The REIT Marketplace
The Current Boom Offers New Opportunities for Brokers.
The real estate investment trust (REIT) boom continues as it prepares to enter its eighth year in 1998. Last year produced one of the strongest returns yet for REITs and their investors, but 1997 is gaining ground fast. While caution guides today's market, the strongest companies will continue to prosper as long-term value creation is rewarded and innovation separates the successful from the unsuccessful.
Today's REIT market offers tremendous opportunity for everyone wanting a piece of the pie. The total value of U.S. commercial real estate is estimated at $4 trillion, and today's REITs represent just 4 percent of that. Continued growth of this market segment is inevitable—in industrialized countries in western Europe and the Far East, publicly traded real estate companies own 10 percent to 30 percent of all commercial real estate holdings.
The influx of capital into the REIT market, coupled with the vast changes in the investment climate, will result in impressive growth for the REIT industry, especially in relation to other growth stocks. One of the greatest opportunities in 1998 will be a direct result of the utility industry deregulation. Both REITs and utility stocks traditionally attract investors interested in current yield with growth. The utility industry deregulation will dramatically reduce utility stock profit margins and reduce dividend-paying capacity. The inability of utility stocks to grow the dividend will give REITs favored status, providing another boost to an already growing market.
Among publicly traded equity REITs, total stock market capitalization has more than quadrupled in the past few years. In December 1996, 166 equity REITs had a total market capitalization of $78.3 billion. This compares with only 82 equity REITs with a market capitalization of $12.9 billion at year-end 1992. The implied market value-market capitalization plus any partnership units converted to shares—of the 100 largest REITs will grow to more than $100 billion in 1997. Activity continues to be brisk and will remain so for the foreseeable future. By year-end 1997, at least 24 REIT initial public offerings (IPOs) and about 12 mergers are expected to take place, according to Deloitte & Touche, LLP.
By the end of the decade, REITs increasingly will be recognized as an efficient, user-friendly way to invest in U.S. real estate. They offer liquidity, allow small players and funds to participate, provide oversight of management, and are designed so that management compensation is directly related to investors receiving a commensurate return on their investment.
Clearly, REITs offer the most user-friendly investment in which to buy and sell stocks. The market is continuously changing and new players are entering the market almost daily. Strong demand should continue through the end of the decade, regardless of interest rates, since REITs today are less interest-rate dependent than they were 20 years ago.
For those interested in doing business with REITs—the time is now.
Opportunities for Brokers
As capital continues to pour into the national real estate marketplace, commercial real estate brokers will find more opportunities available to them. For educated, progressive brokers who are able to understand the special interests and needs of this quickly emerging industry, REITs are the perfect niche. (For more information on selling to a REIT, see "The REIT Stuff," CIREJ, January/February 1996.)
Demand is at an all-time high for properties—especially in the office and hotel sectors—to fuel REIT growth. Prices of underlying properties are being bid up across the country. But brokers should move with caution—with only so many properties to acquire, this opportunity will be short-lived because consolidation is inevitable as the industry matures.
Another opportunity for brokers is the popular trend of REITs using partnership units as currency to buy properties. This type of transaction is more complicated due to its tax ramifications (a seller's tax is deferred), but its recent popularity makes it a viable alternative to brokers looking to sell to REITs.
The Urge to Merge
As the REIT industry continues to grow and consolidate, the momentum that gathered strength in 1996 and early 1997 is still in full force. The "bigger is better" attitude many investors express is having a marked effect on the consolidation trend. Five years ago, the market equity of the 20 largest REITs was only $3.6 billion, with just two having more than $500 million of market equity. Today, however, the REIT industry has experienced a growth explosion, with 23 REITs currently holding a market capitalization in excess of $1 billion and 59 REITs having a market capitalization of $500 million or more.
In 1998, the market will continue its growth. Wall Street ideally would like to see as many REITs as possible reach $1 billion of market equity before the turn of the century. This would lead to more outstanding shares, and consequently, a broader market and greater liquidity. A market comprising large REITs with greater market equity will lead to a more diversified ownership and ultimately a greater trading volume, giving more small players the ability to buy in.
Several factors contribute to the increase in REIT mergers: successful REITs have access to the capital markets; the most successful REITs raise relatively inexpensive capital through secondary stock offerings; others raise funds through perpetual stock offerings; and still others issue partnership units to pay for property acquisitions.
REIT stocks are priced based on a multiple of "funds from operation" (FFO), which is net income plus depreciation expense after eliminating gains and losses from sale or refinancing of property. For a REIT to appreciate in value, it must sustain growth in its FFO. Such growth can be difficult to sustain with a shortage of growing acquisition properties to deliver acceptable returns. REITs seeking to maintain growth will look toward underperforming REITs whose stock prices are less than the value of the underlying real estate.
Another factor shaping the future of the REIT industry is the economy. If a particular sector is performing poorly because of prevailing economic conditions, the easiest way for a REIT to grow its FFO is to reduce operating expenses. In an effort to cut costs, a merger is the next logical step to building a larger portfolio to spread the overhead.
Both REITs and private firms gain economies of scale in administrative costs and purchasing power as their portfolios increase in size. However, large REITs also benefit from increased liquidity that tends to decrease their cost of capital. A recent example illustrates this. In early 1997, Equity Residential Properties Trust in Chicago absorbed the 19,000-unit apartment portfolio of Wellsford Residential Property Trust, based in New York. Wellsford choose to merge with Equity Residential because of its low cost of capital, stable cash flow, strong balance sheet, and well-regarded management techniques. Since going public, Equity Residential dropped its general and administrative costs to less than 2 percent—one of the lowest in the industry—and saw per-unit property management costs drop more than 100 basis points since its IPO.
Another key trend shaping the REIT industry and contributing to increased merger activity is the creation of joint ventures between REITs formed in the 1970s and 1980s with first-generation property owners. A number of older REITs still exist, even though they haven't grown or kept pace with the times. They typically have managers who may not have the requisite real estate operating experience, but they are good at dealing with Wall Street. On the other side, many property portfolio owners don't want to go through or don't have the critical mass to go through the IPO process—which can be expensive—and may have a portfolio category that Wall Street currently favors. These smaller REITs have tremendous opportunities to create joint ventures with older property owners. By converting these smaller REITs to an UPREIT structure and letting the property owners/real estate companies continue to manage the real estate and the REITs continue to interface with Wall Street—it's a win-win situation for everyone. In an UPREIT, all the assets are transferred to a partnership and the property owners can convert their partnership interests into REIT shares. The UPREIT then has access to capital and the REIT is able to grow and can go back to the equity market to raise money. REITs in the $50 million to $100 million range are good candidates for this type of transaction.
Initial Public Offerings
IPOs continue to be the fastest-growing area of REIT activity. REIT IPOs totaled more than $1.1 billion in 1996—the third highest total of the last decade. By year-end 1997, REIT IPO activity should reach almost $3 billion.
Before 1992, an average of 12 IPOs were completed annually—1997 will exceed this historical average by almost double, according to the National Association of Real Estate Investment Trusts.
Renewed interest in REIT IPOs can be attributed to a number of factors. First and foremost, many companies that did not participate in the 1993-94 boom years are finding themselves in industries now attracting tremendous interest, such as suburban office product. Consequently, these companies are becoming active players in today's market. Second, significant capital is being invested in REIT mutual funds, and these funds are, in turn, investing capital in IPOs. Third, many select markets, like southern California, were left behind in 1993-94 because of weak economies but have since rebounded. In southern California's case, the economy is growing faster than the rest of the nation, and a number of very attractive REIT IPO candidates are in the works. Last, investors are trying to diversify out of common stocks and growth stocks and look toward REITs.
The top five best-performing REIT IPOs were up an average of 114 percent at year-end 1996 versus 56 percent on average for the five REITs topping 1995's list. Additionally, according to Dean Witter Reynolds, Inc., 81 of the 96 IPOs since 1987 are up in price, whereas last year only 58 out of 92 were up.
REITs going public in today's positive investment climate should raise between $200 million to $300 million in new equity capital and, if the market continues to improve, can expect to double in size within two to three years. REITs generally are exceeding Wall Street's expectations of returns. As long as the underlying real estate continues to perform well and construction remains limited, the number of REITs that exceed a billion dollars in market value should continue to increase twofold by the end of the decade. While total common equity capital raised in 1996 exceeded $12.7 billion, IPO volume was less than 25 percent of that. This figure may not change as a percentage of total, but IPO volume definitely is on the rise.
Foreign Properties and Investors
As the market becomes more global and foreign investors become increasingly more comfortable with the notion of owning real estate through publicly held corporations instead of owning the real estate directly, significant foreign investment will come into the United States using the REIT structure as the primary vehicle. REITs are attracting the attention of foreign investors because they allow them to obtain a share of U.S. real estate returns without facing the liquidity problems of direct ownership and management of U.S. properties.
The biggest advantage REITs have in the United States that foreign companies don't have overseas is the avoidance of a corporate-level tax. U.S. tax rules allowing for the elimination of the corporate-level tax make REITs even more efficient for owning U.S. real estate on an after-tax basis.
Pension funds from Europe and the Netherlands are by far the largest foreign investors in REITs—particularly domestically controlled REITs, in which more than half of the investors must be U.S. residents. Netherlands pension funds invested more than $1 billion in U.S.-based REITs in 1996 and are expected to increase their REIT investments to more than $5 billion in the near future.
When a foreign entity invests in a domestically controlled REIT, the disposition of REIT shares is not subject to the Foreign Investment in Real Property Tax Act, a huge benefit for many institutional investors. Pension funds favor REIT investment because it allows them greater oversight of management and the ability to elect a board of directors.
Even with all of this foreign interest, REITs still only own about 2 percent of the $1.22 trillion institutionally owned real estate market. This is easily explained by the fact that REITs historically have not invested in institutional-grade properties due to their tendency to trade at much higher yields. Instead, REITs traditionally seek out higher-yielding properties—avoiding trophy properties.
On the other side of the game, a key venue for the acquisition of properties that generate yields in excess of a REIT's cost of capital is in foreign jurisdictions—particularly in Mexico and Canada, but more so in Canada. The biggest structuring issues REITs face in both countries usually concern foreign tax since most foreign jurisdictions do not have tax provisions similar to U.S. REIT rules. Properties in either one of these countries must generate an after-tax yield comparable to pretax yields in the United States. Additionally, difficulties in exit strategies are frequent. Canada currently is reviewing its tax rules and is considering amendments similar to the U.S. structure. If such changes are enacted, expect to see a tremendous increase in U.S. REIT investment in Canadian properties.
There is significant room for continued growth of the REIT market as innovative financing and structuring guide the marketplace. Fundamentals have remained strong and investors still can expect the better REITs to return 15 percent to 20 percent for 1997. In 1996, the five largest REITs delivered returns exceeding 40 percent. As we enter 1998, industry stratification will show the top third outperforming everyone else and the bottom third becoming acquisition targets.
In the next 10 years, the market will remain cyclical, with IPOs dominating the climate, then another consolidation phase. REITs will continue to grow faster than the rest of the industry, providing tremendous opportunity for investors and brokers.
While competition from investment banks and Wall Street will make it increasingly more difficult for real estate brokers to find their place in today's REIT market, a niche exists. By remaining aligned with REITs' interests and knowing their special needs, specific methods, and markets of the REIT industry, brokers can prosper. The increasing amount of capital pouring into the real estate market today has insured the longevity of the REIT market. By investing the time and energy now, brokers can secure their future for years to come.