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Is Real Estate Value an Oxymoron?

Our commercial real estate outlook viewed through real estate investment trusts.

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Depending on the measure used, residential real estate has been losing value for nearly three years and shows few signs of reversing course. Now, as history predicted, commercial real estate is set to follow suit. In this article, we'll explore the various head winds facing CRE investors, primarily through the eyes of publicly traded equity real estate investment trusts with additional support from various capital market and macroeconomic data.

At Morningstar, we have one of the broadest equity REIT coverage universes, including 70 companies spread among every major property type, putting us in good position to survey the situation from the top down and bottom up. Our current take is that while certain property types should fare substantially worse than others, we expect cash flow to stagnate or decline across all of them. In order of severity, here's our outlook from worst to bad: hotels, retail, office, industrial, apartment, and health care. There's a long list of catalysts for this forecast, but the strongest head winds include excessive leverage, tight credit markets, excess property supply, plummeting property demand, reduced consumer spending, and strained government budgets.

Where Does This Leave REIT Investors?
The unfortunate reality at the moment is that the current dividends of most REITs are unsustainable. To maintain their tax-advantaged status, REITs must pay 90% of taxable income to shareholders in the form of dividends, which is generally well below actual cash flow because of noncash expenses, primarily property depreciation. Over the last few years, irrational overconfidence driven by a strong economy, appreciating property values, rising rents, and easy credit led many REITs to send nearly all of their cash flow to investors. While this strategy led to impressive dividend growth and rising stock prices for years, the music has officially stopped--cash-flow trends are reversing and dividend cuts are spreading rapidly. Hotels are leading this unwelcome charge, as their one-night leases leave them immediately exposed to reduced demand. If our company-level forecasts prove correct, few REITs in any property type are likely to maintain their current payouts.

Our advice, in short, is not to invest in REITs for dividends, unless the yield is still attractive once the dividend has been reduced to a sustainable level. For valuation purposes, our Consider Buying prices target forward sustainable and attractive yields; in addition to our discounted cash-flow models, we use a variety of triangulation methods to approximate the return that investors can expect based on our recommendations. Free cash-flow yield (cash flow from operations less capital expenditures divided by market capitalization) is one of our favorite measures, as it reveals the potential cash return, if any, that equity investors can expect. However, as cheap debt on the balance sheet is refinanced at less favorable rates, we forecast a growing portion of cash flow ending up in debt holders' pockets instead of equity holders'.

Senioritis
Thanks to leveraged business models, REIT common equity is at the wrong end of the risk spectrum in an exceptionally risk-averse world. During uncertain times, investors not only sell low-quality common equity in favor of high-quality common equity, but they also move from common equity to more senior parts of the capital structure, such as preferred equity, subordinated debt, or senior debt. Taking the fear trade a step further, investors move away from senior corporate debt to agency debt, and then finally direct to the safest investment of all: Treasury securities. What's the current situation? Equity markets are enduring the worst decline since the Great Depression, investment-grade corporate debt is trading at spreads larger than those experienced during the Great Depression, and short-term Treasury yields are effectively zero. In the panic-stricken capital market environment that is currently our (and your) reality, the flight to quality has been nothing short of frenzied, making common equity seem like a tiny sliver of value too thin to be seen or realized.

This is proving especially true for hotel REIT common equity, which must compete with other readily available parts of the REIT capital structure for investment dollars. At times over the last couple of months, the market has priced in nearly certain chances of bankruptcy for most of the hotel REITs. Given this backdrop, we're resigned to the fact that the value we see in some of the common equity may not be realized for an extended period, because of attractive opportunities in more secure parts of the capital structure.

To demonstrate, let's look at the potential preferred and common equity returns for  Sunstone Hotel Investors (SHO), one of our few 5-star REIT recommendations. As of this writing, Sunstone preferred is offering roughly a 2-to-1 return while the common equity---again, the most exposed part of the capital structure---is offering a 2.5-to-1 return, assuming our fair value estimate is accurate. Granted, 2.5 is greater than 2, but 2-to-1 seems good enough, considering that the investment is higher in the capital structure and that common equity in general has been cut in half this year. Therefore, it's not hard to see why income-oriented investors have been backing away from the common equity of REITs. As the pain spreads to other property types, this phenomenon is likely to spread.

Got Capital?
Excessive leverage, tighter lending, and falling cash flow foreshadow a shifting return paradigm for REITs and other CRE owners. The days of leveraging assets with easy credit predicated on unrealistic forecasts of constantly increasing cash flow are over. Now there appears to be a large pool of highly encumbered assets that are worth less than the debt they secure (also known as "underwater") just as acceptable loan/value ratios are falling. Barring heroic (risk-seeking?) back flips by lending institutions or government initiatives, many REITs will have to reduce debt outstanding as it comes due in order to satisfy current loan/value standards in light of reduced asset prices. This is not an easy feat, considering that most of the cash that REITs generated recently has already been paid to equity holders in the form of higher-than-advisable dividends.

When cash isn't available to reduce debt, REITs must raise capital. The cheapest source of capital at this point is cutting the dividend, which is already occurring and should continue. However, this dollar value often pales in comparison to debt maturities and therefore generally isn't a sufficient solution. Assuming new or refinanced debt is unavailable at the scale and price needed--as is predominantly the case today because commercial mortgage-backed security and high-yield markets are effectively nonfunctioning--REITs must then turn to asset sales, including outright asset divestitures or taking on equity investors via joint ventures. At the moment though, even this option is not guaranteed. Various industry sources have indicated that CRE transactions are down by 70% compared with year-ago levels, as the combination of tight lending standards and expectations for falling property values has created a virtual abyss between buyers and sellers.  Developers Diversified Realty (DDR) is a timely example: A joint venture sale valued at nearly $1 billion fell through after the deal seemed certain just a couple of months ago. Now the firm will either have to reduce the selling price, sell higher-quality assets, or both. While these are typically not attractive alternatives, property buyers are in the driver's seat as sellers are shifting their focus from capturing value to ensuring survival.

More Supply on the Way. Doh!
As the economy deteriorates, occupancy declines, and margins and rents fall, more CRE owners become distressed sellers, pressuring CRE values even further.  General Growth Properties (GGP), a firm that we believe is most likely headed for bankruptcy, is the second-largest retail CRE owner in the U.S., with $27 billion of properties on its balance sheet. Over the last few weeks, there have been presumably intense negotiations to refinance a substantial amount of maturing debt, as deadlines have been extended for just weeks at a time and then come and gone. While the outcome is still uncertain, we're confident that equity holders will not be winners--assuming there are any winners at all.

Recent negotiations between severely distressed Centro, an Australia-based property owner with $13 billion in mostly retail U.S. CRE, and its lenders could provide some insight. From the outside looking in, it appears that Centro's lenders were terrified at the prospect of liquidating such a large property portfolio in a highly illiquid market. The solution as announced will help the firm temporarily avoid bankruptcy by gradually granting 90% of the firm's equity to debt holders, leaving existing equity holders with severely devalued positions. While General Growth and Centro's resolutions thus far have been good news for property markets, we suspect that as property values fall, cash flow declines, and credit remains tight, distressed assets will eventually hit the market, increasing supply. Then it will be very difficult to avoid marking assets down to market clearing prices, eventually putting additional weight on CRE values and compounding leverage issues.

It's hard to believe, but there is still a large development pipeline that will come online over the next couple of years. Due to multiyear lead times for construction, CRE investment only recently began to fall, peaking at about $400 billion annualized over the last year, including $45 billion in hotels and $35 billion in retail, two areas that we expect to be especially hard-hit. As a percentage of gross domestic product, the latter two figures are substantial outliers relative to historical trends, indicating that a material amount of supply is about to come online at the worst possible time. We've been especially mindful of this fact when valuing REITs for which a large portion of property, plant, and equipment is in the development stage. For example, more than one third of  Cousins Properties Inc(CUZ) property value consists of property developments and land available for development. It's safe to assume that the return expected when these projects were started or land was purchased is markedly below the return that will ultimately be realized.

What Else Could Go Wrong?
The peak of unemployment in this recession is still to be determined, but there's no doubt that it will have a material impact on CRE values and REITs. As unemployment increases, there are fewer workers filling office buildings, fewer business and consumer travelers checking into hotels, and more family and friends consolidating households, which reduces apartment demand. In addition, we would expect to see much less consumer spending at retail REIT properties, which would also weigh on global economic activity, putting further pressure on industrial properties. It's no longer absurd to expect a 10% unemployment rate, but it's very difficult to say what the peak and impact will be--other than that there's downside risk to CRE values from here.

The last unknown is also unfortunately one of the most important long-run variables for CRE values and REITs: interest rates. We already know that the borrowing interest rates that CRE owners must pay over the next few years will be higher than those that they've paid in the recent past, because, despite recently improved base rates--LIBOR and 10-year Treasuries--spreads are a multiple of their former selves. Eventually, we think the appropriate price of risk will settle somewhere in the middle. However, the future base rate is much more difficult to predict. The global flight to quality has pressured Treasuries to historic lows, but there is a risk that this trend could reverse, which is beyond the scope of this article. Suffice to say that, given the currently low rates, there appears to be more upside risk to rates than downside. Still, even if rates did fall further, it would probably be due to a more negative economic outlook (such as severe asset price deflation), in which case spreads seem unlikely to compress. However, if rates go up, spreads would have to compress materially to reduce borrowing costs and maintain reasonable returns on CRE properties. Given that we're starting from what should prove to be a high point for years in terms of CRE values, both the upside and downside risk of interest rates create reason for concern, at least in the short term. In the long term, an extended period of very low interest rates could lead to another round of irrational asset price inflation, benefiting CRE values and REITs, but the probability seems remote enough to put in the back of our minds for now.

So, Is Real Estate Value an Oxymoron?
For anyone who purchased CRE property at prevailing market prices in the last two years, the answer is unequivocally yes. This also holds true for REIT common equity, excluding the last few months of trading for a few overly punished companies. CRE values should fall from recent marks, so for buyers to find value they must negotiate purchase prices low enough to account for future price declines. As for REIT common equity, given the opportunities in more secure parts of the capital structure and our expectations for falling cash flows in the next few years, we'd be surprised to see much investor enthusiasm, even in companies that we find to be cheap. In the long term, though, conditions should improve once again, and we believe that the REITs that we view as undervalued will outperform the overvalued, according to our fair value estimates.

Joel Bloomer does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.