We would like to share with you our review and outlook for the U.S. real estate securities market as of September 30, 2011. The FTSE NAREIT Equity REIT Index had a total return of –14.7% for the quarter, compared with a –13.9% return for the S&P 500 Index. Year to date, the indexes had total returns of –6.0% and –8.7%, respectively.

 

INVESTMENT REVIEW

The third quarter saw a repricing of assets throughout global capital markets as investors factored in meaningfully lower expectations for global economic growth. The market’s confidence was further eroded by the spiraling debt crisis in Europe, as well as concerns about the long-term fiscal health of the United States, highlighted by the symbolically significant downgrade of the country’s credit rating by Standard & Poor’s. Actions by the Federal Reserve offered little encouragement, as interest rates—already at historically low levels—were not seen as an impediment to growth.

Within this challenging landscape, U.S. real estate securities had significant declines along with the broad equity market. While earnings reports for the second calendar quarter were generally positive, share prices for REITs reflected investors’ expectations for reduced demand, particularly for the more economically sensitive property sectors. Performance generally diverged within each property type according to quality, as companies with lower leverage, premium assets and strong market share exhibited greater resilience.

Hotel REITs (–32.1% total return) sold off dramatically, even though the corporate environment remained strong and group bookings for 2012 have been solid. The sector is considered among the most cyclical, and investors anticipated reduced growth in occupancies and room rates. Industrial landlords (–28.1%) also underperformed, as the sector tends to operate with greater leverage and its largest constituent, ProLogis, earns a meaningful portion of its revenue from Europe.

Retail landlords were generally in line, although the free standing sector (–1.8%) was a standout, benefiting from defensive cash flows and generally low debt levels. Among regional mall REITs (–12.8%), there was a vast differential between Class A malls, which saw strong competition for prime storefronts, and Class B malls, which tend to have a harder time maintaining occupancies and rents during weak economic periods. In shopping centers (–14.1%), Equity One announced the sale of a large portion of its lower-quality properties to Blackstone at a cap rate of 7.5%. The price was a positive data point for other strip center owners wanting to sell similar assets.

Apartment owners (–10.8%) outperformed in July and August, benefiting from solid fundamentals and continued weakness in the single-family housing market. However, the sector dropped sharply in September amid signs of slowing growth in net operating income. Office REITs (–19.7%) underperformed during the quarter, as investors worried that additional job losses in the financial sector would limit the ability of landlords to raise rents.

On a relative basis, investors favored health care REITs (–7.5%) for their defensive qualities and predictable cash flow streams, which outweighed concerns about reduced Medicare and Medicaid reimbursement rates.

Investment Outlook

Based on recent economic data and the growing risk of recession in Europe, we have positioned our portfolios with the expectation of challenging economic conditions over the next several quarters, including a high probability of rising unemployment. However, the credit quality of many commercial tenants remains very strong, particularly those located in premium locations. We also expect the lack of new supply to counter slowing demand.

While this macro perspective helps inform our underlying assumptions, our investment decisions remain predominantly driven by bottom-up stock analysis. Within each sector, we continue to focus on companies with strong balance sheets, stable cash flows and high-quality portfolios. We believe these firms are more likely to see sustained demand in a weak economy, and are well-positioned to benefit from historically low interest rates and attractive acquisition opportunities.

From a sector perspective, we believe apartment REITs will continue to benefit from positive market fundamentals despite a weak job market. We are overweight retail property owners, with a substantial bias toward those with Class A assets. We have increased our allocation to the health care sector, which tends to have longer lease durations, as well as data center operators, which stand to benefit from positive secular trends. We remain underweight in office REITs, but continue to see attractive opportunities in urban markets.

Sector returns as measured by the FTSE NAREIT Equity REIT Index.

 

 

 

(c) Cohen & Steers

www.cohenandsteers.com