Just when it seemed that all the stops had been pulled on the REIT juggernaut and nothing else would be able to surprise to the upside, save for Vornado finding an ancient Mayan city made of 24k gold in its back yard, after we read the attached research report on US REITs from Goldman analyst Jonathan Habermann, we have a dead taste in our mouth. The reason for that is we believe Goldman is within 2-4 weeks of upgrading the entire REIT space to something comparable to a Conviction Buy (not sure if that is possible for an entire industry, but we are confident GS will find a way).
The source of our consternation, the following phrases. As always, with Goldman what is not said is much more valuable than what is said.
Since the start of 3Q earnings, shorter lease term sectors have delivered relative outperformance versus the long lease term segments, marking a clear divergence in performance from the year-to-date trend. The gap was meaningfully apparent as Industrial and Apartments delivered amongst the strongest price performance over the last few weeks. Before we declare a shift in sector strategy, we point out that the data reflects our recent view that a more “balanced approach” to sector strategy will take hold in 2010, with a focus on growth leaders and income names.
Source of opportunity
We maintain our focus on our lists of growth leaders and income names as we think relative growth and the ability to pay an all-cash dividend should become increasingly important in 2010. It is becoming more evident that companies with access to capital and stronger balance sheets should be in a position to deliver higher growth in the near term. Our income list has a net cash yield of 5.4%.
3Q earnings highlights – stronger than we expected
Many of the 36 companies we follow met or exceeded our 3Q estimates, a positive sign, but we caution that growth should remain at a depressed level in 2010 and 2011. In fact, 2010 should be another tough year, with FFO down roughly 15%, but a relief from the earnings steep slide of 2009 (down 25%); we see only modest positive growth in 2011. Several highlights from the most recent quarter: (1) 88% of REITs we cover met or exceeded consensus estimates, which is reflective of solid results and a focus on expense control in a market defined by weak fundamentals; (2) Lease term is still important, as SS NOI for malls and office exceeded results from apartments and industrial names, a relative call we have been making for most of 2009; but, as we pointed out already, we are increasingly focused on the near-term growth which should favor a more balanced sector strategy in time; (3) Focus will remain on two key areas in 2010 – operating performance and the balance sheet. In short, with declining rents and occupancy to persist next year, relative operating results will drive upcoming growth as well as REITs that can deliver external growth given their better balance sheet.
A sector upgrade (with umph, gusto and, of course, conviction) would make a lot of sense strategically: lately Merrill has been unable to raise equity for a company if Cohen & Steers were to drop $1 billion on their door step in exchange for a $500 million secondary. As such, Goldman is about to flex its pipes. And as everyone knows, the best way to curry favor with 20 or so companies is by having the CEO's stock holdings appreciate by 10% overnight.
We hope we are wrong in our cynicism, as the real estate market, and particularly the CRE subset via REITs, is so distorted that it bears absolutely no resemblance with underlying fundamental cashflow reality. Another upgrade will just make this distortion even more unfathomable, yet in today's banana market, this may be the most expected outcome. It would also explain Mr. Cramer's recent all-in bet on CRE. As everyone knows, the man never speaks without an agenda. And what better way to be proven right than to have his former employer upgrade his chosen sector. Little does it matter that in 4 years CRE will look darker than a black steer's tuchus on a moonless prairie night.