REIT Rally Facing a Challenge

High Debt, Lower Commercial-Property Values Present Obstacles By LARRY LIGHT While housing may be nearing a bottom, commercial real estate likely has much further to fall. And that could snuff out a significant rally in real-estate-investment-trust stocks. REITs, which own everything from office buildings to strip malls, have seen their shares rocket 60% since hitting an 18-year low on March 6. Now REITs face at least two years of crushing debt maturities, sliding property values, dwindling occupancy and weakening earnings. These are major obstacles for their shares to overcome. REITs face crushing debt maturities, sliding property values and dwindling occupancy. Here, Maguire Properties' U.S. Bank Tower in Los Angeles. REITs, which took off in the early 1990s when many private-property owners went public, used to be pitched as something in between a stock and a bond. Over time, most of the gains investors get from REITS come from their high dividends. And REITs pay no corporate income tax as long as they pay 90% of taxable income to investors as dividends. But, in the short run, REITs have turned out to be surprisingly volatile. The sector lost 57% from last Sept. 30 to March 31. A lot of the current market rebound stems from relief that the dire forecasts for REITs in late 2008 and early 2009 didn't come true. Thus far, General Growth Properties Inc., a debt-laden mall owner, is the lone big REIT to file for bankruptcy. Many REITs improved their financial standing by cutting dividends and raising fresh equity capital, further heartening the market. But those moves mightn't be enough in light of the challenges ahead. "Additional shocks are coming over the next six to 12 months," says Robert Arnott, chairman of financial strategy firm Research Affiliates LLC. More Small Stocks' Run Set to Pause 08/03/2009REITs must refinance a daunting $152 billion in debt through 2013. Some REITs have crushing debt levels, such as office landlord Maguire Properties, with 94% debt to capital. Anything much above 60% is considered onerous. Another office REIT, Kilroy Realty, has had tenant outflows that have whittled away its occupancy rate to near 85% -- the minimum level allowable under its loan covenants. Kilroy had to get its banks to waive them. To be sure, some REITs could still do well, even if the sector as a whole suffers. Green Street Advisors, a REIT research firm, notes that some trusts sport strong fundamentals that should make them long-term winners: Simon Property Group in regional malls, Avalon Bay Communities in apartments and Liberty Property Trust in offices and industrial. Although all three have seen tenant occupancy slip, their debt loads are at a comfortable 50% of capital or slightly below. The bullish view on REITs is that many of them have gone through the worst, and 2010 should mark an upturn. The spate of recent capital raisings "bought them time to get through the recession," says Tom Bohjalian, senior vice president at Cohen & Steers, a real-estate investment firm. As a whole, however, the sector doesn't look cheap any more. A big reason to buy REITs, their superior dividend yields, has worn away, thanks to rising share prices. In the spring, yields averaged around 10%, says researcher SNL Financial. Now they are down to 4.7%, below many investment-grade corporate bonds. Despite REITs' current rise, the Dow Jones Composite REIT Index is still down almost two-thirds from its February 2007 peak. Owing to a horrendous first quarter of 2009, REITs are off 5.2% year-to date, versus a 4.5% gain for the Dow Jone Industrial Average. "REITs have out-performed recently, but off a very low bottom," says Ross Smotrich, head of REIT research at Barclays Capital. In the winter, he says, "the stocks were trading as if the REITs were all going insolvent." REITs have received nowhere near the federal support that the financial-services industry has enjoyed. A Federal Reserve program offering financial backing for debt, called the Term Asset-Backed Securities Loan Facility, or TALF, has just started for commercial real estate. Even though some big REITs like Vornado and Developers Diversified are expected to benefit from the program, some others are too leveraged to qualify under the Fed's standards. Meanwhile, commercial-property owners have dimmer prospects for recovery than their residential brethren. The long housing slump has shown signs of ending, with home prices in many markets nudging up lately, partly because residential real estate now offers so many bargains. REITs, however, operate on tougher terrain. Unlike houses, whose mortgage terms typically are 15 or 30 years, REIT debt often matures after three to seven years and must be rolled over -- hard to do when credit is tight. Only four REITs have issued unsecured debt this year, according to Fitch Ratings, paying pricey yields between 7% and 10.75%. "Housing stocks peaked in 2005 and REITs in February 2007, so REITs have two more years in their recovery cycle," says Samuel Lieber, president of Alpine Woods Capital Investors LLC, an asset manager that invests in real estate. Write to Larry Light at larry.light@wsj.com