| DEBT & EQUITY JOURNAL |
Volume 3 - Number 6 | March 27, 2006
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Worcester, MA—No matter how you approach them--dividends, yields, cap rates or earnings--REIT valuations are overstretched by historical measures. At the same time, the current trend of taking REITs private is limiting the field even further for many investors.
Yet they continue to invest. They are not ignoring market realities. They are just becoming more selective. “By historical standards, REITs have become expensive,” says Melvin Cutler, founder of Cutler Capital Management LLC. “We used to have between 25% to 35% of our portfolio in REITs. Now it is down to 10%.”
On a selective basis, he adds, there are still buys to be found-–just fewer than before. “A few years ago, if we were following 20 REITs, 10 might be buys. Today, we still might follow 20, but we might buy only four.” The current Cutler portfolio includes Ashford Hospitality Trust Inc., Ramco-Gershenson Properties Trust, Lexington Corporate Properties Trust and Nationwide Health Properties Inc.
These offer fairly good yields, he says. “We also look for a history of rising dividends that are a little above average. I like to see a cash-on-cash return when making an investment,” he continues.
Another investment standard is credible and fiscally responsible management. “We are also looking for some upside where we think the market has not recognized the true net asset value of the REIT or it is just not followed in many cases,” he explains, adding that Wall Street has reduced coverage of REITs, especially smaller cap ones.
Right now, he likes--along with the rest of the investment market--hotel REITs. “There have not been many hotels built in the past few years and now traveling is beginning to take off again. Hotels have been able to raise their rates,” Cutler says. He likes Ashford because it fits his investment criteria: it has been increasing its dividend and, less importantly, it is not a widely followed REIT.
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A relative dearth of new IPOs is part of the reason why selective REIT investment has become more challenging. “I am surprised we haven’t seen more IPOs lately because valuations are so high,” says Dennis Yeskey, a national director of the Deloitte & Touche LLP real estate capital markets practice.
He believes more will come to market this year, despite the current trend of taking REITs private. “Cash flows and fundamentals are improving,” he says.
Another problem for investors is that properly valuing REITs has become more difficult as they expand beyond their original business mandate. For instance, some REITs are moving into unusual asset classes, such as entertainment malls, which can be a difficult concept to value, says Eric Kea, a tax partner in the real-estate practice at BDO Seidman in New York City.
Much of this activity is because more money is chasing fewer deals, a characteristic of the real estate markets in general for the past five years. “Yields have come down in some commercial properties, which means many REITs have had to look for other investments,” Kea notes. Theoretically, though, the market caps should be easy to establish since they are based on the property’s underlying value. It is when REITs move beyond equity investments that valuations get tricky, he explains.
“REIT structures are morphing, which can make valuations harder,” Kea says. “Now we have situations where some REITs are becoming so-called hybrid structures that own both equity and mortgages.” It can be difficult to value these REITs, especially if the majority of earnings come from the mortgages instead of the equity, he continues.
The upshot of these new patterns is that “each REIT is different and must be looked at individually,” Kea says. That is just what investors are already doing in this current market environment.
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Washington, DC—Few investors have historically viewed low-income housing or workforce apartments as an attractive harbor for their dollars. But some may be rethinking their positions.
Although affordable housing is still associated with excessive government rules and regulations, the perceived risk could be offset by potential rewards. Moreover, the federal low-income housing tax credit program is so widely accepted on Capitol Hill that it is becoming the tool of choice to restart apartment construction along the hurricane wracked Gulf Coast.
Victoria Spielman, executive director of the Affordable Housing Tax Credit Coalition, says the federal low-income housing tax credit program has become the program of choice to rebuild housing devastated by Hurricanes Katrina and Rita, especially in light of potential increased allocations of credits for Texas, Louisiana, Mississippi, Alabama and Florida.
Under federal law, each state can authorize $1.95 per capita in low-income housing tax credits each year. Under pending legislation, that amount would double in hurricane-struck states for at least two years.
The federal government long ago reduced direct funding of low-income housing. But since 1986, the federal tax credit program has stimulated the construction of hundreds of thousands of new housing units. It has also handsomely rewarded private equity investors. Until recently, investors in low-income housing partnerships were scoring 20% annual yields.
Now demand from private equity investors for limited federal low-income housing tax credits has grown so strong that anticipated yields have dropped to single digits. What investors like about the tax credit program is that defaults on privately owned low-income housing project are virtually nil. “We found a foreclosure rate of 0.02% on multifamily buildings financed through the federal low-income tax credit program,” says Richard Floreani, senior manager with Ernst & Young's Boston-based tax credit investment advisory services.
In his recently released third annual study of the real estate sector, Floreani notes that low-income housing tax credit investments provided average returns 2% greater than originally projected. He reviewed more than 13,503 low-income developments, representing a cumulative 1.02 million units that were funded by $4.37 billion in tax credit equity. Currently, about 80,000 apartment units a year are funded through the federal tax credit program.
In recent years, private investors nationwide have purchased nearly $600 million in federal income tax credits. That’s roughly enough, when leveraged, to finance five to seven times that much in construction, industry experts say.
Along with virtually no risk of foreclosure, the median occupancy rate in the properties averaged 96%, the study reports. Low-income housing is easy to rent and rents are collectable, Floreani adds.
In any given year, however, some projects have too little income to cover their debt payments. Such statistics would normally raise red flags. But the report notes that the tax-credit properties are designed just to break even. There may be years when projects fall below the threshold of profitability, but they could subsequently cut costs or raise rents to move above the redline.
Under federal law, apartments constructed with the help of tax credits for investors have to remain certified low-income units for 15 years. One expectation was that the units would then revert to higher market rates. However, the study found that happened with only about 20% of the properties. The majority sought new federal tax credits and remained certified low-income housing--an indication of the attractiveness of the investment to investors.
Spielman says the future of the federal low-income housing tax credit program seems assured. In past votes, Congress assured the permanence of the program, she explains.
In addition, the capital market for federal low-income tax credits has matured. There are about 40 major syndicators nationwide that command the bulk of the business, Floreani adds. The Affordable Housing Investors Council, which represents developers, syndicators, lenders, nonprofit groups, public agencies and others concerned with the low-income housing tax credit program, estimates that its 60 members buy 80% of the annual allotment of federal tax credits.
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Cupertino, CA—Rumors are swirling that Mission West Properties Inc., one of the largest property owners in the Silicon Valley portion of the San Francisco Bay Area, will join the parade of public real estate investment trusts that are moving into the private world.
“Wall Street still doesn’t get it,” says Craig Silvers, founder of Bricks & Mortar Capital LLC, a Los Angeles investment firm specializing in REITs “Main Street will pay more for real estate than Wall Street.”
By that, Silvers means that private equity funds and other investors are often willing to pay more for REIT portfolios than the market capitalization of the portfolios on Wall Street.
There has been speculation for several years that Mission West planned to go private. The REIT, founded in 1969, owns more than 100 properties totaling nearly eight million sf of rentable space through four limited partnerships.
Its founder and patriarch, the 68-year-old Carl Berg, recently complained about the pressures of the Sarbanes-Oxley Act, the federal legislation enacted to protect shareholders and the public from accounting errors and fraudulent practices in corporate America. “The auditors tell us how to run the company,” he said during a conference call with analysts. “That’s what it really boils down to. Everything we do, they think they have a say in.”
He said he did not expect to make a decision on going private in 2006, but left the option open for 2007. Some analysts think it could happen even sooner, since Berg would likely want to sell before the real estate market cools.
Berg’s REIT has not been making acquisitions of late. Berg says it doesn’t make sense to acquire Silicon Valley properties unless rental rates increase substantially. The Silicon Valley office market has been soggy since the dot.com bust of the late 1990s. If rents do not leap, “you have a whole bunch of idiots who are really going to lose a lot of money,” he notes.
Mission West is one of the few equity REITs that failed to score big on Wall Street in the past five years. The stock traded last week at around $12 a share, not far from its 2001 high of $14.45 a share and 2003 low of $8.90.
Berg is ranked as one of the world’s wealthiest people, with a net worth of $1.2 billion. He owns a controlling stake in Mission West. Another large shareholder is the New York City-based Ingalls & Snyder LLC, an 82-year-old money management firm that owns 22% of the firm's outstanding shares.
Mission West has a market capitalization of nearly $220 million, based on recent trading prices. On March 16, its board declared its regular first-quarter cash dividend of $0.16 per share, which represented a 5.7% annualized yield on the stock’s closing price of March 15.
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New York City—Earlier this month, CarrAmerica Realty Corp. announced that it was being acquired by the Blackstone Group. The phenomenon--a private equity company taking a public REIT private--has become nearly routine. According to the National Association of Real Estate Investment Trusts, more than $3.2 billion of investment grade-rated bonds have been affected by merger activity this year.
But what happens to bondholders and other investors once the flurry of merger announcements pass out of the public spotlight? Analysts from Fitch Ratings took a stab as this question at a recent investor roundtable. They concluded that it is difficult to generalize given the range of possible scenarios, which include prepayment, downgrades and restructure. However, in general, they say, REIT bonds offer bondholders a better chance for prepayment than other investment grade bonds. Thus, according to managing director Tara Innes, “most REIT bondholders will be offered prepayment at yield maintenance when REITs are privatized.”
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That is only one possible legal issue that can arise in such transactions, attorneys say. Los Angeles attorney Ellen Marshall says, “There is an entire set of legal issues you go through when taking any company private, starting with what is a fair price at which you will buy out outside holders. There are valuations that are very real in these transactions. And valuation is as much art as it is science.” Marshall is a partner at Manatt, Phelps & Phillips, which specializes in business transactions, including capital markets, finance, mergers and acquisitions and securitization.
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Ettore Santucci, a Boston-based partner in Goodwin Procter’s business law department and chair of its securities and corporate finance practice, notes, “These issues are examined at the bid stage with an enormous amount of care. The problem is, on the market side, people sometimes don’t look at these issues--which can be very granular--as carefully.”
The market might, for instance, think there is an arbitrage opportunity on a bond or preferred stock that is in fact not there. “So when the rumors start circulating that company X is getting set to make an acquisition, investors could wind up making a costly mistake,” he explains.
Santucci says many public REITs have used preferred securities--fixed income securities that are not convertible--as a financing mechanism. These are typically listed on the NYSE with no maturity dates. They could be outstanding forever, in other words.
“In many privatization transactions, what happens is that the preferred securities are left outstanding because the buyer has no obligation to pay them off,” Santucci says. It is fairly routine. But, if the preferred stock does not get redeemed in the acquisition, then the holder might find itself with illiquid stock that is not listed.
“There have been examples where institutional investors bought preferred stock without focusing too much on the specific rights of paper," he says. "Then, when there was a merger and acquisition, they discovered the documents didn’t give them the rights to be redeemed.”
Correction: In a story about the acquisition of CarrAmerica Realty Corp. by the Blackstone Group LP in the March 13 edition of D&E, Jahn S. Brodwin, a partner with the Schonbraun McCann Group in Roseland, NJ, was incorrectly quoted. His quote should read: “It is yet another case of a private company acquiring a public REIT for the arbitrage opportunities. You can expect to see more of such transactions this quarter.”
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What’s Hot . . . Dumb Money Fleeing
New York City—Real estate returns probably peaked last year, says Edward M. Casal, managing partner of the locally based private equity firm Madison Harbor Capital LLC. “Real estate is still a strong investment,” he adds. “I think we will see properties perform well, but duplicating last year’s total return rate of 20.6% will be very difficult.”
Nonetheless, the tradeoff is a good one for the market. In exchange for a lower rate of return, the market can start to say goodbye to dumb money, that is, inexperienced investors that pumped capital into the market at its height. “Ultimately, this will set up better buying opportunities in the next two years,” Casal says.
There are signs of outflow of capital, he says, include declining valuations in the public market. “The REIT market has sold off a little bit in the last few weeks,” he says. In addition, “we are seeing situations where a property is going back to market a second time after the first bidder wasn’t able to close--specifically it wasn’t able to put together equity financing. Debt financing is still there in most cases for most borrowers, but equity financing is getting harder,” Casal says.
Private REITs that acquire net lease properties are also finding that the sales pace has declined dramatically--another sign Casal says. “This is because short term rates have come up so much that investors now have other alternatives in mind,” he explains.
It will not be painless for capital to leave real estate. However, it will make the markets more predictable. “Dumb money is very hard to predict,” Casal says. It is easier for an investor to analyze demographics, population migration, market supply and demand and make an educated guess as to which markets will flourish. But you can’t calculate when dumb money will leave.”
Casal says the Miami condo market is a good example. The market has been expected to burst for the past three years, but hasn’t because inexperienced investors have yet to decamp.
One sign of dumb money leaving that Casal wishes he would see, but hasn’t yet, is more due diligence in the investment decisions in 1031 Exchanges. “We are seeing some very haphazard fund buying and that is going to create a dangerous environment,” he says, noting that one nasty or very public blowup will trigger a federal investigation. “When an institutional investor makes mistakes, it’s one thing. But when a partnership implodes with lots of individual investors hurt, that is when the federal government steps in,” he explains.
What’s Not . . . Homebuilders Who Ignore Changing Demographics
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New York City—Some homebuilders are going to have to pay closer attention to aging trends among baby boomers and incorporate changes in the products they offer in senior housing if they want to remain competitive, warns Paul Prescott, national director for Deloitte & Touche USA LLP's residential development industry segment. “Even as they age, baby boomers remain very active compared to the population of 20 years ago. Therefore, the product mix and design concept of retirement housing, assisted living, timeshares and continuing care retirement communities will have to meet these new requirements.”
Some homebuilders are sensitive to these changing demographics, but some are not, he says. “Typically, it might be a smaller developer only building for current demand,” Prescott says. Such projects may lack the flexibility to offer an array of choices, he adds.—Erika Morphy
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Charlotte, NC—A rash of fourth quarter defeasance activity has prompted Fitch Ratings to upgrade 319 CMBS classes and 24 CDO classes. “We try to be as proactive as possible about putting transactions on Rating Watch Positive,” says analyst Adam Fox.
In the 319 CMBS asset classes recently upgraded, 60% of the transactions had greater than 5% additional defeasance since the New York City-based rating agency last looked at the transactions, he continues. In early 2005, Fitch Ratings tweaked its systems to better monitor defeasance activity--a change that is just now becoming apparent. Volumes from the previous year weren’t as huge as they are now, Fox says.
“Throughout 2005 is when we really saw the pick up in activity,” he notes. Now, defeasance has become so prevalent, that it can have an instant affect on ratings. Fitch upgraded its algorithms to recognize the presence of defeasance. It is an important metric to watch because it can have an instant effect on credit enhancement levels and hence, ratings.
A process standardized largely through the efforts of locally-based Commercial Defeasance LLC, defeasance is the substitution of capital in a CMBS transaction. Essentially, the borrower uses the proceeds from a refinance or sale to purchase a portfolio of US government securities. The redemption from the securities is used to cover the remaining debt service payments, allowing the note to remain in place and payment made on schedule, even though the property has been released from the lien.
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Jason Kelley, CFO of Commercial Defeasance, says the company does not release figures on specific volumes. But he estimates that business is up about 60% compared to same period a year ago. Rising interest rates have not had an impact on activity, he says.
In theory, rising rates would increase the cost of a property. However, they would also decrease defeasance costs by lowering the cost of the securities. “We believe defeasance is tied to overall real estate values and in that regard rising rates would affect defeasance, but we haven’t seen an impact,” Kelley says.—Erika Morphy
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Commercial Real Estate Will Outperform Other Sectors
Pittsburgh—Real estate markets still look solid, but there are potential threats on the horizon, warns Nicholas Buss, senior vice president of the real estate finance division of PNC Financial Services Group Inc. The risks include rising energy prices, a cooling of the red-hot housing market, high consumer debt levels and an over-reliance on foreign investment. However, capital should continue to flow into commercial real estate. "The investors' love affair with real estate is still very much alive," he says, citing his firm’s recently released annual real estate forecast.
Buss expects the more economy-driven sectors including office, industrial and hotels to outperform consumer-driven sectors like retail, apartments and residential housing.
The housing market has peaked and activity overall will gradually slow this year. However, select markets, including Austin, TX, Atlanta, Dallas, Denver and the San Francisco Bay Area may benefit from strong job growth. In contrast, Midwest markets with a heavy dependence on the embattled domestic auto industry could slow considerably.
In commercial real estate, the office sector, driven by white-collar employment growth, should stay strong. The national office vacancy rate could fall to the mid-13% range this year, potentially allowing property owners in many markets to increase rents and reduce tenant concessions.
The apartment sector could improve enough to allow property owners to raise rents, even in markets that have been soft. If condo converters keep snapping up supply and home buying weakens, apartments could be especially strong.
The industrial sector faces a modest threat from the on-going restructuring within the auto industry. However, the threat is unlikely to offset the positive influences of other areas of the economy, most notably trade flow.
New construction in all sectors continues to be cramped by rising demand for construction materials overseas, particularly from China and India. In addition to overseas demand, US developers are challenged by significant domestic demand for materials for rebuilding efforts in the hurricane-ravaged Gulf Coast.
GE Invests In Chinese Real Estate
Stamford, CT—Plenty of capital from mainland China flows into the US, mainly in the form of purchases of US Treasury bonds. Now a locally-based unit of General Electric Co. plans to send American capital to China.
The real estate group of GE’s commercial finance division will invest $20 million and be the sole strategic investor in the newly formed Citic Capital Vanke China Property Development Fund. The fund, in partnership with China Vanke Co. Ltd., the largest publicly listed real estate developer in China, plans to invest up to $150 million in residential real estate in select economically developed regions.
It will be based in the Cayman Islands and managed by Hong Kong-based Citic Capital Markets Holdings Ltd., the investment banking arm of Citic Group in China.
Michael Pralle, president and CEO of GE Real Estate, calls the fund an ideal vehicle for entry into the mainland China market. The company describes residential real estate as the most robust and liquid commercial real estate segment in China.—Benjamin Mark Cole
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Florham Park, NJ—GSC Partners, a locally based alternative asset management firm, appointed Alexander K. Zabik a senior managing director and head of high yield real estate. Zabik will be a portfolio manager in a new fund focusing on US commercial real estate-backed high yield debt and mezzanine investments. The fund has not been named. Zabik joins GSC Partners, which manages more than $10 billion of assets and focuses on complex credit-driven investment strategies, from BlackRock Inc. in New York City. At BlackRock, Zabik was a senior member of the real estate debt group and a member of the investment committee and investment strategy group.
New York City—Jeffrey Dauray is a new senior vice president with CB Richard Ellis Co.’s investment properties institutional group. He has focused on hospitality sector brokerage, opportunistic real estate investment and portfolio management in previous positions. Most recently, he was managing director of a boutique hospitality brokerage firm based in Washington, DC.
Toledo, OH—Health Care REIT Inc. has promoted Scott A. Estes to senior vice president and chief financial officer from vice president of finance. Charles J. Herman Jr. has also been promoted to executive vice president and chief investment officer from vice president and chief investment officer. Jay Morgan has been appointed to the newly created position of vice president-acute care investments and Joseph P. Weisenburger was named to the newly created position of vice president-senior housing. Morgan was most recently a vice president in the real estate investment banking group at Lehman Brothers and previously an analyst with Health Care REIT. Weisenburger has been with the company since 1998, most recently serving as investment officer.
Warrendale, PA—American Eagle Outfitters Inc. announced that Joseph Kerin, EVP, store operations, will add real estate and construction to his responsibilities. These areas previously reported to Dennis Parodi, who left the firm to become EVP/COO of the New York Design Center, where his responsibilities include design operations, global sourcing and production.—Erika Morphy
