save cash and leveraging their relatively strong lender relationships to secure not insignificant totals of mortgage financing, we still think one or more of the following steps are critical: (1) a thawing of the real estate transactions market, allowing REITs to sell assets, (2) a functioning unsecured bond market for access to capital, and (3) equity issuances where necessary. Recently, the industry has seen progress on all three fronts: Large-scale dispositions by ProLogis and AMB are expected or done totaling approximately $1.7 billion. Simon Property Group completed a $650 million (face value) unsecured bond offering (after which SPG s CDS spreads came in). In addition, three companies concluded equity issuances near the end of March, all well-received. While there remains much work to be done, we believe this progress could be the initial sign that REITs are close to turning the corner. For the remainder of 2009 we continue to expect volatility in REITs. But today s attractive valuations are undeniable. And when current headwinds cease, we believe REITs should reward investors who exhibit patience and foresight. The REITs case for NOW may be around the corner. 4 Source: Global Property Research, NAREIT, J.P. Morgan Asset Management. J.P. Morgan Asset Management 7

8 Contributor Michael C. Hudgins Global REITs Strategist Opinions offered constitute our judgment and are subject to change without notice. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any financial instrument. Real estate investing may be subject to a higher degree of market risk because of concentration in a specific industry, sector or geographical sector. Real estate investing may be subject to risks including, but not limited to, declines in the value of real estate, risks related to general and economic conditions, changes in the value of the underlying owned by the trust and defaults by borrower. The value of investments and the income from them may fluctuate and your investment is not guaranteed. Past performance is no guarantee of future results. J.P. Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide JPMorgan Chase & Co.