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US REITs
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March 31, 2008
We are pleased to share with you our review and outlook for the U.S.real estate securities market as of March 31, 2008. For the quarter, the FTSE NAREIT Equity REIT Index had a total return of 1.4%.
Investment Review
Real estate securities advanced during a period that was decidedly negative for U.S. equities; the S&P 500 Index had a total return of –9.5%, its largest quarterly decline since 2002. Having entered the year with considerable pessimism priced into their shares, REITs benefited from relatively attractive valuations and better-than-expected 2007 earnings results, combined with various Federal Reserve actions. The Fed lowered short-term interest rates from 4.25% at the start of the quarter to 2.25% by mid-March in an aggressive response to weak economic reports and instability in global financial markets.
Lender of last resort
The Fed also announced new lending programs aimed at easing a persistent credit crunch. This included plans to lend $200 billion in Treasury bonds to commercial and investment banks at a lower discount rate and for an extended period, accepting banks’ riskier mortgage-backed securities as collateral. Late in the period the Fed’s role in the proposed acquisition of Bear Stearns by JPMorgan Chase eased financial market concerns somewhat. Also of note, federal regulators lowered capital reserve requirements for Fannie Mae and Freddie Mac, increasing those companies’ ability to purchase troubled mortgages.
Self storage and apartment companies had significant gains
Self storage was the top-performing property sector with a total return of 20.2%, aided by favorable earnings and generally strong balance sheets. Apartments (+11.5%) outperformed, with share prices validated by recent sales (property sales in most sectors have been scarce). This activity included apartment REIT UDR agreeing to sell more than 25,000 of its units to DRA Advisors for $1.7 billion. While M&A activity among REITs has remained generally quiet, American Campus Communities did announce that it would buy GMH Communities for $1.4 billion, at a 72% premium to the stock’s previous day closing price. Transactions for apartments have been made possible by the availability of low-cost debt financing from Freddie Mac and Fannie Mae.
The office sector (–4.0%) did not fare as well; it struggled on concerns that employment levels could decline, particularly in areas with high concentrations of financial services tenants, such as New York City and Orange County, California. The industrial sector (–4.8%) also underperformed, reflecting investors’ concerns over a slowing global economy and business models driven by transactional income, in contrast to recurring income from long-term leases. The health care sector (+2.5%) performed well due to its defensive characteristics in an uncertain economic environment, while also benefiting from the inclusion of Health Care Properties in the S&P 500 Index (the first health care REIT to be included). There are now 14 REITs in the index.
Performance was helped by self storage overweight
Our portfolios outperformed their benchmark in the quarter, aided by our overweight in the self storage sector, which we believe is benefiting from more resilient fundamentals in a lackluster economy. Our underweights in the industrial and specialty sectors also benefited performance, as did our overweight in apartments, although apartment stock selection detracted from performance. The portfolios were hindered by our overweight and stock selection in the office sector.
Investment Outlook
We believe that as capital markets ease, decreasing risk premiums will result in more rational pricing—and hence a reduction in U.S. REITs’ discount to net asset value, currently at 14%. Further, REITs in our view are appealing for their defensive characteristics, such as long-term leases and tangible assets, as well as attractive dividend yields. As of March 31, REITs had an average dividend yield of 5.0%, compared with a 2.3% dividend yield for the S&P 500 Index and a 3.5% yield for the 10-year Treasury bond.
While the U.S. economy is slowing and we are likely to see a softening in demand for commercial space across property sectors, fundamentals should benefit from high initial occupancies, along with limited new supply due to the decreased availability of construction loans and high construction costs. We expect this to provide some stability for REITs until the economy re-accelerates in response to fiscal and monetary stimulus. We believe that may begin in the end of 2008.
The views and opinions in the preceding commentary are as of the date of publication and are subject to change. This material represents an assessment of the market environment at a specific point in time, should not be relied upon as investment advice and is not intended to predict or depict performance of any investment
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