Goldman turns bearish on equity REITs

The Goldman Sachs Group Inc. is taking a bearish view on commercial real estate, with a prediction that equity real estate investment trusts likely will deliver a return of -10% this year and continue to deteriorate through at least 2009. "REITs are no longer a relative safe haven," the New York firm said in a 50-page report released this month. "The worst is yet to come in our view," analyst Jonathan Habermann wrote in a note.

So far this year, the REIT dividend yield, which currently averages 4.9%, has enticed investors into the group. Equity REITs have posted total returns, including dividends, of about 3.9% this year, outperforming the Standard & Poor's 500 stock index returns of -10.2%, according to the National Association of Real Estate Investment Trusts in Washington.

However, Mr. Habermann wrote, real estate fundamentals are beginning to deteriorate, and valuations don't reflect the slowing growth ahead. Rising unemployment, slowing real estate demand, higher funding costs and rising cap rates — which aren't reflected in REIT stock prices — all pose risks, he wrote.

"We continue to see downside risk of 10% or more, from current levels, and would continue to underweight REITs," Mr. Habermann wrote. "Commercial real estate trends lag the broader economy."

During the 2001 recession, commercial real estate didn't hit bottom until 2003, Mr. Habermann noted.

Real estate fundamentals, which include occupancy rates and rents, peaked last year and "are likely to weaken in 2008 and 2009," according to the report. This will translate into slower funds from operations growth for equity REITs.

The Goldman report predicts that REITs likely will post FFO growth of 0% to 3% this year and in 2009, below analyst consensus expectations of 4% to 7%.

Goldman's economics research team projects anemic U.S. gross domestic product growth of 1.5% this year and 1.1% in 2009, and predicts that unemployment will hit 6.5% by the end of 2009. This likely will cause corporations to pull back on their real estate needs.

Then there are rising debt costs.

"Although spreads [over 10-year Treasuries] have recently tightened, we expect access to capital to remain constrained in the second half of 2008," according to the report. As a result, refinancing debt "may prove challenging in the current environment," it said.

Also, access to cheap capital to purchase real estate is now evaporating, which will mean fewer bidding wars for properties and subsequently falling property values.

"The question of: 'How bad will this cycle be?' is yet to be determined," Mr. Habermann wrote. "We have already seen early signs as reflected by the ongoing work-out of an overleveraged New York City office portfolio as well as the sharp increase in cap rates for less desirable properties."

Mr. Habermann was likely referring to real estate mogul Harry Macklowe, who went on a buying spree at the height of the market last year, purchasing seven Manhattan skyscrapers for about $7 billion, mainly using short-term loans that have since come due.

When the credit crisis erupted, Mr. Macklowe couldn't refinance the debt, forcing him to put a number of properties, including his prized General Motors building, on the block to keep creditors at bay. There is speculation that other overleveraged buyers could face similar woes.

In mid-June, Harry Macklowe's son, William, replaced him as chairman and chief executive of Macklowe Properties Inc. of New York.

The report said that REIT valuations don't reflect all these risks.

Equity REITs currently trade at about 15 times 2009 FFO, which is well above the long-term average of 10 to 12, Mr. Habermann wrote.

According to New York-based TIAA-CREF Asset Management, there has been an uptick in vacancies, higher cap rates, a steep drop-off in transactions and deterioration in demand for space.

In a recent weekly monitor report, the company cited a number of statistics indicating a slowdown: About $35 billion in U.S. commercial real estate changed hands in the first quarter, which is less than half the amount of sales done during the comparable period a year ago, the TIAA-CREF report stated.

"The decline in sales activity is due in part to tighter credit conditions," according to the report. Indeed, credit generated from issuance of commercial mortgage-backed securities plummeted to $10.9 billion in the first four months of the year, from $96.8 billion for the first four months of 2007, the report said.

However, it hasn't seen a surge in distressed sellers — at least not yet.

A recent survey conducted by Bryan Cave LLP of St. Louis showed that 59% of real estate executives polled thought that commercial properties were overvalued, and just 4% considered them undervalued.

This sentiment is contributing to the slowdown in property sales.

Mr. Habermann wrote in his note that REITs that have long-term leases in major markets will weather the stormy economy the best. As a result, he favors office REITs that have a big exposure to the New York office market and mall REITs, with his top picks being Simon Property Group Inc. (SPG) of Indianapolis, Taubman Centers Inc. (TCO) of Bloomfield Hills, Mich., and Vornado Realty Trust (VNO) of New York.

Mr. Habermann is cautious about REITs with short-term leases, such as apartments, and REITs that rely on acquisitions and developments to grow, and has "sell" recommendations on AvalonBay Communities Inc. (AVB) of Alexandria, Va., Camden Property Trust (CPT) of Houston and Liberty Property Trust (LRY) of Malvern, Pa.