COVER STORY, JUNE 2006

ALL THE REIT MOVES
The industry’s hot sectors and its privatization trend.
Daniel Beaird

Real Estate Investment Trusts (REITs) always spark interest across the Southeast and the nation. From which sector is hot to which sector is not, from mergers and acquisitions to the privatization trend hovering over the industry to the kinds of returns investors can expect in 2006. A REIT is a company that owns and operates income-producing real estate. According to the National Association of Real Estate Investment Trusts (NAREIT), to be considered a REIT, a real estate company must distribute at least 90 percent of its taxable income to shareholders annually in dividends. Southeast Real Estate Business recently spoke with some leading REIT investors and took a look at some of the trends affecting the REIT industry.

Determining which property type to invest in a particular REIT can be a challenge. Should one invest in the lodging, multifamily, office, retail or senior housing sector? The cyclical nature of the real estate marketplace can be intimidating. So, which sector is hot right now? “The apartment sector seems to be really picking up on the positive earnings reports,” says Nitin Chittal, chief executive officer and principal at Fairfax, Virginia-based KRA Capital Management, which specializes in institutional real estate securities management. According to Chittal, coastal markets and Southeastern markets are experiencing very strong rental growth and opportunity in the multifamily market because mortgage rates are finally rising and pushing potential homebuyers back into the rental market.

“We are also seeing continued strength and recovery in the hotel sector,” Chittal says. “It has been a consumer-driven economy, so hotels have been a little soft on their ability to grow in the past 24 months, but, today, groups are booking in advance and we believe the sector has the potential to experience double-digit earnings growth in the next 2 to 3 years.” The hotel sector is still trying to recover from the massive blow it felt post 9/11. It is finally doing so, as both business and leisure travel is coming back. The economy is improving for the lodging sector and new supply for the industry remains limited, creating an increased demand for hotel rooms. “After looking at the first quarter earnings for this year, we see very robust and strong RevPAR growth for the lodging industry,” Chittal says. Chris Lucas, managing director and REIT analyst for RW Baird, agrees. “The full-service lodging sector is bouncing back through more business and leisure travel,” Lucas says. According to PricewaterhouseCoopers, the estimated occupancy rates for hotel REITs this year is 64.3 percent, up from 63.1 percent last year and 61.3 percent in 2004. Meanwhile, the average daily rate has jumped from $90.70 last year to an estimated $95.21 this year.  

The office sector, while still showing strength in Washington, D.C., has appeared to bottom out in the other markets around the Southeast. “Rents are down and occupancy is up in the office sector,” Lucas says. However, according to Chittal, KRA Capital Management believes the next 24 months are going to provide landlords the ability to start increasing rental rates. “We are very bullish on the office market in the next 24 to 36 months,” Chittal says. While the aforementioned three sectors – apartments, lodging and office – could have a bright future ahead, the REIT industry remains cyclical.

“There has been a general concern in the broad market that REITs have outperformed for 6 years and a day is going to come when they won’t,” Chittal says. “I’m continually surprised that day hasn’t come yet.” But, according to Chittal, if the market is analyzed closely, the industry has witnessed some up and down cycles. “From 1999 to 2001, the sectors that really generated the strongest revenue growth are the three that are doing it today,” Chittal says. Post 9/11 and the acceleration of the recession, however, led to downturns in all three sectors. “The consumer-driven economy from 2001 to 2004 greatly benefited retail REITs, and going hand-in-hand, the industrial REITs and facility operators did well because of the demand from the retail side,” Chittal says.

Today, though, the retail is changing. While retail is enjoying high occupancy rates, it is not predicted to have the same strong revenue growth it benefited from in the past. “High occupancies for the retail REITs have led to an inability for these companies to generate a strong year over year revenue growth that was seen in the prior 4 years,” Chittal says. “A reasonable rate of return of 7 to 9 percent is still expected for retail REITs during the next few years, but it won’t be as strong as it was.”

According to Chittal, the sector facing the biggest challenge is healthcare. “Due to the uncertainty of the Medicare reimbursement program, an uneasiness has set in as Congress moves forward on cost cuts for the program,” Chittal says. The healthcare sector delivered the lowest returns in 2005 on the NAREIT index. Once again, the healthcare sector has begun 2006 with the lowest returns on the NAREIT index. However, can the aging baby boomer population help the healthcare industry? “It depends on how much of the aging population has the resources to pay for retirement homes and assisted living versus those that require Medicare to help them,” Chittal says. “Medicare is going to be an interesting element to watch as it unfolds. If Congress diminishes the benefit to retirees, it will really place a burden on the retired population as well as eliminate substantial business venues for certain operators.”

On the flip side, the aging baby boomer population will be looking to supplement their incomes. “REITs are going to be interest to them because of the dividend component, which can serve as a complement to the fixed-income security they are already receiving,” Chittal says. The strength of recovery in apartments and hotels as well as the continued strength in rental pricing for office REITs has the industry predicting solid returns for 2006.

Privatization Trend

How has the privatization game affected the REIT industry in the past year? Let us count the ways: Blackstone Group purchases CarrAmerica Realty and MeriStar Hospitality; LBA Realty purchases Bedford Property Investors; GE Real Estate purchases Arden Realty; Morgan Stanley/Onex purchases Town & Country Trust; CalEast Industrial Investors purchases CenterPoint Properties Trust; and Morgan Stanley purchases AMLI Residential Properties as the list goes on. The aforementioned acquisitions are just some of the REITs taken private since 2005. The recent privatization trend within the REIT industry has been driven by the fact that private buyers will pay more for the company than stock investors will. These private entities that purchase REITs, in return, gain property that could be flipped immediately for a profit or held on to for the long term. These privatizations cause the sector prices to jump dramatically in anticipation for the next REIT to turn private. The catch is that the private market might be soaring too high, allowing the public market to rebound. The REIT market is definitely healthy as private and public entities target REITs.

“Our belief is that just as many REITs will go private as REITs come into play in the IPO stage during the next few years,” Chittal says. “I think there has been an equal balance with public companies buying public companies as well as companies just going private.” Chittal also believes public real estate is still very valuable as compared to the private real estate market as private real estate still commands a higher value. “So, it is efficient if a private entity spends $1 billion worth of property at better prices than if it took the same $1 billion and purchased several buildings,” Chittal says. “Also, if the private entity is buying companies that offer a platform of operations and strong management teams, the private entity enhances the platform it already has as an asset manager.”

On the public M&A side, the idea is to enhance a company’s weakness through the merging company’s strength. “Such as Brandywine Realty Trust acquiring Prentiss Properties Trust, but staying public” Chittal says. “Brandywine really didn’t have a strength in development opportunity and Prentiss has been a big developer of properties.” So, whether its private or public, REITs are being bought up left and right. As the market continues to undervalue REIT stocks, the time to buy is ripe.

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