Is REIT Rally Rooted in Reality or Wrongly Rising?

SL Green Points to Undervalued Properties and Fund-Raising Advantages; Cousins, However, Girds for More Pain By ANTON TROIANOVSKI Share prices of real-estate investment trusts have climbed so far that according to some analysts, the sector is trading at a premium to the value of the underlying assets -- for the first time since the heyday of the real-estate boom. To some stock-pickers, that is one of several signs that REITs are overvalued and a correction is around the corner. During the third quarter, REITs posted a 33% return, according to the Dow Jones Equity All REIT Index. That is the biggest gain since the index's inception in 1989, beating out the previous record, which was set three months ago. The hotel and office sectors both delivered gains of about 45%. Only six stocks in the index of 114 companies posted a negative return. As a result, REITs were trading at a 24% premium to their net asset value as of last week, according to research firm Green Street Advisors. That is both because REITs are up nearly 90% from their March lows and because commercial real-estate values are estimated to have fallen some 40% from their peak. But the high premium helped prompt a warning last week from analysts at Goldman Sachs Group Inc., who expect REITs to fall an additional 15% even after a 10% selloff in late September. Citigroup analysts downgraded office REITs because of concerns that high valuations limited investors' potential gain. Consider the case of SL Green Realty Corp., one of the largest office landlords in New York. The company's shares gained 91% in the third quarter, more than any other REIT with a market capitalization of $500 million or more. Last week, SL Green was trading at about $41 a share, a 38% premium to what Green Street believed was the net value of the company's assets. SL Green has recovered from fears that its big financial tenants, such as Citigroup, would go bust. But now some analysts, including those at Green Street, believe the price of the company's shares is greater than what's warranted. REITs are still off some 35% from where they were trading a year ago. Overall, Green Street says that investors are valuing REITs fairly, and that the premium to net asset value is a sign that property values are due to increase. Investors may be willing to pay more for real-estate stocks if they expect the companies to be able to ride a rising market. "I think real-estate prices have already troughed, and the numbers we're using show they've bounced back a little bit," says Mike Kirby, Green Street's director of research. REITs can take advantage of the continuing dearth of capital in the private markets, Mr. Kirby argues. While mortgage financing and private capital is still hard to come by for landlords, REITs have been able to get relatively good pricing in secondary stock sales and corporate-bond issues. "They get to raise capital in a market that prices real estate much more dearly than the market in which they're going to be spending the capital," Mr. Kirby says of public REITs. So far, however, most REITs have been wary of pursuing an aggressive strategy. Many have their hands full putting out fires in their existing portfolio. Take Cousins Properties Inc., a company that posted a 3% loss in the third quarter -- making it the worst performer in the Dow Jones index among REITs with a market capitalization greater than $500 million. Cousins said last month that it would write off its entire investment in Terminus 200, a newly built, 25-story Atlanta office tower that is only 9% leased. Even though Cousins has few big debt maturities before 2012, new Chief Executive Larry Gellerstedt has tried to batten down the hatches by putting the company airplane on the market and raising $330 million in a stock sale last month to pay down debt. He says he is eyeing potential acquisitions but hasn't seen any compelling deals. Mr. Gellerstedt ascribes his stock's poor performance largely to the company's delay in raising equity. When REITs raised more than $13 billion through secondary stock sales between March and June, Cousins wasn't one of them. Many analysts believe REITs are far from finished with raising cash to reduce leverage. Goldman estimates REITs will seek to trim their debt by at least $40 billion over the next three years. As fresh debt and equity capital has become easier to access for public REITs in recent months, that process of "deleveraging" has come to appear a lot more feasible than it did last winter. That is why companies with heavy debt loads were among the biggest winners as the capital markets opened up. J.P. Morgan Chase & Co. reported last week that REITs with high leverage have nearly doubled their stock price since March 19, and the most indebted companies gained 351% between then and the end of September. Write to Anton Troianovski at anton.troianovski@wsj.com