Morningstar Advisor - August/September 2011 - (Page 33)

oversupply experienced was generally at the local level as opposed to being more widespread or national. However, we did see some aggressive commercial real estate pricing in 2005–2007, which may require some time to digest and justify from a return perspective. Guziec: There was no excess square footage that we would see normally when heading into a recession; we had a price spike, collapse, and recovery. Martin: We had the price spike, but we didn’t have oversupply. So, the fundamental underpinnings are a bit better. Coming out of the late 1980s and early 1990s, most commercial real estate was in the hands of private owners and operators. The Resolution Trust Corporation took over a significant portion of real estate owned by the savings and loans, much of which was sold to professional commercial real estate owners and operators. Coinciding with that, we saw the publicly traded equity REIT sector begin to grow significantly. So, all of a sudden, a significant portion of commercial real estate was being owned in a publicly traded structure, where there is more discipline. Who’s underwriting and financing a big chunk of the sector from this point forward? It’s not just a bank— it’s an institutional investor. The broader public equity and debt markets are financing a larger percentage of the commercial real estate business, where there is, arguably, better underwriting discipline, transparency, and corporate governance and structure requirements. Jason Ren: From the banks’ balance-sheet point of view, relatively more of the construction troubles came from residential construction than commercial. Todd Lukasik: Certain pockets of commercial shopping centers obviously took a hit. But as Philip [Martin] was saying, generally a lot of the loose credit we saw went into acquisition financing, and that drove pricing up to very high levels. What’s interesting since then is that we’ve seen a full cycle on the valuation side. REITs are among the most highly levered investments in the stock market, and when the financial crisis hit, there was concern that there just wouldn’t be capital available to repay loans. So, equity values for a lot of REITs got decimated. But with the return of capital market activity, we’re again seeing very low cap rates and very high valuations for commercial real estate. It’s been pretty stunning how quickly that valuation cycle went from peak to trough and back to a very, very strong recovery. Ren: At the time, the leverage concerns were 2008 and into 2009 were portfolios maintaining occupancy levels and REIT management teams proactively working with clients to renew and modify leases. So far, and with some benefit of hindsight, equity REIT management teams and portfolios proved successful due to a proactive approach and the overall quality of underlying commercial real estate portfolios. Guziec: In today’s landscape, are there different stories to be told by geography or industry, versus commercial real estate as a whole? Lukasik: I think there are two ways to break compounded by the REITs’ liquidity position. Owing to the REITs’ business model, they can’t really retain much of their organic earnings for growth. They aren’t taxed at the corporate level, but they have to pay out 90% of their capital income to shareholders as dividends. So, they have to constantly tap the capital markets in order to grow. Guziec: So, the depressed valuations in commercial real estate, as driven by distress at the REITs, were basically a manifestation of financial risk? Martin: Yes. Affordable and available equity and debt financing is a critical component of successful real estate investing. Guziec: The underlying assets were performing reasonably well, fundamentally, but the market was concerned that even with a decent asset, could it get the refinancing done? Martin: Yes, and I think there was some question as to how deep the crisis was going to be and how well the REIT portfolios would weather the storm. What I think the equity REIT sector generally experienced coming out of it down. One is based on the length of the lease that the landlord is dealing with, and the other is based on the competitive advantage of the property portfolio. Going into the downturn, companies that had very short-term leasing structures—hotels, self-storage facilities, apartment landlords that reprice on a shortterm basis—felt the impact of the downturn in the pricing in their markets more immediately that the areas that have longer-term leases, such as office or retail. And they’re also recovering relatively faster as their markets recover. The other way to think about it is the way we’re analyzing REITs in general, which is in terms of moats. Landlords that have competitive advantages in their property portfolios have generally done a lot better than those who haven’t. We’ve seen “moaty” landlords able to maintain higher levels of occupancy, higher levels of rent, and oftentimes still being able to achieve positive releasing spreads—where even when leases expire, the rents that they’re getting on new leases exceed the rents that were in effect on expiring leases. Really being able to assess a REIT’s property portfolio from the competitive-advantage standpoint has proven valuable throughout the downturn and during the initial recovery. Guziec: The competitive advantage, as we’re looking at it, is the advantages of the individual properties? Or is it something to do with the management team? real estate associated with that residential construction were also hit hard. If you’re talking about a shopping center built on the prospect of a new community going up in suburban America that never got off the ground because of the residential real estate crisis, those MorningstarAdvisor.com 33 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2011

Morningstar Advisor - August/September 2011
Contents
Contributors
Letter From the Editor
Simplicity and Design Matter
Do You Use ETFs Strategically or Tactically?
The Institutional Way
How to Analyze an ETF
Eyeing ETFs’ Next Chapter
Small-Cap/Large-Cap Flip-Flop?
Four Picks for the Present
Investment Briefs
Morningstar Investment Conference
Pitfalls of Peer Groups
A REIT Recovery, With a Catch
Turning Fund Distribution on Its Head
Here Come ETF Managed Portfolios
Circle These Picks Amid the Crop of New ETFs
ETF Analyst Favorites
Beware, the Accidental Portfolio Manager
It’s the Destination, Not the Vehicle
New Growth, Rooted in Experience
Better Ways to Look at ETFs
How to Better Manage Your Clients’ Future(s)
More Bargain Than Bubble
Cheap, Local, and On a Roll
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
First-Quarter Assets Hit an All-Time High
You Say You Want a Revolution?

Morningstar Advisor - August/September 2011