The Tide Turns Against REITS

06/21/2007 12:00 am EST

Focus: REITS

Peter Slatin

Founder and Editor, The Slatin Report

Peter Slatin, editor of the Forbes/Slatin Real Estate Report, says that REITs' lagging stock performance, as well as rising interest rates, could mean the seven-year party is over.

By the close of trading on Thursday, June 7, the NAREIT Equity index has lost 1.6% in the year to date, in contrast to positive returns for the [major market indexes.] As we approach the end of the second quarter, there is little on the horizon-or right in front of us-to suggest that this trend of serious underperformance will lessen.

REITs (Real Estate Investment Trusts) can be fairly said to be limping along-and why shouldn't they, given the amazing race they have run over the past seven years?

Not coincidentally, the market for ten-year Treasury notes made its biggest move in two years, and closed above 5% for the first time since last summer. REIT stock yields averaged just under 4%, establishing a negative spread between REIT dividend yields and the ten-year Treasury of more than 100 basis points. That's surely a significant inflection point for yield-conscious investors pondering their options.

What bears are watching right now is retail and consumer spending. Bear Stearns REIT analyst Ross Smotrich pointed out that the investment bank's weighted same-store sales report for May showed gains of 2.6%-vs. a 4.7% year-earlier rise.

In fact, for the week ended June 7, the regional mall sector was off 5.9%, while hotels dropped 5.5% and storage fell 5.8%. Whether these drawdowns were in anticipation of a larger consumer pullback than is already underway, a reflection of a market consensus on overheated valuations, or simple profit-taking at an opportune moment-or some of all three-they are surely an indicator of a rising tide of negative sentiment towards the entire REIT sector.

And therein is the crux of the problem for the real estate sector, and, perhaps more importantly, for the best companies in that sector. Despite all of the growth in wealth, performance, governance, and even in reach, that has taken place over the past 15 years, the sector remains with at least one foot planted firmly in the prehistoric world of back-room, back-slapping deal making. This is a tough image to shake, especially as the subprime market's bursting bubble begins to leak into commercial lending.

Which brings us front and center to the continuing M&A wave, and how strong or weak that wave is given current market conditions. With the announcement [that Lehman Brothers and Tishman Speyer will buy Archstone-Smith (NYSE: ASN)], it seems that virtually any and every company, the strong as well as the weak, is fodder for acquisition.

But if rates continue to rise, that will put a crimp in both purchasing power and even appetite, even as multiples contract. As companies and properties appear less robust (or just less inflated), demand, too, will wane.

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