Morningstar Advisor - February/March 2009 - 56

Sector Rap How to Spot a Trustworthy REIT By Haywood Kelly Real estate investment trusts have slid off a cliff, but while some firms deserve to fall hard, others are on better footing. Real estate sits at the epicenter of the global financial crisis. Although housing was the first area to implode, we’re now well into a severe downturn in other types of real estate—a downturn that has crushed equity real estate investment trust stocks the past year. In 2008, the REIT industry shed 62% of its value, according to the Dow Jones Equity REIT Index. I recently spoke with Morningstar senior stock analyst Joel Bloomer, who heads up Morningstar’s REIT team. The team covers more than 70 REITs, which gives Morningstar one of the broadest coverage lists out there. Haywood Kelly: Joel, walk us through health-care-related facilities. Apartments will see head winds as cash-strapped consumers trade down to more-affordable accommodations and in some cases consolidate with friends or family to save cash. The oversupply of residential properties being converted into apartments won’t help matters, either. We expect demand for public storage to suffer as consumers realize that storing goods used infrequently (if at all) is not worth the monthly expense. Demand for industrial space is obviously tied to general economic activity, which is declining rapidly around the globe. Retail properties should suffer from the growing number of retail bankruptcies. In addition, as retailers reduce store expansion plans or, in more extreme cases, shutter stores, the supply of retail properties will expand sharply. Lastly, hotel demand is inherently the most discretionary, and consumers and businesses are rapidly reducing expenses to the bare necessities. Plus, the oversupply picture in the hotel space appears to be worse than all other property types—a recipe for trouble, in our opinion. HK: Despite that negative outlook, REIT stocks JB: I think investors should second-guess their initial reactions regarding REITs. This sentiment might be surprising given how awful REIT stock performance has been, but the fact is that much of the punishment was justified. Earlier this year, it became clear to us that there was a major disconnect developing between the perceived strength of REITs relative to their tenants. Basically, the question became, How can property owners remain unscathed when consumers, manufacturers, retailers, and various other tenants are very clearly suffering from a rapidly deteriorating global economy? Well, the answer is that they can’t. As a result, REIT stock prices are starting to reflect more realistic outlooks that include falling rents, property value depreciation, and ultimately reduced cash flow. Still, not all REITs are cheap, especially when our concerns about the amount of leverage in this space are taken into account. HK: Are there REITs on your coverage list that might not make it to the other side of this recession? JB: Almost definitely. As was common a likely scenario for 2009 across some key property types. Joel Bloomer: While some firms will be hit harder than others, overall we expect cash flow to decline in all property types. Here’s roughly how we would rank the relative performance from bad to worst: health care, apartments, public storage, industrial, retail, and hotels. Health care should remain relatively insulated from turmoil, with the one caveat that some health-care REITs have concentrated tenants with weak balance sheets. Still, it’s hard to imagine mass reductions in the number of hospitals, skilled nursing facilities, and other are now yielding 8% to 9%, up from 3% to 4% a year ago. The knee-jerk reaction might be to think the group is a bargain. What do you say? in several industries over the past few years, REITs became drunk on capital. Exceptionally lenient debt markets acted as a bottomless wallet that some REIT management teams 56 Morningstar Advisor February/March 2009

Morningstar Advisor - February/March 2009

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