Property: A crisis in confidence

Todd Briddell, chief investment officer at Urdang Securities Management

A crisis in confidence

Given what has transpired in the real estate market in 2008, it has become clear that the sub-prime crisis didn't instigate the credit crunch and the global slowdown we face today. Instead, it is now widely believed that sub-prime borrowers, as the least creditworthy, were merely the first group to show the symptoms of a very sick and over levered financial market.So far, 2008 has generated levels of investor fear not witnessed since the Depression era. Fear has wreaked indiscriminate havoc on valuations, seized-up credit markets, and forced liquidations. While the circumstances of the Great Depression were quite different from those of today, the fundamental need to see confidence in the system restored is the same. Unfortunately, the vast complexity of today's financial instruments will most likely prevent a quick recovery. What will it take to restore confidence? In addition to coordinated efforts from central bankers, a restoration of confidence will require massive de-levering of financial markets, which will be costly to world economies in the short term. Evidence that this de-levering process has already begun in earnest can be seen in the widespread selling and near panic levels of volatility across financial exchanges. Ultimately, today's fears will only begin to dissipate when asset valuation levels hit rock bottom and strategic investors - lured by long-term buying opportunities – resume buying.

The impact of financial crisis on real estate

As a capital intensive industry, the reduction of available credit to property buyers and developers has resulted in a drop of more than a 65% in purchase and sale activity in 2008 relative to 2007 levels. This drop in transaction activity reflects sellers’ hopes for a quick recovery and buyers' more realistic demands for higher yields and lower rental rates and occupancy levels. As in-place financing agreements mature, pressure to sell will mount as property owners face higher credit spreads, tougher underwriting standards and lower loan-to-value ratios. In anticipation of the ensuing selling pressure, most privately financed property investors are currently sitting on the sidelines waiting for valuations to fall.

URDANG's strategy for 2009

We don't expect to see any near-term catalyst for real estate values until we see confidence restored and a contraction of the 'fear premium' for financial assets. To the extent that a low yield environment develops once the financial markets regain their composure, we believe that institutional investors will once again be drawn to the liquidity, transparency and diversification offered by the global real estate securities market. For the time being, a defensive investment focus is required, with an emphasis on companies with low leverage, cycle tested management teams, high quality real estate assets and limited exposure to new development. Companies with a 'war chest' of capital and prudent strategies to acquire high yielding properties from distressed owners should also outperform. In the current market, we are avoiding companies that have material external financing needs. This includes real estate companies with significant development pipelines, near-term debt maturities, fund management business models and over levered 'stories' with potential debt covenant issues.

Today's environment may favour global real estate securities

In a market environment characterised by low interest rates, the threat of inflation and higher premiums for liquidity, transparency and diversification, we can expect to see institutional investors increase their allocations of fresh capital to publicly listed REITs and REOCs. Capital committed to global real estate securities allows investors access to longer-term growth opportunities in Asia and emerging markets and attractive values (relative to private real estate) in the US, UK and Europe. In this sort of environment, global real estate securities should prove popular given their attractive dividend income and property's potential as an inflation hedge. Lastly, listed real estate companies typically maintain lower debt levels as compared to private real estate funds which, when coupled with the transparency of their asset holdings, should add to their appeal in a market anxious to move away from excessive complexity and leverage.

Business of real estate still sound

Notwithstanding our expectations for privately held property values to fall through 2010, the fundamental business model of leasing real estate to tenants remains sound. Entering 2009, most property owners will begin the year more than 90% leased. Few other industries can boast this level of pre-sales for 2009. Given tough economic headwinds, occupancy and rental rate levels are expected to fall in 2009. However, the long-term nature of property leases will soften these effects and property income levels should be only modestly lower in 2009.

Regarding share prices, we believe the indiscriminate and forced liquidations of listed property shares has been overdone. For long-term investors able to envision a return to normal market conditions, listed property shares offer a compelling valuation entry point today. Equally important, the 6.93% dividend yield for global listed real estate securities should provide a strong incentive for investors to exercise patience and wait for share prices to recover.