REITs next to feel pinchof debt woes

Real estate investment trusts are expected to be net sellers as they try to weed out unprofitable properties and bring their debt liabilities in line with the expected sinking value of the properties in their portfolios.

“A lot of people are expecting commercial real estate to be the next shoe to drop,” said Sarah M. Snyder, investment consultant in the real estate consulting group at Callan Associates Inc., San Francisco.

It all comes down to debt. REITs typically have less leverage across their portfolios than non-core private real estate investment managers. But debt was so cheap and easy to come by during the past few years that some REITs couldn't resist. A bit more leverage did wonders for a portfolio's returns. Even the most conservative REITs bumped up the debt on certain properties to give returns a boost, industry insiders say.

And these were equity REITs. The woes of mortgage REITS such as CBRE Realty Finance Inc. were first to hit the papers, but they make up just 6% of the overall REIT market, said Brad Case, vice president of research and investor information at the National Association of Real Estate Investment Trusts, Washington.

“When the downturn started, it was really a case of the tail wagging the dog,” Mr. Case said.

Not only were mortgage REITs hit hard, but also investors shied away from apartment and other residential REITs, Mr. Case said.

Industry consultants and fund of funds managers estimate that more than 10% of REITs packed on the debt. Equity REITs had average leverage of about 40% as of Sept. 30, 2007, but 45% were carrying more than 50% debt, according to NAREIT.

Mall REIT Centro Properties Group, Melbourne, Australia, is fast becoming the REIT industry's Enron Corp. If officials don't refinance $4.9 billion in outstanding debt by April 30, Centro will have to sell its properties — a good portion of which are in the United States — at fire-sale prices. But it is not alone. REITs such as Macquarie Office Trust, Maguire Properties and Allco Commercial REIT have put properties up for sale because they need the cash to pay off their debt. The falling value of their portfolios is causing their liabilities to increase beyond the value of their assets and could cause them to break the covenants in their lending agreements.

“Over the last five years, adding debt was an exceptionally good strategy,” said David J. Oakes, chief investment officer of Developers Diversified Realty Corp., Cleveland.

REITs informally have set a rule of 40% to 60% leverage to enhance returns without changing the portfolio's risk profile, Mr. Oakes said.

“But some companies took leverage to much, much higher levels ... running 80%,” he said.

Even conservatively leveraged REITs are expected to suffer because the debt squeeze.

“I think all REITs and property companies have had to suffer to some degree, regardless of overall leverage employed, because leverage markets have dried up,” said Charles “Chip” McKinley, global portfolio manager of New York-based Cohen & Steers Inc.'s $11 billion global real estate fund of funds.

Bank balance sheets have been so curtailed that banks' ability to lend has been reduced, Mr. McKinley said. Plus, there are virtually no more commercial mortgage-backed securities being issued. As of April 23, six CMBS were issued totaling $8.8 billion, compared with $78 billion in an undetermined number of deals as of the same date last year, according to the Commercial Mortgage Securities Association, a New York-based trade group. And the debt that is available is more expensive by 20 to 30 basis points, he said.

“Even the average REIT has found it more difficult to secure or access the debt markets,” Mr. McKinley said.

This will cause their internal rates of return to drop, because all REITs eventually need to access the markets to secure refinancing or debt for new purchases.

Even REITs on relatively solid financial footing — like Developers Diversified, which is included in the Standard & Poor's 500 stock index — plan to be net sellers this year.

“Our REIT is selling property but not from the position of lenders making us do it,” Mr. Oakes said. “We own $20 billion of real estate and we should always be in the market selling something. There is always some group of assets that offer the lowest expected return.”

The idea is to sell properties DDR executives now expect to be lower performing to reinvest the capital in properties expected to provide higher returns, he said.

As a group, apartment REITs are starting to put properties up for sale, said Darren Fisk, principal in the Denver office of Johnson Capital, which provides debt financing for real estate deals.

“They (apartment REITs) feel their stock is significantly undervalued and are selling to raise cash to buy their own stock,” Mr. Fisk said.

Although REITs enjoyed better stock performance in March, stock prices had been plummeting for months, according to data provided by NAREIT.

“When the news (of the credit crunch) started to hit, REITs sold off fairly heavily,” Callan's Ms. Snyder said.

REIT stock prices plummeted as hedge funds and small-cap equity managers dumped their REIT holdings, creating rampant volatility that continues to date, Ms. Snyder said.

Executives at apartment REITs also are selling properties in secondary real estate markets to raise cash to make new acquisitions in the top five or six markets across the United States, Mr. Fisk said.

But there are problems along this road to selective property sales. One is that debt is scarcer and more expensive. Another is that valuations are difficult to determine because transactions have dried up, Mr. McKinley explained. Real estate valuations are based mainly on appraisals that depend on current sales figures.

Contact Arleen Jacobius at [email protected]