REIT Retreat

The upcoming third-quarter earnings reports from real estate investment trusts will not be pretty. Second-quarter earnings for the sector were boosted by one-time gains from buying back publicly traded bonds at discounts, and taking advantage of bond investors’ newly whimsical attitude toward credit risk by floating new bond issues. Earnings were also boosted as REIT executives slashed property operating and maintenance expenses. But that can only go so far before real estate quality becomes an issue. The competitive environment to fill vacant space will squeeze REIT profits. If you’re a high-quality tenant, it will be a ‘buyers’ market’ for years.

Sell-side analysts have adjusted their earnings estimates for REITs upward, and the bar is now higher. But same store net operating income (i.e., trends in rent pricing) is what really matters for investors’ expectations looking out several years. As rents remain depressed from tepid new business formation and slow retail sales, the supply of credit to REITs will once again tighten, which will dampen REIT owners’ expectations for future free cash flow.

The Dow Jones U.S. Real Estate Index has tacked on a hefty 30% rally since second-quarter earnings season in July. REITs are now priced for perfection, rather than being priced for the obvious multiyear depression staring REIT owners in the face.