Analysts Say Investors' Gains May Be Hard to Sustain
By Dana Hedgpeth
Washington Post Staff Writer
Monday, April 25, 2005
As an example of entrepreneurial vision and verve, Saul Centers Inc. of Bethesda ranks at the low end of the excitement meter. Last year, the real estate investment trust bought a shopping center in Silver Spring and one in Loudoun County, all anchored by grocery stores, and all predictable income producers.
CarrAmerica Realty Corp. of Washington followed the same safe path. In adding to its collection of office buildings, it sought out properties like the 15-story granite and glass structure in Rosslyn that has had the same steady tenant -- the American Chemistry Council -- for a decade.
Even Arlington's cutting-edge Mills Corp. has lately shied from its history of innovative mall development: Over the past year the company bought an interest in nine regional malls, including Marley Station in Glen Burnie and Lakeforest Mall in Gaithersburg, that were already built, mostly full and pumping out the rental income.
Real estate investment trusts may not be the flashiest players in the Washington economy, but over the past decade they have become a steady presence among the region's largest companies and generated even steadier returns for investors.
In the Washington area, there are roughly 19 locally based REITs with a combined market cap of $27.7 billion, according to the National Association of Real Estate Investment Trusts, a District-based trade group. With the area's real estate boom driving up prices and REITs emerging as a popular way for even smaller investors to share in the gains, about a dozen of those companies have now moved into The Post 200 list of the area's top firms.
As a group, REITs over the past decade have made more of an impact on the economy and become more well known as investment vehicles. In 1990, there were 119 publicly traded real estate investment trusts with an equity market capitalization of $9 billion. Now, there are nearly 200 publicly traded REITs with a market capitalization of $283 billion, according to the industry trade association.
REITs receive favorable tax treatment in exchange for passing most of their income straight to shareholders.
"They allow you to have an investment in real estate that would not otherwise be available to small investors," said Marti Tirinnanzi, a senior real estate analyst at Ferris, Baker Watts Inc. "They are low risk and they're not volatile.
"Real estate doesn't disappear in the middle of the night," she said. "And it's easy to feel a sense of ownership for small investors. You drive down any street in Washington and you see buildings that are owned by public REITs."
Most of the local REITs are relatively small when compared with nationally known outfits such as Boston Properties Inc., which is a major developer in the District. CarrAmerica, for example, is best known locally for a few of its office buildings that include Terrell Place at 575 Seventh St. NW, which opened in 2003, and the Atlantic Building at 950 F St. NW, which is under construction.
The other attraction of REITs is that they've produced favorable returns compared with other investments in recent years.
In the past five years when the Standard & Poor's 500-stock index had a negative return, the REITs that are based in this region had a total return, on average, of 18.4 percent, according to the industry trade group.
The question is how long the good times will last in a period of rising interest rates and a national real estate market that shows some signs of being overinflated.
What's driving the incredible returns to investors, according to real estate analysts, executives and advisers, are some of the same forces that are making the prices of homes in the Washington area skyrocket. Just as low interest rates and skepticism of stocks are driving home buyers to pay high prices, investors have been bidding up the price of REITs.
But share prices have risen in many cases more quickly than operating earnings. The big question for REIT executives is how long they'll be able to keep up.
Consider Corporate Office Properties Trust. Its returns over the last five years made it one of the best-performing REITs in the industry, according to trade groups and analysts.
The company's funds from operation per share, a common measure of REITs' operating performance, rose a healthy 35 percent between 2001 and 2004. But its share price in that span rose 147 percent. That disconnect, between underlying operations and the company's stock price, makes some analysts think the REIT sector will be hard-pressed to continue its gains.
Indeed, there are hints that the market is already readjusting. REITs have a total return of minus 6 percent so far in 2005.
"The valuations might be starting to catch up with some of these companies," said Keven Lindemann, director of the real estate group at SNL Financial. "The REIT market has been well above a sustainable level of returns since 2000. It's inevitable that we have a bit of a pullback."
Other local REITs have situations more unique to them. CarrAmerica Realty Corp. has seen strong performance from the 23 properties it owns in downtown Washington and the suburbs. It owns several large buildings in the 1700 block of Pennsylvania Avenue and a building in Reston where Nextel Communications Inc. has its headquarters.
But analysts and executives at CarrAmerica said its performance has been dragged down by the 85 properties it owns in places like San Francisco, where the office market has lagged in occupancy and rents have fallen 50 percent or more since 2001.
"The Northern California market has lagged D.C. and Southern California," said Tom Carr, chief executive of Carr. "It's now beginning to kick in. Occupancy rates are rising slightly. We're seeing leasing activity pick up significantly and in certain sub-markets rents are beginning to move as well."
Carr netted $192 million from the sale of buildings it had in Atlanta, and sold a building it owned in suburban Austin. Both are competitive markets and have performed below the rest of the country. The company's funds from operations for last year were up slightly, to $3.09 per share.
"Carr has lagged because of its exposure to California," said Keith Pauley, managing director at LaSalle Investment Management Inc. in Baltimore. "They're in a lot of markets that are much weaker than D.C."
Carr said the company has only 1.6 million square feet in its portfolio that it is rolling over for new leases this year -- less than the roughly 2.5 million square feet in a typical year. That should help, analysts said, as rental rates are still soft. In the District, Carr has about 347,000 square feet of space rolling over.
In the housing sector, AvalonBay Communities Inc. -- which has 148 apartment complexes in 10 states and the District -- saw its best year in several years, as the rental market began to recover. For the year, its occupancy rate was 95.3 percent, up from 93 percent. One thing that helped boost the occupancy at its units in markets like the Washington area has been the conversion of some apartment buildings to for-sale condominium buildings. And for the first time since 2001, the company posted a growth in its funds from operations, which were up 2.4 percent for the year after several years of decline.
"You had job losses and a strong for-sale market in 2002 and 2003, and then in 2004 we started to see it stabilize," said Timothy J. Naughton, the company's president.
AvalonBay's 15 Washington area properties, which include a 200-unit apartment building near the MCI Center and other buildings in Columbia, Rockville and Bethesda. While they posted the strongest rental revenue growth of any of its markets nationwide, its properties in Northern California have lagged, Naughton said. Two projects totaling 1,000 units in Montgomery County were finished last year, and are nearly fully leased. The company expects to step up development of new projects in New York, Seattle and San Francisco.
In the retail sector, the performance of companies such as Mills Corp., which owns large shopping centers including Potomac Mills in Prince William County, and Federal Realty Investment Trust, which owns mostly locally based shopping centers that include Bethesda Row and Pentagon Row, has benefited from a "golden period," said David Fick, an analyst at Legg Mason Wood Walker Inc. in Baltimore. While office tenants are still able to shop for deals, rents for retail tenants are at market highs.
Donald C. Wood, president and chief executive of Federal Realty, said his company last year signed 1.8 million square feet of new and renewal space at its centers -- 12 percent more than what it did the year before. Rents for those spots were up 18 percent, he said. "As old leases roll over, we're able to get in many, many cases -- but not all -- significantly more rent," Wood said.
But shopping center landlords are cautious of how long the strong consumer confidence and spending will last.
"Consumer confidence is absolutely important," Wood said. But he cautioned, "we're just the landlord. Retailers don't have to be doing the best they've ever done. They have to be doing well enough to pay the rent."
Mills Corp., which has on average opened two to three of its mega-malls every year, according to analysts, is now expanding into Europe. It has several projects in the early development stages in Rome and Milan in Italy, Glasgow in Scotland and Valencia in Spain.
"They're expanding into Europe because eventually there will be a saturation in the U.S. market," Fick said. "European retail is very tired and they're looking for a new shopping experience."