31 July 2010

REITs in the Right Cities


Manhattan is on the mend and Washington, D.C. is a growth town. Here's how to get a piece of those real estate markets.

Investors should take comfort in the pullback that has recently hit the REIT group. These companies bounced back from near insolvency with a vengeance, but then the realities of a slow growth recovery set in. It just didn't make sense to bet on companies that were priced ahead of their earnings growth, not to mention the value of their hard assets--values that had become very slippery during the downturn.

What does make sense is investing in businesses that have a proven record of managing in a volatile environment and have shown the courage to seize opportunities. This works in any market, but the key is to avoid overpaying.

Office REITs have been written off by most analysts. Big empty spaces and lackluster leasing prospects are the scene in most urban office markets. Still I continue to like New York office landlord SL Green (SLG, 56). SLG has been making bold moves, buying high-quality buildings in a market and at a time when players managing tens of billions of institutional and private dollars are forced to give back money because they can't put it to work.

There is a glimmer of hope in SLG's New York City market. A report from real estate broker Cushman & Wakefield in July shows that the Manhattan market's leasing slide has reversed course: The volume of new square footage leased in the first six months of this year was double that of the same period in 2009; leasing in the second quarter reached the same level as in the same quarter of 2006. Rents are still sliding, but at a much slower rate than previously. Sales of office buildings are already well ahead of the total for 2009.

In other words, the sparks of a recovery are evident. As financial services firms recover--and they are recovering--Manhattan is likely to be one of very few office markets with a positive story to tell over the next 12 to 18 months.

As SL Green is the city's largest office building owner (with 24 million square feet), it is the REIT to play for a New York City recovery. You're buying growth, not yield (which is a meager 0.7%). Management cut the payout last year in order to keep debt manageable. At $4.7 billion, debt is 51% of enterprise value (defined as debt plus market value of common). REITs are compelled to pass their taxable income through to shareholders, but that sum is depressed by depreciation charges. Thus, REITs that have a lot of noncash depreciation expenses have the option of using cash flow to pay down debt instead of paying dividends. I'm hoping that, as rent rolls improve, SL Green management will be inspired to boost the payout significantly. That should help the stock.

Another office market that will do well is the one around Washington, D.C. Office demand comes not just from the U.S. government but from the contractors, lobbyists, trade associations and law firms that feed off it. To rewrite H.L. Mencken, no one ever went broke overestimating the growth in government.

Corporate Office Properties Trust ( OFC - news - people ) (OFC, 38) is the buy. This REIT derives 58% of its revenue from D.C. and environs; all of its development projects now in the pipeline are for government and related entities. Government or not, all of Corporate Office's properties are net leased to single tenants. Corporate Office has a 4.2% dividend. I think the company will continue to grow through acquisition and development--in one of the very few markets where adding square footage makes sense.

Another buy is Home Properties (HME, 47), which has a concentration of assets in and around the nation's capital and additional buildings in mid-Atlantic and Northeast markets. Home Properties buys and manages medium-quality apartments in crowded, high-demand markets like Washington, Annapolis and Manhattan, where so many aspirants are priced out of the best rentals. This is of particular interest as a vast population of college grads and others get jobs and leave doubled-up households. You'll also see household formation by youngsters who have jobs and are finally convinced they won't be in the next layoff.

These folks are not about to step into top-tier apartments or buy homes or condos. They can rent one of Home Properties' 37,000 apartments. The REIT's debt is $2.2 billion and market value $1.7 billion. The $4 billion enterprise value comes to seven times the apartments' earnings before interest, taxes and depreciation. Home has said it will acquire another $250 million in assets this year. The dividend is 5.4% of the share price and is likely to climb nicely over the next five years.

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