Sunday, January 30, 2011

David Shulman's Crystal Ball

Reprinted by permission from REIT Wrap dated January 19,2011.

Editor’s Note: REIT Wrap contributor David Shulman writes that he’s not
especially bullish on REITs this year. Neither, however, is he bearish.
REITs, Shulman says, are likely to be little changed from year-end 2010 in
2011. Why does Shulman see REITs treading water this year? He lays out his
case and the reasons for it, below. As always, your feedback is
encouraged. And best wishes for a profitable 2011!

After plunging 41.51% in 2008, the price-only version of the MSCI U.S.
REIT Index (RMZ) jumped 20.97% in 2009 and another 23.53% last year.

Yes, the closely followed benchmark remains well below – nearly 40% -- its
February 7, 2007 all-time high of 1,233.66. Before you get carried away
with how far away the index is from its 2007 peak; I should tell you that
I view the RMZ 2007 high as the equivalent of the Nasdaq peak of 5,132.52
in March 2000. Said differently, I don’t expect the RMZ to test its
all-time high anytime soon!

What lies ahead for REITs this year? My best guess is that the RMZ will
trade in a broad range -- between 680 to 820 – and end 2011 roughly where
it began the year, at 760-ish. Why am I not as bullish as others?

Simply put, in terms of equity valuation, REITs are way ahead of
themselves trading at 17X 2011 estimated FFO and trailing EBITDA. Frankly,
REITs are quite expensive. Remember the Standard & Poor’s 500-stock index
is currently trading at roughly 8X 2010 EBITDA and 13X 2011 estimated
earnings. And, to top it off, REITs are still trading at a roughly 15%
premium to net asset value. Of course this state of affairs has been with
us for quite a while. So, why should it be different this year?

The answer is not complicated. The great bond bull market of 2007 to 2010
appears to be over. Ten-year Treasury yields have surged from 2.5% in
early-November to approximately 3.3% as of this writing.

Whether the bond market sell-off resulted from concern over the Fed’s
quantitative easing policies, higher deficits coming from the recent tax
deal, or higher growth in 2011 coming from the same tax deal is really
irrelevant. The fact remains that yields have dramatically backed up
causing the recent huge underperformance by REITs versus the broad market.

Rising rates and still tepid earnings growth for REITs are not a formula
for strong gains in share prices. This will be especially true against a
back drop of double-digit earnings gains expected for the S&P 500 in both
2011 and 2012. Said differently, the headwinds coming from the bond market
will more than offset the modest earnings gains of about 6% that most
REITs will report in 2011 even if those earnings exceed current estimates,
which I think they will.

Wearing my UCLA hat, I recently forecast 2+% GDP growth in 2011 and
just above 3% growth in 2012. Though those numbers are low compared to the
4% GDP growth forecasts coming from several of the major investment banks
following the recent tax deal; the UCLA forecast was put to bed prior to
the deal. It also only included a one full year extension of the Bush-era
tax cuts and it did not include the very important payroll tax cuts that
were added to the compromise. If I had to do a new forecast today, I would
mark it up to 3+% in 2011 and 2012;, still below where the Wall Street bulls currently are.

The economic environment will be improving going forward. Even the more
modest UCLA forecast calls for 150,000 jobs a month in 2011 and just above
200,000 jobs a month in 2012. That kind of labor market improvement will
certainly help real estate absorption going forward. Contrast that data
with the very tepid 100,000 a month job gains reported for 2010.

More important, sometime this year, real estate and REIT investors will
conclude that the era of extraordinarily low interest rates has ended.
Interest rates will start to normalize and that means instead of sub-3%
10-Year U.S. Treasury yields, 4+% though still low, will become the norm.
As a result, the scramble for yield that we witnessed over the past few
years will abate making REIT yields relatively less attractive. Put
bluntly, REITs, in my opinion, are not priced for a more normalized yield
world and it will take a year or two of rising dividends to help them
catch up.

Over the longer-term REIT investors should keep a keen eye on several of
the tax proposals made by the Bowles-Simpson Deficit Reduction Commission.
Their proposals to lower income tax rates and tax dividends and capital
gains at the new lower ordinary rates (23% to 29%) would be a boon to REIT
investors as REIT dividend taxation declines and corporate dividend
taxation increases.

On the other hand, the commission’s proposal to lower the corporate income
tax rate to 23% to 29% makes the REIT corporate tax exemption far less
valuable. When coupled with longer depreciation schedules for REITs
compared to C-Corps more than a few real estate companies might decide
that the REIT structure might not be as suitable to their needs as they
once thought.

Although the commission’s proposals are now out of the “new”
news, the long-term fiscal deficit faced by the United States makes it
almost inevitable that its ideas will be soon be revisited.

In terms of sectors: an improvement in economic growth will likely benefit
the hitherto lagging regions of the economy as the expansion broadens. It
won’t only be New York and Washington D.C., so I suspect that the much
maligned suburban office sector might surprise to the upside in 2011.

Moreover, the really new thing in the tax compromise, the payroll tax cut,
will help the Wal-Mart customer far more than the Nordstrom customer in
2011. With improving employment and a much needed pay raise coming from
the payroll tax cut, strip and power centers might outperform malls
this year. That’s a tough call, because the high-end consumer will benefit
from a continuation of the Bush-era tax cuts.

In sum, it is hard for me to be bullish about REITs in 2011. (No surprise,
I’m sure, to those who know me.) On the other hand, it is also hard for me
to be really bearish, despite high valuations. The economic environment of
modest growth and still low, albeit rising interest rates, makes it hard
to be outright bearish. There is still way too much money out there that
is looking for a home in real estate!


David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. He
is now affiliated with Baruch College, the University of Wisconsin and the
UCLA Anderson Forecast. He can be contacted at

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