As another 7.5% decline in the Wilshire REIT Index and numerous quarters of underperformance to the various private commercial real estate and equity market indices demonstrate, being relatively cheap is not reason enough for a positive outcome. At the recent Citi CEO conference, REIT management teams quietly bemoaned their Net Asset Value discounts and analysts and investors cried out for strategic initiatives but, with a nod to Vladimir Lenin, “What is to be Done?”
SL Green, the New York City landlord, is doing the most obvious thing, selling non-core assets in the private market and buying back shares in the public market (on a leverage neutral basis). As of March 1, the company has repurchased 11.9 million shares at an average price of $100.30; the shares closed at $96.83 at the end of the quarter, netting the company $41.1 million in unrealized losses.
There has been some M&A activity during the quarter but the discrepancy in implied cap rates that GGP and Westfield are being valued suggests that these deals have more to do with the cost of capital of the acquirer than the intrinsic value of the acquiree. Ditto Pebblebrook’s bear hug on LaSalle; CEO Jon Bortz is afforded the opportunity to buy back his former company only because of the cost of capital advantage he has garnered in the public markets; wake us up if and when private equity gets involved.
REITs are fighting battles on a number of fronts. Dedicated REIT funds, both in the US and Japan, have been seeing steady outflows; while it is difficult to discern whether investor disinterest is the cause or effect of underperformance by the asset class, it is hard to make headway when funds are being steadily withdrawn. As we enter First Quarter earnings season, equity investors are eagerly anticipating the beneficial effects of recent tax cuts. Not so for REIT investors; traditionally tax advantaged vehicles like REITs are suffering in comparison to their more heavily taxed brethren and will do so for at least the next 12 months. Retail REITs comprise 18% of the Index and are experiencing a secular deflation in rents due to well documented technological disruption; until retail rents get to a point of equilibrium, expect continued headwinds for the entire Index. Put another way, many pundits have suggested that retail real estate is not overdeveloped but under-demolished; higher and better use has to be found for much of the obsolete retail real estate that comprises at least a portion of the afore-mentioned 18% but unfortunately, the rents that current tenants are paying are still too high. Retail is certainly one arena where the public markets are giving a more honest assessment of operating fundamentals than private; however, that does not mean that the outlook is rosy.
Finally, REITs are perceived to be interest rate sensitive and investors are concerned about rate path. Interestingly, since the sharp spike at the beginning of the year, the yield on the 10-Year Treasury Note has been on a steady decline. With a FOMC on a steady course to raise the federal funds rate three if not four times this year, the yield curve has flattened noticeably; the spread on the yields on the 2-Year and 10-Year Treasury Notes has gone from a high of 78 bps during the quarter to 47 bps, suggesting that the bond markets have a less sanguine outlook than the equity markets. This longer-term view of the future dovetails with what John C. Williams, the recently named president of the Federal Reserve Bank of New York wrote in a recent missive: “The sustainable growth rate of the economy has slowed dramatically from prior decades…This slowdown reflects a one-two punch of a sharp decline in labor force growth and slower productivity growth.” Put simply, REIT underperformance may reflect the short term expectations of faster growth and higher inflation as a result of fiscal irresponsibility; however, stubbornly low rates on the 10-Year Treasury Note augurs a brighter future for the asset class once the sugar high wears off. Unfortunately REIT management teams, investors and analysts may have to exhibit a bit more patience.