Should REIT Investors
Prepare for Trouble?

Information on this page is provided by GlobeSt.com.

The good news might be the bad news for REITs. At least one analyst is expecting a wave of sell-offs as the markets normalize and the safe-haven of real-estate investing in general -- and REIT investing in particular -- begins once again to pale in relative terms to the stock market. That analyst is Chris Hartung, managing director of San Francisco-based WR Hambrecht & Co. Observers may remember Mr. Hartung from his former life in the tech world, specifically his stint at iBuilding.com. But prior to that, he served at Bank of America after leaving a stint at J.P. Morgan, and he tells me that arriving at the boutique investment bank was in many ways like coming home. But the homefront is causing some concerns, he says. Nothing alarming, mind you, but there are areas that must be flagged, even as REITs continue what he terms their "epic run."

GlobeSt.com: So you say there's going to be a sell-off in REITs. What concerns you in the current market?

Hartung: The REIT market in the new millennium, and specifically over the past number of months, has had an epic run. But given the fundamentals out there, I wonder if it's not time for a pullback in prices, simply because REIT stocks have been so strong in the face of conflicting data about the underlying fundamentals.

GlobeSt.com: What's the bottom line, given strong REIT stocks and questionable fundamentals?

Hartung: My conclusion is confusion.

GlobeSt.com: I'm glad we clarified things.

Hartung: I heard a great quote recently: "Today if you're not confused, you're just not thinking clearly." When you look at the amount of contradicting data and trends that are out there, to not acknowledge that there is a level of confusion or uncertainty concerning the year-forward path is to be held captive to past thinking or biases.

GlobeSt.com: So what biases can cloud your judgment about the year forward?

Hartung: Everyone is saying the market is putting a premium on dividends and safety. That's true, and those are both a great strength of the REIT market. But what is also true is that because of corporate America's ability to control earnings and reduce expenses in a tough environment, the S&P is expected to grow between 8% and 12% this year. In contrast, we expect that REITs will probably see between a 1% and 2% decline in earnings in 2003. Now this is one of the confusing points for me; real estate is historically a mid- to late-cyclical sector. Given REITs' strong price performance, it's acting like an early-cyclical sector. This says to me "disconnect," and prices are running too far too fast.

GlobeSt.com: It's an oddity that we have to worry because prices are good.

Hartung: Exactly, and at some point you need to pay the piper if expectations are too high. Again, REITs have had an epic run; we all know that. But now we're heading into a time when job growth is still weak, we don't know what's happening with business spending and there's a lot of excess capacity in corporate America, yet REITs from a valuation perspective have held up quite well through the downturn.

GlobeSt.com: Two-part question. First: wasn't all of this true months ago, and second: when do you see REITs -- as you say -- paying the piper?

Hartung: To the first part, it is the same, just more so, in that they've been very strong but earnings have been weak. Now we're talking about continued strong performance, although we are in a weaker position fundamentally. People were expecting a recovery at first at the end of '02, then the first quarter in '03. Now, depending on the region or market, you're looking at late 2003 at the earliest and there probably won't be a substantive recovery until 2004. Those expectations need to get dialed in at some point and when that happens, future relative performance may not be that great. All of these disconnects have to work themselves out. Answering the second part of your question, if we continue to have compressions and reductions in 2003 guidance through second quarter earnings, we will be in trouble.

GlobeSt.com: How much trouble?

Hartung: I think a 5%-to-10% reduction in REIT stock prices is not out of the question. Keep in mind that we're up significantly for the year, so that would bring us down to par with where we started.

GlobeSt.com: Essentially, as markets normalize, the safe haven goes away.

Hartung: The short answer is yes. But that's how one would expect a late-cyclical industry to act; you have corporations that have excess capacity but have still been able to cut expenses dramatically and increase profit growth. That profit growth will accelerate in a strengthening economy, but it will take some time for that economic strength to flow through to the real-estate market. I'm not saying that the sky is falling. There are simply enough questions and disconnects that it makes me anxious about current pricing levels. It is a nuanced argument regarding the relative position of more normal trading environments.

GlobeSt.com: Is this sell-off straight across the board or only for certain REITs?

Hartung: We've seen strong moves across the board, even though there are definite differences in the underlying strengths of the various sectors. The other thing that's important to put into perspective is that we have not yet seen a full cycle of modern REIT market.

GlobeSt.com: How do you define the modern REIT market?

Hartung: From '91 through '95, there was a big bulk of REITs that went public. That's where I start looking at it. In 1990, the REIT market was $6 billion in market cap. Today, it's anywhere from $150 billion to $170 billion. That's fairly substantial growth, and it makes apples-to-apples growth comparisons fairly difficult. So in terms of long-term cyclical performance, we're still newbies. So when the question arises about REITs' place within the economic cycle and how they should be trading vis-a-vis other stocks, the reality is that we're all trying to figure this out on the fly.

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