Knowing REIT From Wrong

News Analysis
BusinessWeek.com
May 22, 2006
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Five for the Money: Knowing REIT From Wrong

Real estate investment trusts look appealing after their recent pullback, but some might be best to avoid

After five years of impressive returns, real estate investment trusts (REITs) may once again seem like a buying opportunity. Along with the broader stock market, this group has hit a rough patch. The Standard & Poor's 1500 REITs Sub-Industry index, which hit an all-time high on Mar. 17, was down 9.7% from that level as of May 18. While the drop could provide opportunities to pick up shares on the cheap, investors should look under the roof first.

A REIT is a tax-advantaged company that invests in a portfolio of real estate properties. As always in real estate, location is everything. Shopping center REITs and office REITs continue to be cheaply priced, but residential REITs are "tricky," according to Andrew Clark, a senior research analyst at investment tracker Lipper. "The market seems to be trading residential REITs on much more of a speculative basis than on a fundamental basis," Clark says.

Residential REITs, which invest mainly in apartments and manufactured housing, could benefit as the market for single-family homes shows signs of cooling. On May 16, the Commerce Dept. said U.S. housing starts slowed to 1.85 million units in April, the lowest since November, 2004. A day earlier, the National Association of Home Builders announced that its May index of builders' perceptions of sales conditions dropped to its lowest level in more than 10 years.

PULLBACK OVER?  Despite the recent downturn, REITs have posted benchmark-beating returns in recent years. The S&P 1500 REITs Sub-Industry index has climbed 38.3% since its Oct. 9, 2001, launch, compared to a 20.4% gain for the broader S&P 500 index over the same period.

If the bulls are right, the sector's pullback may have run its course. On Apr. 10, S&P Equity Research warned of a potential correction of up to 15% over the next six months in the S&P 1500 REITs Sub-Industry index. Mark Arbeter, chief technical analyst at S&P Equity Research, says most of the expected damage has already occurred.

Still, as with any investment, investors shouldn't try to outsmart the market. REITs can best boost returns as a core asset class in a well-diversified, long-term portfolio, says Michael Grupe, executive vice-president of research and investor outreach for the National Association of Real Estate Investment Trusts. "You can't just invest in three, four, or five REITs and expect to realize the kinds of diversification benefits we have in mind," he says. This week's Five for the Money looks at REITs that investors should survey carefully before buying.

1. Management still matters.
Newtown Square (Pa.)-based GMH Communities Trust (GCT ), which focuses on housing for college students and the military, delayed filing its 2005 and first-quarter 2006 financial reports in the wake of an investigation into its accounting procedures. The investigation revealed "material weaknesses" in the company's financial reporting, along with "tone at the top" behavioral issues, GMH said in a Mar. 10 statement.

Facing at least 10 class-action lawsuits, the company has begun efforts to set a new tone. In another statement May 15, GMH announced it had hired J. Patrick O'Grady, a partner with accounting firm KPMG, as its new chief financial officer. The company also said it was close to finalizing its 2005 report and expects to post funds from operations, a common REIT performance measure, of 69 cents a share on $227.6 million in sales. Kathy Grim, GMH's vice president of marketing, declined to comment beyond the statements.

GMH shares have fallen 32.9% from a 52-week high of $17.10 hit on Mar. 1. On Apr. 28, investment researcher Morningstar (MORN) removed its rating on the REIT amid its mounting difficulties. "That's one that we're recommending that investors steer clear of," says Morningstar stock analyst Ryan Dobratz.

Other analysts' opinions were more lukewarm, including two holds and two hold/sells, according to data from S&P Equity Research. On May 15, J.P. Morgan Securities maintained its underweight rating on GMH shares. "We believe that the accounting issues cause an overhang that could linger for a few quarters," analyst Anthony Paolone wrote.

2. Keep an eye on dividends.
Part of the appeal of REITs lies in their generally high payouts. If a company shrinks its dividend, steer clear. On May 2, S&P reiterated a strong sell recommendation on shares of Chicago-based Equity Office Properties (EOP ), the largest publicly held owner of office buildings. One reason: a recent dividend cut.

A day earlier, Equity Office Properties posted first-quarter funds from operations of 55 cents a share, a penny above Wall Street's forecast. On Dec. 14, 2005, the company sliced its annual dividend by a third, to $1.32, to better align the payout with taxable income. S&P analyst Roland Shepard says he sees additional risks to dividends in the next year.

The REIT also faces the risk of tenants currently paying above-market rents renewing their leases at cheaper rates. Rents in areas like San Francisco and Boston are lower than they were a few years ago, Shepard says. He projects a 10% decline in rent prices on leases that roll over in 2006, after a roughly 15% drop in 2005. "They also need to make improvements to their buildings," he says, which would place another drag on margins.

Wall Street analyst opinion varies, with "hold" the most common recommendation. Terry Holt, a spokeswoman for Equity Office Properties, points to the stock's strong performance history. In the three years ended Dec. 31, 2005, shares posted total returns of 15.1%, compared to 14.4% for the S&P 500.

"Our geographic diversity offers less risk compared to REITs that have a more narrow market focus, that have heavy development, or that have significant noncore business income," Holt says.

3. Check the price tag.
On May 17, shares of Los Angeles-based Kilroy Realty (KRC) closed at $67.83, down 13.1% from their 52-week high of $78.04 reached on Mar. 30. Founded in 1955, the company invests in commercial office and industrial properties in Southern California, including the lucrative San Diego, Los Angeles, and Orange markets.

Morningstar's Dobratz says the REIT should be priced far lower. He pegs Kilroy's fair value at $45 and assigns it a one-star rating, arguing that investors bid up the shares after another Southern California REIT, Arden Realty, went private at a hefty price. Moreover, Kilroy's 3% dividend yield is low for its industry, according to Morningstar. "If investors are paying that price they should expect mid- to high single-digit returns, or more," Dobratz says.

Still, he applauds the company's latest news. On May 8, Kilroy said it would sell 2 million common shares to lead underwriter Bank of America (BAC ), for a price later set at $69.50. Selling shares around the current price level was an "incredibly smart move," Dobratz wrote in a May 9 report.

Other analysts take a more bullish view of Kilroy's value. On Apr. 25, Deutsche Bank Securities reiterated its hold recommendation on the stock, while maintaining a $75 target price. "Some people may be disappointed that rent growth was mixed" in the first quarter, wrote research analyst Lou Taylor. "This is very normal at this point in the cycle, so we're not terribly alarmed." A Kilroy representative did not respond to requests for comment prior to deadline.

4. Conservative investments may lack strong growth.
Newton (Mass.)-based HRPT Properties Trust (HRP) owns office buildings in attractive markets like suburban Washington, D.C., Boston, and Southern California. Its 94% occupancy rating is among the best in the business, according to Morningstar.

Dobratz is concerned about the company's conservative investment approach. Rather than developing buildings and finding tenants, the company buys office properties already occupied by creditworthy tenants, he says. "They're paying up for it," he says. "We don't think there's a lot of value-add there."

While Dobratz rates the stock three stars out of a possible five, he also gives it a C for "stewardship." That's partly because unlike most REITs, HRPT Properties Trust is externally managed, which he says may create conflicts of interest. A company representative did not respond to requests for comment prior to deadline.

Still, HRPT continues to generate solid numbers -- and some analysts like what they see. On May 8, the company posted first-quarter funds from operations of 31 cents a share, in line with Street expectations. Ferris, Baker, Watts maintained its buy rating on the stock, but lowered its target price. "We believe HRP shares are significantly undervalued at current levels and provide an excellent risk/reward investment opportunity," analyst Charles Place wrote.

5. Apartments are lofty.
If apartments in your neighborhood seem expensive, check out apartment REITs. Despite macroeconomic factors working in their favor, many apartment REITs are simply overpriced, some analysts say.

Expenses for apartment REITs are on the rise, notes S&P's Shepard. The costs of natural gas, heating, and insurance impact his outlook on the shares. Meanwhile, apartment REITs have an average dividend yield of 4.1%, which isn't particularly high for REITs, he says.

Morningstar has a one-star rating on apartment REITs such as Avalon Bay Communities (AVB ), BRE Properties (BRE ) and Post Properties (PPS), none of which responded to requests for comment prior to deadline. "Apartment REITs as a group are priced as if they're being taken private tomorrow," Dobratz says. "It could work out for shareholders if they do get taken private, but otherwise, the return implications of paying today's price are below where we'd want to invest."

Nevertheless, apartment REITs ought to benefit if a weaker housing market leads consumers to start looking to rent. That may already be starting to happen. In fact, higher apartment rents were one of the biggest factors behind the recent greater-than-expected rise in the consumer price index, which sent stocks on their latest tumble.