by Meghan Gorman, Strategist for CBRE
Raising a record $24.2 billion in equity, REITs had a banner year in 2009, recovering spectacularly from their lows. The Vanguard REIT Index more than doubled between the spring of 2009 and January 2010.
In spite of declining fundamentals across property types, REITs proved to be an attractive investment to investors, as shown in the chart below.
Source: CBRE Econometric Advisors.
It wasn't underlying property fundamentals or REITs' traditional role as income-producing investments that compelled investors to take positions in REITs last year, since, in light of their recapitalization activity, many REITs had stopped paying cash dividends. The draw has been the ability of cash-rich REITs and their war chests to capitalize on the distressed assets on the market. According to Moody's, for example, Simon Malls has raised $6 billion in cash and Federal Realty Trust has a $265 million capital raise partially earmarked for acquisitions in 2010.
The challenge to REITs' plans in 2010 will be the pricing they will face on the distressed assets that manage to make it to the open market. Most will remain off-market, either due to "extend and pretend" arrangements, or in an overwhelmed special servicing and foreclosure system. Real Capital Analytics reported that, as of the end of 2009, nearly $200 billion of commercial properties had become distressed across the nation, and that less than 10% had been resolved by lenders and borrowers. Assuming this resolution rate doubles, it would take five years to move these distressed assets to market—and this is also assuming no new distressed properties are added. Naturally, this bottleneck has caused prices on distressed assets to appreciate. Further, the weak dollar has piqued interest from foreign investors, who are forming anonymous investor groups to snap up distressed assets in major U.S. cities such as New York and Boston, according to HSBC Private Bank. However, they report that acquisition targets have been scarce in the U.S.
Source: Real Capital Analytics.
Unfortunately, analyzing the fundamentals of the distressed asset market is somewhat of a black box exercise. The chart above indicates that the growth in distress is declining, but we cannot tell whether this is truly the case or whether there is a distortionary effect at play on the supply side.
The acquisition of assets at fire sale prices is a major component of the REIT investment thesis in 2009 and has been priced into their valuations since they started raising equity and recapitalizing the balance sheet in the spring of that year. The outlook for 2010 is very dependent on the efficiency with which these distressed assets can come to market and how negatively investors will react if the rate of resolution continues to stall. If the scarcity of deals makes distressed property pricing less than a bargain, the REIT fever of 2009 may begin to run cold in 2010.