Five Industry Pros Look at 2007

By Jada A. Graves

REITs outpaced all other major market indexes for the seventh straight year in 2006, and the industry set a new benchmark for deals with more than $120 billion in annual M&A transactions, including the $36 billion proposed acquisition of Equity Office Properties Trust (NYSE: EOP) by private equity firm The Blackstone Group.

Portfolio spoke with five industry professionals to learn their opinions on what to expect in the coming year: (l to r): Bret Wilkerson, CEO of Property & Portfolio Research, Keven Lindemann, director of SNL Financial's real estate group, Lisa Sarajian, managing director with Standard & Poor's, Jon Fosheim, CEO and founder of the private-equity investment firm Oak Hill REIT Management LLC and Peter Baccile, global head of real estate and lodging investment banking with J.P. Morgan.

Here's their take on the outlook for REITs in 2007.

		Bigger is Better It's been called "a conundrum," "groundbreaking," "massive," "the mother of all trades," and "an earthquake for the REIT industry"...

Portfolio: Let's start with the topic that dominated industry headlines in 2006: M&A activity. After a record level of activity in 2006, do you expect the deal flow to continue in 2007?

Keven Lindemann: I expect the industry will see continued M&A/privatization activity in 2007. There is still a great deal of capital looking to be put to work. Deal flow is being driven by the perceived disconnect between public and private market pricing of these real estate assets. The arbitrage opportunity will continue to drive transactions. A handful of large office deals—CarrAmerica Realty Corporation, Trizec Properties, Inc., Reckson Associates Realty Corp (NYSE: RA) and most recently Equity Office—have garnered much attention. But the true scope of deal activity can be seen in smaller transactions announced in sectors like shopping centers and hotels.

Peter Baccile: I agree, we shouldn't see the M&A trend slowing down in 2007, and in fact, I expect there will be more money raised. This asset class is a healthy environment for the institutional money manager, and they'll continue to have a strong bid for public real estate companies, as they continue to raise larger investment funds, increasing the need to invest in scale. There's an advantage to the bigger player and the bigger deal.

Portfolio: In many ways, the deal activity is a sign of a healthy public market for real estate. How do you feel the industry has evolved over time as it completes its seventh straight year of outperforming the broader markets? How will it continue to evolve?

Lindemann: The REIT market has grown tremendously over the last seven years, from $140 billion in aggregate market cap to almost $400 billion. However, the number of public REITs has actually declined over that period, from around 170 to around 150.

Consolidation has occurred most notably in shopping centers, going from 26 companies down to 15. The same is true in the industrial sector, going from 13 companies down to eight. But the average size of these sectors' companies is four to six times larger than seven years ago. It wouldn't surprise me to see this trend toward fewer, larger companies continue.

Baccile: In addition to consolidation, the industry has struggled with market price. For the past 15 years, real estate has been underpriced. When you look at expected returns, those available today are pretty much at equilibrium relative to other investments in the debt and equity markets.

Commercial real estate changes hands at returns that are still betterthan most alternative asset classes, especially on a risk adjusted basis without financial engineering. PETER BACCILE

Most would say that real estate values have skyrocketed and that, in general, commercial real estate must be overvalued. However, in reality, commercial real estate is probably valued appropriately. Lately, the stock market has done well but traditionally long-term equity returns have been somewhere around 7 percent or 8 percent. Commercial real estate changes hands at returns that are still better than most alternative asset classes, especially on a risk adjusted basis and without financial engineering. When you think about trends and whether investors will stay invested, and if you believe that they are valued appropriately, then think along the lines of "the trend is still your friend, and you should stay invested."

Portfolio: If investors are looking for a particular sector that might be friendlier than another in 2007, what are your suggestions? Do you foresee any trouble spots?

Jon Fosheim: Any REIT analyst in town can usually predict which property type on Main Street will do better than another in terms of real estate fundamentals next year. Perceived wisdom is to favor apartments over retail. However, for that projection there are too many reasons to cite. In one key area—earnings growth—apartments, as expected, are outperforming retail, and should continue to do so. In anticipation of this phenomenon, share prices for apartment REITs have raced ahead of retail REITs over the last year.

Bret Wilkerson: Going along with what Jon said, it is very important to consider both the future income streams as well as how those income streams are priced. Both factors are likely to further evolve in 2007. Over the next 12 months on the income side, apartments will see the best growth as rents continue to spike. Retail will see the greatest slowdown as new supply ramps up and consumer jitters shake spending down even further.

Over the next several years, office will be the best performer, since construction has not yet begun and reasonable levels of net absorption push up rents and occupancies. Lease rolls will become the investor's friend. I expect capital flows to recognize these broad trends and price in slower growth of income streams in apartments and retail as well as the improving momentum in office.

The emergence of more global alternatives should not affect U.S. REITs in the short run, as they are not substitutes. BRET WILKERSON

Lindemann: However, I believe that nothing in the current market environment suggests that a reversal is imminent. Major property sector fundamentals remain solid, interest rates are steady and low, and there is still a tremendous amount of capital in the direct property market, helping to keep property valuations high. Sell-side analysts are projecting growth rates in 2007 in malls around 6 percent and in office around 9 percent, with industrial, shopping centers and multifamily somewhere in between. Add a dividend yield around 4 percent, and you are looking at total return expectations of around 10 percent to 13 percent in 2007.

Portfolio: In addition to M&A activity and continued outperformance, 2006 was also marked by noteworthy global expansion of REITs, in terms of new countries adopting REIT legislation or new investment options being created. How will the emergence of more global REIT vehicles in 2007 affect U.S. REITs' performance?

Lisa Sarajian: An expanded, global operating platform could result in a broader base of investors and lenders, and expanded market access for a U.S. REIT's key clients/tenants. It could materially diversify/hedge the industry and the economic or geopolitical risk embedded within a portfolio of properties. We would also expect to see increasingly more complex financial statements and the need for more sophisticated management and operating/information systems infrastructure for globally expanding U.S. REITs.

U.S. REITs remain very attractive investment vehicles for retail and institutional investors in search of income and/or growth. The United States is a huge real estate investment market, with public equity REITs still garnering only a modest ownership share. There is still room for growth for well positioned companies with well defined strategies and good capital access.

Wilkerson: The emergence of more global alternatives should not affect U.S. REITs in the short run, as they are not substitutes. However, there may be more competition with global funds. Several U.S. REITs have undertaken international expansion, and will recognize the diversification benefits while working through the complex struggles of globalizing a business. Many investors want to target specific property types, countries and regions in their asset allocation decisions, so there is definitely room for both focused and broad platforms.

Lindemann: I'd add that the emergence of more global REITs certainly has the potential to draw some attention away from the U.S. REIT market. The majority of our REIT buy-side clients are taking in new capital under a global mandate that's 50 percent U.S. REITs, and the other 50 percent split between Europe and Asia/Pacific. More capital and resources are focused outside the United States.

That said, U.S. REITs are absolutely still relevant many companies are expanding their presence overseas, particularly industrial and retail, and the U.S. REIT market is still the bellwether.

Portfolio: Lastly, other than the issues we have discussed, do you see any factors outside the industry that could have a positive or negative impact on the commercial real estate market in the months ahead?

Baccile: A shock to the system created by terrorism or global dislocation in the capital markets will always be a threat. However, I think real estate fundamentals are strong and ought to continue. Will real estate continue to outperform as it has for the past several years? Perhaps not, but the fundamentals suggest the commercial real estate sector will continue to be an above-average performer.

One could argue that any disruption in the financing markets for real estate assets would also spell opportunity for many astute U.S. REITs. LISA SARAJIAN

Fosheim: The overall capital market is a factor with negative implications. REIT specialists are often guilty of viewing the world with tunnel vision. We rationalize that REITs must be cheap because they often trade for less than what their real estate holdings might sell for in the private market. Those private market buyers of commercial real estate project long-term returns on equity that sound acceptable if you buy into the assumptions that go into the projections. However, what they overlook is that capital ultimately seeks the best risk-adjusted relative return. As good as the return expectations might pencil out for today's commercial real estate buyer, they look downright paltry compared to what is achievable in equity markets in both the U.S. and abroad. Whatever earnings growth expectations are for commercial real estate and REITs, they are dwarfed by what is expected in the broad stock market, if market experts' consensus opinion is to be believed.

Wilkerson: Two big factors are the U.S. consumer and the relative performance of other asset classes and alternatives for investors. If consumers close their wallets, it would not bode well for underlying demand growth. Retail sales would obviously diminish, the trade that drives industrial demand would moderate as well, and office demand would slow with lower business spending. An investor has to think about how the alternatives perform—and this could impact commercial real estate in either a positive or a negative way, depending on interest rate repercussions and on corporate profits.

Sarajian: On the expense side of the ledger, I'd include property taxes and labor costs, which rarely backtrack once they've risen. One bright spot to the sharp housing slowdown we are witnessing should be some softening in previously escalating costs for both construction materials and land.

Since REITs essentially compete with the secured financing market for assets, an increase in the cost or a pullback in the availability of commercial mortgage-backed securities (CMBS) or conventional mortgage financing could accrue to public equity REITs' benefit.

Tax law changes that dilute the effectiveness of popular investment/tax deferment vehicles, like tenant in common properties (TICs) and 1031s, could negatively impact overall liquidity in the market, which could conceivably affect cap rates and valuations. One could argue that any disruption in the financing markets for real estate assets would also spell opportunity for many astute U.S. REITs.