Sweeping Earnings for Economic Landmines

REITs Report
Commercial real estate has been a focus of many investors for months amid concerns that a wave of commercial defaults could create a renewed banking crisis. Non-residential real estate fundamentals typically lag residential as long lease terms make prices and occupancy stickier than they would be otherwise.

One way to gauge the health of the commercial real estate industry is to examine the earnings of real estate investment trusts (REITs). REITs are not a perfect proxy; they tend to be higher-quality properties with more conservative financing, but they do give a general sense of broad trends. This quarter, there was broad weakness across property types (office, apartments, retail, etc.), but rents and occupancies have not dropped off a cliff. Cost controls are also providing a positive catalyst for earnings.

One unexpected bright spot this quarter was at  SL Green , which saw operating revenue fall about 1%, but earnings before interest, taxes, depreciation, and amortization rose slightly to $116.6 million, thanks mainly to general and administrative expense savings. Other operating metrics held up well, with SL Green's Manhattan occupancy rate at 95.7%, about 500 basis points higher than the average in its core midtown Manhattan submarket. The firm also achieved positive leasing spreads (the difference between the rental rates on new versus expiring leases) of 5% for its Manhattan leases. This is down meaningfully from recent historical spreads, however, and concessions for tenants were significant, including nearly seven months of free rent and tenant improvement allowances of $56 per square foot on average (with an average lease term of 9.6 years). Equity analyst Todd Lukasik sees this as a sign that the weak Manhattan leasing market is beginning to negatively affect SL Green's business, and we expect weakness in its financial results to follow.

Other office landlords saw slightly improved results but also showed signs that there is significant weakness to come.  Boston Properties , which owns buildings in the Northeast, saw total revenue increase 5% and earnings before interest, taxes, depreciation, and amortization increased 8.5%. But these results were aided by an increase in revenue-generating property assets and somewhat masked the weakness in the firm's same-store (internal) results. On a cash basis, same-store net operating income fell 5%. Lukasik thinks these results mainly reflect the recent loss of major tenants Lehman Brothers and General Motors, which together represented about 4% of revenue. Given the difficult leasing market in midtown Manhattan where these vacancies arose, he believes it will be difficult for Boston Properties to re-lease the space, causing a drag on internal results for some time.

Apartment owners, which have much shorter lease terms than office owners, had a tougher time in the quarter.  AvalonBay saw established community rental revenue tank by 4.8%. With all of its major geographies seeing drops in average rental rates and unemployment remaining at heightened levels, analyst Jason Ren says more difficult quarters are likely in store for AvalonBay.  Equity Residential saw weakening across the board. Total revenue fell 3.5% from the third quarter of 2008. Year-over-year comparisons on a same-store basis were worse, with revenue tanking 3.9% because of a 3.2% drop in average rental rate and a 70-basis-point dip in occupancy. With expenses falling just 0.6%, the firm's net operating income on a same-store basis saw a 5.8% decline from the comparable quarter in the previous year.

Cost controls at  Simon Property Group allowed this retail landlord to post year-over-year improvements in third-quarter results. Lower cash expenses helped boost EBITDA 5%. Simon was able to increase occupancies at its regional malls and premium outlet centers sequentially to 91.4% and 97.5%, respectively, both up 50 basis points from second-quarter levels. However, Simon's tenants' comparable sales per square foot were down 11% to $438 at its regional malls and down 5% to $492 at its premium outlet centers. Lukasik believes it will be difficult for Simon to maintain rents in the face of falling tenant sales, as tenants will attempt to reduce occupancy costs to better match their lower sales levels.

 Realty Income , which is presenting at the Morningstar Stocks Forum next week, had an impressive quarter. Results showed that Realty Income's portfolio of well-underwritten, triple-net leases is performing well, despite the challenging retail environment. Revenue was down slightly, as a result of the firm's net disposal of 21 properties during the past year. On a same-store basis, however, rents increased 0.4% from last year's quarter. This increase includes the negative impact of the bankruptcy of Realty Income's largest tenant. Lukasik believes that Realty Income is one of the best positioned REITs in the current environment. The firm has no mortgage debt on any of its properties, no debt due before 2013, no development properties, no joint ventures, and plenty of cash available to take advantage of accretive acquisitions, if they become available.

This quarter, several of the oil majors reported precipitous declines in earnings.  ExxonMobil saw earnings fall 65% from the same period a year ago. Total production increased 3% for the third quarter compared with the year-ago period, as the company realized production from project startups in the United States, Kazakhstan, and Qatar. However, production year to date remains flat, and in all likelihood ExxonMobil will not achieve its goal of 2% production growth for the year. Analyst Allen Good hopes the firm will be able to deliver on its production targets in the coming years after investing at high levels the past few years.

 Chevron also had tough comparisons to last year and the firm reported a 51% drop in earnings. Despite the earnings decline, Chevron demonstrated robust production growth, partially offsetting the effects of lower commodity prices. Worldwide production jumped 11% from a year ago. A 15% increase in U.S. volume came primarily as a result of oil production from startups in the last year of Blind Faith and Tahiti fields in the Gulf of Mexico and restoration of production knocked offline by hurricanes last September. Good believes Chevron is well positioned as the firm's anticipated production growth from continued development of its promising portfolio should help drive earnings in the coming years.

Another firm that reported tough third-quarter results, but that looks poised for somewhat better times is  ConocoPhillips . Earnings were off 71% from the year-ago period, but there were some bright spots. Production increased compared with the year-ago quarter, despite shutting in about 300 million cubic feet per day of natural gas production in August because of low prices. International crude production growth led the gains, and year-to-date production is now up 5% from the same period last year. Also, the refining and marketing segment returned to profitability after sustaining losses in the second quarter. Good is cautiously optimistic about the firm's plans to become more competitive with its larger rivals. The company previously announced its intentions to sell $10 billion worth of assets over the next two years and cut capital spending to enhance returns.

 BP had better-than-expected earnings thanks to improved earnings from both its upstream and downstream businesses according to analyst Catharina Milostan. Adjusted third-quarter earnings of $4.7 billion were 60% above the second quarter, thanks to efforts to cut costs and boost operating efficiencies. Lower-than-year-ago oil and gas prices and refining margins were still factors in lower year-over-year earnings comparisons. Cost savings were a key factor behind sequential earnings gains for both operating units. Lower unit production costs along with 20% higher oil prices combined to boost upstream earnings 37% from the second quarter. Higher refinery throughputs and oil sales volume in the United States and Europe helped boost sequential downstream earnings 35%. She sees continuing cost savings, production gains from new field development, and operating efficiencies at downstream operations to drive earnings improvement in the fourth quarter and into 2010.