Michael Grupe is NAREIT's executive vice president for research and investor outreach. SNL recently spoke with Grupe about second-quarter earnings, the challenges REITs face in the current volatile economic environment and his outlook for the sector.

What follows is an edited transcript of that conversation.

SNL: Would you comment on second-quarter results? Were there any surprises from your point of view?

Grupe: My sense from what I've seen is that the economic fundamentals continue to weaken in the real estate market, and that is apparent to one degree or another with most property sectors and most companies. It's a very severe recession. Unemployment levels are very high. Spending has clearly deteriorated. Credit is contracting. Financing is still very difficult to obtain. Cap rates continue to increase, maybe slowly, but continue to increase. Property valuations as reported by the major property indexes … are off appreciably. … Those are the fundamentals that we see in the market, that the analysts see, that the companies see — and they're having to deal with it. So it certainly shows up in terms of occupancy rates and rent rolls and renewals and things like that. But I did have the sense that on balance, the earnings performance for the second quarter appears to have been fairly encouraging in that most companies either were within reasonable range of what their expected performance was, with a few situations where companies did somewhat better and other situations where companies perhaps didn't meet their earnings targets. It either was a small miss, or the miss was really some very special circumstances in terms of timing, when to realize certain losses that did not seem to either surprise the analyst community very much or to worry them very much. So I think the performance was fairly encouraging, and the outlook is reasonably encouraging. And I think that has been endorsed, if you will, by the frequency and volume of equity offerings that we've seen so far this year.

What are your projections for the sector for the second half of 2009 and for 2010?

There's a real dichotomy in the market right now. There's widespread recognition that commercial real estate tends to be a lagging indicator. So when the economy is expanding, the demand for space expands, but the supply is relatively inelastic. And so it takes a while to satisfy that growing demand, so the performance sort of lags. And on the downside, of course, with the economy contracting and unemployment levels rising and spending down … the demand for space contracts as well, but the supply of course is still relatively inelastic. So occupancy rates tend to decline. Vacancies likewise rise. And rents tend to weaken. Then that begins to show up as tenant leases roll over and operating performance deteriorates. So the market seems to have a pretty broad sense that that is what is unfolding and will continue to unfold until the economy stabilizes and probably some time thereafter. That continued deterioration of fundamentals is likely to affect the performance of real estate owners, both private and public owners, including REITs. I think that in the REIT market, that's pretty widely anticipated and sort of discounted.

I think the question that comes along with that is then, what might happen to share prices? I think there, you know, when you look at performance, when you look at our indexes as a measure of performance across the industry … what you see is that the equity REIT index is … up about 80% from its low on March 6 of this year. … So there's been a significant rally over the last four months or so, but there would still be a considerable ways to go back to the prior peak. But then the question is, whatever you expect from operating fundamentals in terms of company earnings, what do you expect the market to do in terms of share prices? There's something that none of us really know. I think it's fair to acknowledge that there's been a pretty good rally in share prices already from what may have been — and I say that very carefully — what may have been the lows of this cycle. Although that I suppose could still be retested, I frankly don't expect the index to go back to its lows in early March. I don't think that's going to happen. But likewise, I wouldn't expect stock prices to continue rising at the rate they've been going for the last several months. So I think on balance, relative to the deteriorating economic and property fundamentals that we're likely to see play out over the next year or so, REITs are basically pretty well-positioned.

Do you see another wave of equity raises coming?

There was some activity very early in the year, but then it really started to pick up in April, May and June. It fell off a little bit, I think, in July, when stock prices weakened somewhat. But it's picked up again in recent weeks as we've seen stock price strength again. … I do think that we're in a period that has some similarities to where we were about 18 to 20 years ago, just before the IPO activity in the mid-'90s and the modern REIT era. I think we're looking at an industry, the commercial real estate industry, that needs and will require a significant amount of new equity, which is the same thing that was required following the real estate collapse in the late '80s and early '90s. At that time, 20 years ago, a lot of property companies came public as REITs, and they took the equity that they received from their IPOs and they used it to pay down their debt. So they recapitalized. And we're going to see something like that. I'm not exactly sure what the profile will look like, but we're going to see something like that play out again over the next few years as additional amounts of equity are required to recapitalize commercial real estate. We may not see the level of IPO activity that we saw 20 years ago. We may see some IPOs, but I think it's perhaps more likely that what we'll see is external growth by the companies that are already major players. Using the equity and debt that's available to them, they will try carefully to take advantage of distressed property portfolios that become available on the market and to grow in that manner.

When do you think we will see some initial activity on the distressed acquisitions front?

I can see some of that activity in 2010. But I think it may play out a little more slowly than many people expect. There's very, very little liquidity in the property market right now. There are just very, very few transactions. If you look at the Real Capital Analytics databases, you can see this. There's just a huge falloff in activity from 2008 to 2009. So there's very little liquidity, and because of that there's also very, very little price discovery. So a big problem is that nobody knows what to pay. And they don't want to rush in. And the companion problem is that there's very little debt financing available. One of the reasons why a lot of these properties are in distress, or will be in distress, is that they were acquired at very high valuations in 2004, 2005 and 2006 at very high property valuations with a significant amount of debt. Now, property values have fallen so much that most of those properties are basically underwater. And either the debt would need to be refinanced as it comes due, and that seems very difficult, or new owners would have to step in with additional amounts of equity and some debt financing to acquire those properties. But again, they're going to have difficulty raising debt.

What would have to happen for those circumstances to change and for activity to pick up on that front?

I think basically what you need is a rebirth of the [commercial mortgage-backed securities] market. You need an active securitization market. Because the traditional lenders, and in many cases the banks, aren't going to ramp up their lending unless they know that they have an outlet for those loans, unless they know there's some way they can lay off that risk. And right now the CMBS market doesn't work, so they can't do that. So they not only don't want to originate new loans to put on their own book, they don't want to originate new loans, because they can't resell them. Because of that, there's no financing readily available. And I think that's what needs to change, and I think we may begin to see that change through the Federal Reserve's TALF. It is expected that there will be some CMBS activity through that program, probably beginning in September. If that begins to work as well as it has been working with household credits — credit card receivables, auto loans and so on — then that may be the beginnings of a new CMBS market.

Anything else you'd like to add?

I think for us, the most encouraging thing is the access that the industry has been able to demonstrate to equity and credit markets. I think that's a very favorable development. Credit in general remains very tight, and it seems pretty clear that access to equity does not extend across much of the commercial real estate industry. I see very little capital raising or equity raising taking place in the private equity world. But most of what I hear is that many of the institutional investors that have funds locked up in those programs are in queues trying to pull money out, not put more money in. And yet REITs are able to go into the public equity market and raise about $20 billion so far this year. That, to us, is a very favorable development.