Morningstar Advisor - August/September 2011 - 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
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
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
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
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
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?
MorningstarAdvisor.com 33
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