Diagnosing The Downturn
Commercial Real Estate Sell-Off Puts Investors in a Tricky Position

By Dina ElBoghdady
Washington Post Staff Writer
Saturday, June 16, 2007

It seemed almost a sure bet.

In the past seven years, stock prices of publicly traded commercial real estate companies had soared more than 160 percent, far outpacing the broader market. Then, early this year, the shares stumbled, falling about 14 percent since early February.

"This drop is a big deal," said Arthur E. Oduma, a senior equity analyst at the research firm Morningstar. "It's not a good feeling for investors. They're used to double-digit returns."

Some investors are taking their profits and running, even though commercial real estate stocks are considered a staple of any well-balanced portfolio. These shares are typically a protection against inflation because investors collect handsome dividends that increase in high-inflation times as landlords raise rents. In addition, after real estate assets appreciate, investors get a share of the profit when the properties are sold.

But getting in now can be tricky. Turmoil in the softening housing market has muddled investor sentiment and cast a shadow over commercial real estate stocks.

For small investors, the most affordable and efficient way to gain exposure to commercial real estate is through real estate investment trusts, or REITs. Most of these companies own a mix of buildings. Some are specific to certain types of property, such as office buildings or shopping centers. Others focus on regions of the country. A few hold a diversified property portfolio. Through REITs, investors get a small piece of a variety of properties without the hassle or expense of being a landlord.

The fundamentals that drive these companies remain strong because the economy is growing, creating demand for hotels, offices, shopping centers and even industrial warehouses, especially in land-constrained urban hubs.

But some investors have confused the housing and commercial sectors, especially after trouble surfaced early this year in the market for subprime home mortgages, which cater to people with blemished credit and other risky borrowers.

"People think of real estate and clump everything together," said Dan Fasulo, a managing director at Real Capital Analytics, a research and consulting firm. "The commercial and residential are very distinct marketplaces."

Short-Term Focus

Consider the events that unfolded at Municipal Mortgage and Equity on Feb. 9, shortly after some subprime lenders announced a string of bad news. That day, shares of the Baltimore company tumbled 11 percent after the market opened. Investors -- jumpy about the home residential market -- saw the word "mortgage" in the company's name and bailed out.

The company's slide stopped only after the lender released a statement clarifying that it provided financing for developers of commercial property and rental housing -- not for the residential market. The shares then reversed course, recovering most of their losses in after-hours trading.

That kind of knee-jerk approach to real estate investing is shortsighted, said Keith Allaire, a managing director of Robert A. Stanger & Co., an investment banking firm specializing in real estate. Investors need to think of commercial real estate in the long term and stop worrying about its day-to-day performance, he said.

"You should not get into real estate investing to pick the hot spot of the day," Allaire said. "If you want to play that game, you'll be subject to the whipsaw of timing."

But as with any industry, when one sector gets hit, the rest usually suffer.

The subprime crisis and rising interest rates have prompted investors to pull money out of mutual funds that invest in REITs since early March. About $439 million left the funds during the week ended May 23 -- a record for the sector, according to AMG Data Services. By contrast, the funds attracted $505 million in the first week of February, before the subprime crisis deepened.

Even with the sell-off, the prices of many REITs are still far above the value of the assets they own, said Fran Kinniry, a principal at Vanguard, a provider of mutual funds that has a large REIT investment product. He warns investors that the drop in prices has yet to create any bargains. "This is not a good entry point into REITs," Kinniry said.

Searching for Value

So investors must do their homework carefully, as they would in selecting any stock. For starters, recognize that sector-by-sector performance varies widely among REITs and pick stocks accordingly, said Oduma, the Morningstar analyst. Reduce exposure to ones that are overvalued, and search for less-recognized cheaper opportunities.

In the latter category are some niche players, including health-care REITs, which own properties including nursing homes and hospitals. Building permits for those properties are limited, Oduma said. "The barriers to entry are quite high, and a lot of their leases tend to be protected from any rise in the cost of operating the property. That's great because it means your investment is protected from inflation," he said. These REITs also have potential for growth because of the aging baby boomer population.

Also take a look at office REITs, said Bob Gadsden, portfolio manager at New York's Alpine Woods Capital Investors.

Private-equity firms have paid a premium to acquire office REITs of late, suggesting that the public market has undervalued these properties. One of the biggest deals involved the Blackstone Group, which purchased Equity Office Properties Trust earlier this year in a deal valued at $39 billion, outbidding Vornado Realty.

Hot markets include New York, the Washington area and coastal regions in parts of California.

A shortage of land in those areas makes hotels and apartments equally tantalizing prospects for investors. Rising constructions costs are also discouraging some builders from entering the market.

"In general, urban markets for office properties are stronger than suburban ones because of land constraints there," Gadsden said. "When there's very little office product being built, there's little choice for tenants, so landlords have more pricing power."

REITs invested in hotels are reaping the rewards of rising traveler demand and limited supply. "The hotel industry has had a significant run-up in room rates and occupancy in the past several years," said Chris Lucas, senior research analyst at Robert W. Baird & Co.

"Anybody who has tried to get a hotel room in any major market knows it's not easy to do and that prices have escalated."

Subprime Silver Lining

Apartments may get a boost from the troubles unfolding in the subprime home mortgage market. When the housing market weakened, a lot of subprime borrowers found themselves unable to make their payments, and their ranks are expected to swell.

Many of those homeowners will end up in apartments, if they haven't already. That helps explain why Tishman Speyer Properties and Lehman Brothers Holdings announced plans to purchase Archstone-Smith Trust, an apartment REIT, in a deal worth $22.2 billion. The two firms offered to pay $60.75 a share, a 23 percent premium over Archstone-Smith's price before the offer was announced.

For those not interested in stock picking, experts suggest a REIT mutual fund.

"I would counsel investing in a highly diversified mutual fund, preferably an indexed fund that allows you to invest across all different companies, all different property sectors and all different geographic regions," said Michael Grupe, executive vice president of the National Association of Real Estate Investment Trusts.

To find the right one, investors can use a third-party research company, such as Morningstar, that evaluates mutual funds and money management firms, said Steve Friedman, a partner with Ernst & Young. Look for funds that historically have outperformed various benchmarks.

"You can evaluate their performance, philosophy and track record," Friedman said. "The trade-off is you might pay higher expenses, but you can benchmark their performance against an index fund and see if the expense justifies the investment."

The performance of the REIT industry is cyclical and tied to the fortunes of the U.S. economy. After such a big run-up in REIT share prices, it's no wonder that some investors are rethinking what role the investments should play in their portfolios, said Carl Tash of Cliffwood Partners, a real estate management fund.

"If you've tripled your profits in REITs, why not take some of that money off the table?" Tash said. "We've seen investors do that because REITs have become too big a percentage of their assets."

After years of outperforming the broader market, REITs are now bound to underperform for years to come, the thinking goes.

"That happens," Tash said. "Nothing to be ashamed of."

Staff researcher Richard Drezen contributed to this report.