Morningstar Advisor - February/March 2009 - 57

REITs to Avoid Company Morningstar Rating Fair Value Estimate Fair Value Uncertainty YTD Return % Dividend Yield % Forest City Enterprises FCE.A Maguire Properties MPG General Growth Properties GGP Q Q Q 0.00 0.00 0.00 Very High Very High Very High –84.6 –95.0 –96.7 27.40 3.00 116.28 REITs to Consider Company Morningstar Rating Fair Value Estimate Fair Value Uncertainty YTD Return % Dividend Yield % AMB Property Corporation AMB HRPT Properties Trust HRP Diamondrock Hospitality Company DRH Developers Diversified Realty DDR First Potomac Realty Trust FPO Data as of Dec. 31, 2008 QQQ QQQQQ QQQQ QQQQ QQQQ 27.00 8.00 10.00 14.00 17.00 High High Very High Very High High –58.0 –49.8 –63.8 –86.5 –40.9 8.80 24.93 19.53 55.94 14.62 50%, which tells me that this firm won’t have to deleverage at an inopportune time. In contrast, ProLogis is at nearly 70%, when more than 60% is generally deemed unacceptable, especially today. This means that as debt comes due, ProLogis will only be able to refinance a portion of the capital and must pay the rest with cash. Because most REITs have very little cash on their balance sheets, the only way to reduce debt is to sell properties in the currently inhospitable environment. Other important leverage metrics we look at are earnings before interest, taxes, depreciation, and amortization relative to interest (2.5 times for AMB and 1.8 times for PLD) and total debt relative to EBITDA (10 times for AMB and 15 times for PLD). Clearly, AMB is in a much better capital position. After becoming comfortable with the balance sheet, we turn to our cash-flow forecasts and various valuation triangulation methods to determine what the stock is worth. We then compare this value with the stock and decide if it’s over- or undervalued. One triangulation method in particular that I’m fond of is the free-cash-flow yield of a stock at our Consider Buying price (the price at which the stock would be given a 5-star Morningstar Rating for stocks). This method basically tells me the cash the company produces after expenses in relation to the amount of money I invest in the stock. In today’s much-higher-return environment, where preferred equity and debt yields are often in the double digits, I think there is very little reason to accept less than a 10% free-cash-flow yield on common equity, and depending on the situation, even higher. So far, this strategy has worked out well for our team: It provides an attractive margin of safety in a highly uncertain world. K Haywood Kelly, CFA, is vice president of equity research at Morningstar. tapped aggressively to fund acquisitions, new developments, and redevelopments of existing properties. Unfortunately, profitability projections put in place when new projects were started are proving very optimistic, making current debt loads at several firms appear onerous. Therefore, we think investors who want exposure to REITs are better served picking companies that don’t fall into this category, because those who just buy an index are nearly guaranteed to see several of its constituents go bankrupt. HK: Your team has a handful of 5-star stocks. Which ones offer the best combination of value and financial strength? JB: The valuations on several REITs have amount of debt on the balance sheet, good coverage of interest by cash flow, and at least a decent property portfolio. HK: Your team does a lot of work stress-testing your fair value estimates and cross-checking against other valuation approaches. Could you walk me through an example—perhaps with one of your team’s 5-star stocks? JB: Sure, let’s look at AMB Property Corp. AMB. To put things in perspective, I’ll compare and contrast AMB with its much less attractive competitor, ProLogis PLD. become so compressed that many are undeservedly pricing in a high probability of bankruptcy, in our opinion. While we have a negative outlook, we certainly don’t expect all REITs to go to zero. Through research that sometimes resembles that of a credit analyst rather than an equity analyst, we’ve been able to surface several names that are priced for an outcome much more dire than we think is reasonable. The common theme among these companies is a reasonable One of the first places I look in valuing REITs these days is the balance sheet. I’m already comfortable saying that nearly every REIT will see cash flow decline in the near term. What I need to know immediately, though, is whether or not the company has the liquidity to withstand not only falling cash flows, but extremely unreceptive credit markets. One of the primary metrics we look at in this respect is total debt relative to gross property, plant, and equipment, which is similar to a loan/value ratio commonly quoted in residential real estate. For AMB, this number is below MorningstarAdvisor.com 57

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Morningstar Advisor - February/March 2009

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