Two Takes on REITs

The New York Times chimes in with "Year of Tumult for REITs". The story raises the issue of net asset value (NAV). REIT backers have pointed to the fact that REITs are trading at discounts to NAV as a reason to be bullish on the sector. However, as the one analyst explains here, the volatility in debt markets, eroding fundamentals and low volume of investment sales transactions--all of which are used to calculate NAV--make it a less reliable metric than normal.

According to estimates last week by Green Street Advisors, a research firm that tracks real estate securities, REITs are trading at about a 30 percent discount to net asset value, on average. That number is similar to the level in late 1990, but considerably higher than it was last month, when the discount reached an unprecedented 47 percent.

But Mike Kirby, the director of research for Green Street, issued a caution about the numbers, noting that it was harder than usual to establish a REIT's net asset value, which represents what a company would fetch for the properties it owns if it sold them today.

“Real estate transactions have dried up, so there are no recent comparisons,” he said. “They're based on a guess right now.”

This has been a second consecutive year of losses for REITs — in 2007, they fell nearly 16 percent. The declines show a continued reversal of fortunes for an asset class that not long ago was considered a darling of Wall Street.

Meanwhile, our sister publication NREI, examined the debt side of the picture with "U.S. Equity REITs Susceptible to Downgrades in 2009".

With the capital markets frozen, equity REITs face a pervasive vulnerability to credit-rating downgrades, according to Steven Marks, managing director and U.S. REIT group head at Fitch. Forces weighing down on REITs include weakening fundamentals that threaten to reduce property cash flows, reduced liquidity profiles, and pressure to use assets as collateral in order to access debt. “REITs are in a difficult refinancing environment,” Marks says. “In addition, a slowing asset sales market will hamper REITs' ability to reduce leverage and sell weaker-performing assets to recycle capital to improve overall portfolio quality.”

REITs face the same economic and fundamental challenges confronting the larger commercial real estate industry, Marks says. They may have a unique disadvantage in the credit crunch, however, because REITs must distribute at least 90% of their income to shareholders. “That results in most REITs not being able to retain a meaningful amount of cash.”

Among product types, Fitch changed its outlook from stable to positive for office, industrial and retail REITs, while maintaining a stable outlook for multifamily and health care REITs. Office REITs may face the most severe softening in demand, since space absorption is driven by growth in gross domestic product (GDP) and employment.

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