REIT Expert Shares
A View of the Future

Information on this page is provided by GlobeSt.com.

Not all the boats are sinking equally in this recessed market. Take REITs, which are laboring under weakening credit conditions but still find favor on the part of investors who are fed up with the vaguaries of the stock market. Their ability to weather the tides is, well, tied directly to their degree of diversification. At least that was the opinion of Lisa Sarajian, managing director in Standard & Poor's real-estate finance group. Ms. Sarajian spoke recently before the Real Estate Lenders Association in Manhattan, where she laid out her view of where the public markets are, where they are going and how difficult it will be to get there as the nation's economic doldrums promise increasingly to stretch out into the next calendar year. For the record, Ms. Sarajian's group, a subset of S&P's structured-ratings division, assesses the credit quality of more than 100 domestic operating real-estate companies, including developers, homebuilders, private trusts and real-estate investment trusts, which have roughly $70 billion in rated securities outstanding.

GlobeSt.com: You said in your presentation that credit is weakening for REITs. What's behind that?

Sarajian: The deterioration in property fundamentals. And it's still continuing. Vacancy rates are rising and rental rates are softening due to the contraction in tenant demand. We went into the last downturn saddled with a tremendous surplus of space. Relatively, this situation is better because of the degree of discipline we had in development when things started to slow. We were building to a demand that has since dissipated. But the result is the same.

GlobeSt.com: What was it about this cycle that made it unique?

Sarajian: You've heard it before. It's more disciplined, given the market intelligence that's available -- the transparency, CMBS and access to data. This time, we've seen a tremendous expansion of companies taking space in advance of their need. We've seen it in telecom and financial services, for instance. Companies were grabbing space for future growth. Now that growth is off the table and companies are left with all this space while they find themselves in a financially shaky position. As long as that condition remains, it could get ugly.

GlobeSt.com: Do you expect there to be downgrades?

Sarajian: They're going to exceed upgrades, but only modestly. Strong share prices -- driven by investors' flight to yield and hard assets -- will discourage a lot of the aggressive repurchases and nonstrategic M&As.

GlobeSt.com: How will those downgrades pan out?

Sarajian: It's going to be very company specific. If that company is concentrated in Dallas or Atlanta or emphasizes multifamily, they're going to hurt through the end of this year. If on the other hand, you're holding an office portfolio in D.C., you'll be okay because that market is fairly protected.

GlobeSt.com: With all the former expectations of a turnaround, are you surprised that the sluggishness has continued so long?

Sarajian: Not really, since it's a lagging indicator of the market, which has been weak for more than a year. So we wouldn't necessarily see any recovery immediately reflected in property portfolios. The challenge is determining how long currently weak conditions will persist and how material the hit will be to debt-protection measures.

GlobeSt.com: Such as?

Sarajian: Such as fixed-charge coverage and debt-service coverage. In the meantime, the dance that an owner has to manage is holding the property portfolio in place while we wait for the economy to recover. If the portfolio is well-positioned with well-staggered lease durations -- let's say 10% rolling in one year -- then the downside is only that 10%. So if the recession is short and shallow, the downside is easy to quantify. The longer the recession, the more likely that more than 10% will be affected as more tenant companies go dark.

GlobeSt.com: You mentioned a flight to hard assets. What does weakening credit do to the theory that investors, turned off to Wall Street, see real estate as a safe haven?

Sarajian: I agree absolutely about the flight of investors to hard assets. Institutional investors are turning from Wall Street and toward hard assets. And they're accepting the generally lower investment returns. Their hurdle rate has dropped. So even if real-estate values are lower than two years ago, it's still more attractive.

GlobeSt.com: Are you opting for short and shallow or long and deep?

Sarajian: It's looking less certain that the economy will rebound materially. I'd expect us to be in recovery mode through next year in most sectors. Right now the real-estate industry is benefiting from low interest rates. But we do expect them to start climbing sometime in early to mid-next year.

GlobeSt.com: How much does the corporate-responsibility issue factor into that ugly outlook that you mentioned?

Sarajian: The health of the real-estate market is tethered to the confidence of business executives making the space decisions -- retailers considering expansions or Baby Bells looking for acquisitions. If there's a material contraction in confidence, such as through government concerns that can freeze expansion, it will slow market absorption.

It could also have the opposite effect. Some markets -- such as San Francisco -- were so frothy that a popping of the bubble could actually be better for business. When $80 or $90-per-foot rents return to reality, it can be more palatable for most smaller businesses. If they're not expanding, at least they're not leaving.

GlobeSt.com: What was your firm's reaction to Moody's potential downgrades of certain CMBS deals?

Sarajian: We're taking a different approach. We don't expect to downgrade any existing CMBS deals solely due to terrorism-insurance issues. The lack of empirical data and the very nature of terrorism make it extremely difficult to quantify the risk in an accurate and nonarbitrary manner. Plus, the terrorism insurance coverage that is available is so riddled with holes -- such as the 30-day cancel options and nuclear/bio carve-outs -- that it's not clear what analytical benefit the existence of coverage really provides.

Email your comments to rjeditor@dowjones.com.