Over the last four years, REITs have zigged while the market has zagged, making them quite the perfect portfolio hedge. But don't count on that negative correlation continuing. Regardless of what happens in the broader market this year, the outlook for REITs is decidedly down.

After posting strong gains in recent years (REITs rose 40 percent in the past two years), REITs look ripe for profit-taking as the real estate market is set to show the effects of last year's economic slowdown. Simply put, more buildings were erected in 2001, even as vacancies soared. And that should spell profit woes for the sector this year.

Defying Gravity

The fact that REITs rose in 2001 is pretty remarkable. After all, economic growth was consistently slowing and signs emerged that several sectors of the real estate market were cooling.

Bolstering the sector, however, was a precipitous drop in interest rates, which made the dividend yield on REITs look comparatively juicy. But that should soon end. Later this year, if the economy revives, Fed Chairman Alan Greenspan will likely take away the punch bowl by raising rates a few notches. And that “would tend to make the scramble for yield a less urgent matter,” says Lehman Brothers' David Shulman.

Rising interest rates hurt REITs in another way. Many REITs have borrowed with floating rates of interest. That's fattened profits in recent quarters as rates have come down, but will crimp them as rates rise.

Three subsectors look especially vulnerable to a downturn: office, apartment and mall REITS.

In recent years, giant retailers such as Montgomery Ward, Ames, Bradlees, JCPenney and Kmart have either gone out of business or have severely retrenched. These stores often anchored mall properties, helping to drive traffic to smaller stores. But with more anchor stores sitting empty, broader mall traffic looks poised to decline. That would put pressure on the smaller retailers, some of which are now closing their doors as well, also feeling the pinch from the still-nascent world of e-tailing. Even as the economy cooled, online commerce expanded at a double-digit clip in 2001. And as online sales rise further in the next few years, brick-and-mortar retailers may notice a continued falloff in traffic.

Generally speaking, malls must be 75 percent occupied to break even. That figure assumes that a REIT's debt is half of the total capital base. These heavily leveraged properties are cash cows at 90 percent occupancy rates, but hemorrhage cash at 60 percent occupancy. Kimco Realty, Simon Property Group, General Growth Properties and Developers Diversified Realty are among those REITs with a heavy exposure to retail properties and debt leverage.

Office REITs look equally challenged. A recent article in The Wall Street Journal noted that office vacancies jumped from 8.3 percent at year-end 2000 to 13.5 percent at the end of 2001. Salomon Smith Barney's Jonathan Litt thinks the vacancy rate “could increase further throughout 2002, as ongoing developments are completed.”

A glut of apartment space may also be brewing. At least that's the contention of mega-developer Sam Zell. His Equity Residential Properties Trust, one of the nation's largest apartment managers, is feeling the brunt from industry overbuilding.

At a recent conference, Zell noted that Fannie Mae nearly doubled its investment in multifamily rental housing in 2001, providing $22.8 billion. In contrast, the U.S. population is expanding less than 3 percent a year. And the looser lending practices will affect 2002 as well. New York-based research firm Reis Inc. forecasts 123,500 new apartments will open in 2002. That's up from 112,000 in 2001. Any apartment REITS with significant exposure to Atlanta, Phoenix, Charlotte and Seattle are considered to be especially vulnerable, due to soaring residential vacancy rates.

Investors in the REIT sector are also bracing for an accounting change that could pressure stocks. In December, REIT analysts agreed to start measuring operating earnings in accordance with GAAP policy. That means companies will no longer show an operating profit from asset sales — a trick often used by companies to pump up profits. Raymond James' Paul Puryear figures “the use of operating earnings, which includes depreciation expense, may make REITs look expensive relative to other industry sectors.”

Growth or Contraction?

In the absence of a crystal ball, industry watchers are hesitant to load any meaningful changes in occupancy rates into their earnings models. But “at this point, we believe the probability of higher vacancy rates is much higher than the probability of higher occupancy rates,” notes Credit Suisse First Boston's Lawrence Raiman. He adds that “slower growth and missed expectations are still more likely at this point.”

On a pure valuation basis, REITs are no bargain. The average REIT trades for 10.8 times EBITDA, according to CSFBs Raiman. But if vacancies rise and existing leases are renewed at lower rates, it looks as if EBITDA for the sector could flatten or actually slip. And that would cause dividend payouts to slide, scaring off income-oriented investors.

Wall Street analysts remain bullish on the sector. Even those that are less sanguine try to put a positive spin on the stocks. Morgan Stanley's Greg Whyte suggests buying REITS anytime they pull back, even as he concedes that after two strong years in the sector, “we are having to dig deeper than ever to find new investment opportunities.”

Lehman Brothers' Shulman is one of the few industry analysts to candidly suggest that the real estate sector's outlook is dim. He downgraded his ratings across the board in mid-January, suggesting that 2004 may be “the next strong year for real estate fundamentals.” And while most REIT analysts are predicting that the sector is still poised for yet further gains in 2002, Schulman points out that “real estate is a cyclical business.” Translation: What goes up can also come down.

1998 1999 2000 2001
S&P-500 26.7 19.5 -10.1 -13.0
REIT index -18.8 -6.5 25.9 15.5
Source: Bloomberg

To their credit, real estate developers have learned from past mistakes and have largely refrained from overbuilding as they did a decade ago. The early 1990s saw a host of developers declare bankruptcy as new “on-spec” projects stood empty. So, don't expect to see REITs tumble sharply in the coming year. But you can expect more profit concerns if vacancy rates remain high.

And REIT investors shouldn't count on a rebounding economy to save the day. As Raymond James' Puryear concedes, an accelerating stock market or a renewed focus on growth-oriented tech and telecom stocks would likely reverse the outperformance trends of the past couple of years and leave REITs under-performing the broader market in the year ahead. Conversely, Schulman recently wrote: “Make no mistake, a broad market decline in 2002 would not be good for REIT shares.”

In other words, it now looks as if REIT stocks will face a headwind — whether the economy and the stock market turn up or down.