Friday, April 9, 2010

Winthrop Realty Trust 2009 CEO Letter to Shareholders

Found via My Investing Notebook.

We seem to have a tale of two markets. On the one hand, Moody's recently reported its Commercial Property Price Index has risen for the third straight month. A PriceWaterhouse Coopers survey of institutional investors which gauged investor sentiment indicated an expectation of improved sales volume, improved sales prices and declining capitalization rates. Anecdotally, most major market real estate brokers and investment bankers will confirm witnessing heated auctions for better performing assets that are not dissimilar to those experienced in 2006.

Further supporting this trend is the enormous spread tightening for most senior level commercial mortgage backed securities (CMBS) and performing junior debt. The prices on REIT equity securities as reported by the RMZ Index have risen by 105% since the March 2009 low. All of the foregoing would lead one to conclude that the real estate market has troughed and recovery is imminent, if not already occurring.

On the other hand, REIT earnings, inarguably a relevant measure of ascertaining real estate operating performance, declined during 2009 and are expected to continue to decline in 2010. According to the National Association of Realtors, this deterioration is projected to continue until at least 2011. Moreover, the executive summary of the February 10, 2010, Congressional Oversight's Panel Special Report entitled, "Commercial Real Estate Losses and the Risk to Financial Stability" troublingly states:

"Between 2010 and 2014 about $1.4 trillion in commercial real estate loans will reach the end of their terms. Nearly half are at present "under water"- that is the borrower owes more than the underlying property is currently worth. Commercial property values have fallen more than 40 percent since the beginning of 2007. Increased vacancy rates which now range from 8 percent for multifamily housing to 18 percent for office buildings, and falling rents, which have declined by 40 percent for office space and 33 percent for retail space, have exerted a powerful downward pressure on the value of commercial properties."

Notwithstanding the price tightening of CMBS securities, by February 2010, loans in special servicing increased to $75 billion or 10.7% of the entire CMBS universe with a current loss severity exceeding 44% on defaulted fixed-rate loans. Fitch Ratings now predicts that 20% of all CMBS loans will be in special servicing by 2012. Job growth, the single greatest driver of occupancy rates, continues to remain elusive. These statistics belie any theory that the real estate markets are improving.

Where sentiment/momentum clashes with real time economic data, how should we invest our Company's capital in 2010? While we acknowledge we may miss some of the momentum related opportunity, we believe that capitalization rates will ultimately revert back to historic levels and real estate pricing will trend downward more accurately reflecting its current and near term operating fundamentals. We expect that excessive leverage, reduced liquidity and a reappraisal of value by institutional lenders will create ongoing investment opportunity not presented by the current "pretend and extend" lender policies. Consequently, we intend to continue to invest patiently, with deliberation and dispassionately avoiding market mania.