The Price Is Right

Dec 1, 2008 12:00 PM, By Jennifer Popovec

After a colossal run, REIT stocks have been sold off. Many now trade at deep discounts despite stable financial performance. Are they poised to recover, or is this a classic case of the value trap?

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The REITs that are most likely to weather this economic storm are those with strong balance sheets and manageable debt. Dionisio Meneses, portfolio managers of the Schwab Global Real Estate Fund, contends that most REITs have carefully managed their debt levels for the past two decades. “REITs learned in the 1980s that leverage is their Achilles Heel,” he says, pointing out that on average, REITs have a debt-to-capitalization ratio of 50 percent or less.

Moreover, Jack Foster, head of global real estate research for Franklin Templeton Investments, believes that banks and other lenders will be more interested in capitalizing on REITs than other real estate players. “If you have companies that have spread the maturity rates over five to seven years, they are going to be attractive to lenders,” he explains. In fact, he believes that REITs will be able to boost their earnings by closing a number of accretive acquisitions.

ON SALE: JENNIFER'S REIT PICKS FOR HER PARENTS.

According to real estate reporter Jennifer Popovec, these REITs have strong businesses, yet trade for less than the value of their underlying assets.

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WHAT'S A COMMERCIAL PROPERTY WORTH?

Talk about mark-to-market accounting. REIT stock valuations are determined by the net value of the assets the REIT owns — obvious, right? But now some argue that the true value of real estate assets (NAV) in today's market cannot be accurately calculated because of the lack of property sales over the past 12 months. In fact, according to Real Capital Analytics, investment sales activity in the commercial property sector is down by as much as 70 percent year-to-date.

“In light of the limited number of transactions in the marketplace, there's less confidence in NAV than there has been in the past,” says Rod Petrik, a REIT analyst with Stifel Nicolaus. “No one questions that real estate values are coming down and cap rates are going up, but you don't have the transactions to prove how little or how much.”

That's why Petrik has modified his NAVs to be based off of capitalization rates that have increased 100 basis points. (Cap rate is determined by dividing the property's net operating income by its purchase price; an increase in cap rates means a higher return, and cap rate compression means a lower return. Also related to cap rates and NAV, current cap rates illustrate market demand and pricing conditions, therefore, an increase in cap rate means that pricing and value have decreased.) Even then, the calculations indicate that stock prices have baked in an overly pessimistic expectation of real estate price declines, he says.

Meanwhile, a number of experts have blown off criticisms related to NAV, pointing to the fact that NAV rarely exceeds replacement costs. “We're not talking about dot coms here — we're talking about companies that own properties that are worth millions of dollars,” says Peter Miralles, president of the boutique financial planning firm Atlanta Wealth Consultants. “You can do the math to figure out how much it costs to develop a similar asset today. In most cases, it's more than what properties would sell for on the market.”