Real Estate Investment Trusts (REIT’s) appear to have come to life and some shares are again selling at prices at or above net asset value. Are the current valuations reasonable on a risk-reward basis? It is suggested that the answer is most probably NO.
Historically, REIT shares have been priced based on anticpated “total returns” which are composed of both dividends and share appreciation. This raises the question as to whether either dividends or share values will grow in the forseeable future?
There should be little question that the investment real estate market is in a down cycle. Vacancies in all property classes appear to be increasing and rents appear to be declining. Neither of these results bode well for dividend increases or future appreciation in the values of the underlying properties. If one accepts this thesis, then investments in REIT’s should be viewed as having a relatively high exposure to a risk of declining share values.
When vacancies rise and rent levels fall, there is a very real risk that cash flow will be insufficient to sustain the level of dividends reflected and the dividends become subject to reduction. Thie reduction of income, in and of itself, can cause a decline in asset value. When these kinds of things happen, total returns will decline
There are other problems for REIT investors. First, in the present market environment it is very difficult, if not impossible, for an investor to calculate the net asset value of a REIT portfolio because there are too many unknowns. Analysts do not focus on the operational management of the properties and, accordingly probably don’t know about vacancy exposure unless specific anticipated vacancies have been publically disclosed.
A second problem is that when cash flow declines the priority is to service the debt first which may force postponment of necessary maintenance or capital improvements and may limit cash availability to make necessary tenant improvements. When this happens, the maintenance problems are pushed off into the future and may negatively impact values.
A third problem arises when individual properties in the portfolio are not producing enough net revenue to support the historic values and, if major vacancies occur individual property values can fall below their outstanding debt.
Boards of Directors of REIT’s should be expected to have all of the information necessary to evaluate whether or not these kinds of problems exist but, the way things often work results in the information not being timely enough to direct defensive actions. For example, when a major tenant goes bankrupt and rejects its lease, that information usually comes too late to be useful. Some, but not all REIT’s have a “lead director” who is independent from management and that “lead director”, at least, should personally inspect each of the owned properties in order to verify the type of management job being performed as well as to view the condition of the properties. Many Annual Reports do not disclose the degree to which any director or directors have personally inspected the properties.
Unquestionably, Annual Reports (10 K’s) provide all required financial disclosures but they do not ordinarily discuss specific concerns such as increases in deferred maintenance, value declines that may be leading to debt being in excess of value. Nor do these Repors generally discuss declining rental markets and their anticipated impact on the particular portfolio.
These concerns suggest that REIT shares could come under downward pressure in those instances where share prices are at a premium to real net asset values. The near term does not look favorable for investment real estate and, as values decline, investors may be incentivized to dispose of assets with the result that the market will become an even stronger “buyers market” There is nothing in the current market to give rise to optimism that the real estate market will grow strong in the immediately forseeable future and ownership of property assets may have a much higher degree of risk attached to them than the market may reflect.
This is just the opiniion of one observer but does suggest caution, if nothing else.
