REITs Right Now
Despite Recent Shake-Ups, Real Estate Investment Trusts Continue to Influence Commercial Real Estate Markets.
Throughout much of the 1990s, real estate investment trusts have been significant players in commercial real estate from both the capital markets and property acquisition perspectives.
After last year’s market correction, REIT stocks were repriced as income-generating stocks with moderate growth potential based on the fundamentals of the underlying real estate market. For the first time this decade, REITs are not the 800-pound gorilla that controls the marketplace. However, the REIT segment remains a formidable player that influences the industry.
In the early 1990s, the U.S. economy was in the midst of one of the most severe real estate downturns since the Great Depression. Several factors combined to make this a difficult time for real estate owners and operators:
- The economy was in a recession, significantly reducing occupancy levels.
- Many properties were encumbered by high levels of debt based on optimistic occupancy assumptions of the 1980s.
- Properties had declined significantly in value, often below the amount of debt encumbrances.
- Traditional lenders such as savings and loans disappeared, while other lenders chose to stay away from financing real estate.
- The 1986 Tax Reform Act made the traditional tax-shelter buyer extinct.
At the same time, the great Wall Street bull market of the 1990s was gathering steam. Wall Street had no difficulty raising "cheap" equity capital, as long as the investment vehicle was not a partnership or another entity requiring investors to complete complex tax filings.
In 1991 and early 1992, several real estate entrepreneurs, such as Kimco Realty Corp., raised new money by forming public REITs. Because the cost of capital was cheap compared with the return generated by portfolios at depressed acquisition prices, sponsors reaped significant profits as REIT stocks appreciated.
Many real estate investors had significant portfolios that needed equity infusions to stay afloat. In many instances, if the properties were sold individually, sales proceeds would not be sufficient to pay off the mortgages against those properties. On the other hand, Wall Street was not looking at the value of the underlying real estate.
By forming REITs, Wall Street effectively securitized the income stream generated by these properties on an unencumbered basis. The prices paid for the income stream usually exceeded the value of the underlying real property. Thus, if property owners could value their portfolios based on the REIT model, they could infuse equity into their portfolios, pay off the debt, and still have a significant piece of equity.
This differential between the underlying property value and the REIT-based portfolio valuations created an opportunity for so-called positive spread investing. For example, if a REIT’s cost of capital was 7 percent and it could acquire new properties at a price yielding a 10 percent return, the 3 percent positive spread created significant additional value for the REIT’s shareholders. As a result, REITs were seen as growth stocks rather than income stocks based on the underlying real estate fundamentals.
REITs aggressively bid up prices of properties until the positive spread disappeared and the yield of newly acquired properties was equal to REITs’ cost of funds. Because growth no longer was sustainable through acquisition of new properties, the growth-stock investors bailed out and a fundamental market correction occurred in 1998.
With a current focus on underlying market fundamentals, most of the 300 or so public REITs today find it virtually impossible to fuel growth externally through acquisitions. Instead, growth must come internally through better property management, cost reduction, leasing activities, and repositioning properties to obtain the greatest possible operating efficiencies. This presents a significant challenge for many REITs that have been focused on acquisitions rather than strong management ability.
As REITs retrench, the result is more efficiently run businesses that have raised the bar for all real estate operators. Some of the more interesting enhancements include portfoliowide management rather than the traditional property-by-property approach. For example, economies of scale are obtained by using single vendors across the whole portfolio rather than by using different vendors for each property. One REIT was able to reduce its janitorial costs by more than 20 percent by consolidating contracts with a single vendor.
Similarly, a REIT can become the vendor of choice for a multilocation customer by offering incentives such as quantity discounts and standardized leasing. For example, office REITs have approached the Big Five accounting firms to try to become their landlord of choice. The power of using a portfoliowide management approach is just beginning to manifest itself and is likely to continue to be a factor in the marketplace for years to come.
Lease-management issues also have come to the forefront as REITs seek to improve operating efficiencies. After assembling portfolios from a multitude of sellers, REITs now find it difficult to deal with nonstandardized leases.
The most significant immediate impact is an inability to identify all of the common-area maintenance charges that tenants can reimburse. To deal with this dilemma, many REITs have implemented accounting systems to properly identify such reimbursable costs on a lease-by-lease basis. Furthermore, some REITs outsource functions to operate more efficiently and create a basis for passing those costs on to tenants. For example, if a REIT does property tax oversight internally, those costs presumably are part of the REIT’s general and administrative expenses that generally cannot be treated as common-area maintenance costs. However, a nonaffiliated vendor that bills the REIT on a property-specific basis frequently represents a charge that can be reimbursed by the tenant.
Many real estate operators (both REITs and others) are increasing the returns on their properties by offering ancillary services to tenants. For example, many apartment operators now offer Internet access to their tenants for a fee. REITs have been at a relative disadvantage in this process, because offering such services could cause them to lose their favored tax status. Tax legislation is pending, however, that would allow REITs to offer such services through wholly owned taxable corporate subsidiaries. Unfortunately, because such legislation may not be effective until 2001, REITs could be at a competitive disadvantage until then. (See "Telecommunications Services May Be ‘Good’ for REITs," CIRE, September/October 1999.)
Finally, dressing up a REIT’s balance sheet can improve operational efficiency. Since heavily leveraged REITs tend to trade at lower earnings multiples, many REITs sell noncore assets and use the proceeds to reduce debt loads. Similarly, many REITs are refinancing their debt obligations to take advantage of lower interest rates and to extend the terms of their debt maturities. Such repositioning makes REITs stronger in the event of a capital crunch or a softening in the overall real estate market.
Haves and Have-Nots
The REIT industry is becoming increasingly stratified. The most successful REITs made smart acquisitions and have maximized the operating efficiencies available to their portfolios. Dividends don’t exceed 80 percent of the REITs’ funds from operations. (FFO, which supplement income disclosure, is accounting income, exclusive of gains or losses from the disposition or refinancing of assets, plus depreciation expense attributable to real property.) In addition, total debt does not exceed 150 percent of shareholder equity.
These REITs have rewarded their shareholders with higher returns. Since they enjoy a lower cost of capital, their debt levels are low and they are well positioned to prosper when the economy gets tougher. As a result, in today’s competitive marketplace, they are on the cutting edge.
At the other end of the spectrum are the poor performers. The combination of poor acquisitions and an inability to maximize operating efficiencies has resulted in depressed share prices and higher debt ratios. These REITs face increased financial constraints that limit their ability to take advantage of return-boosting opportunities. If the economy softens, their dividends could be in jeopardy because portfolios may not generate sufficient rents to sustain the dividend payments. In today’s competitive arena, they merely are on the edge.
This scenario is the basis for many investment bankers’ business plans. Indeed, many on Wall Street see a Darwinian survival-of-the-fittest script for the REIT industry’s next act. Strong REITs will acquire weaker REITs as they fall victim to mounting operational challenges. Poorly positioned REITs will be forced to sell out to other REITs or go private. Going private often entails putting the company in play to ensure that shareholders obtain the highest possible offer for their shares.
Index Funds vs. Gazelles
The largest REITs effectively have become real estate index funds. Their portfolios are so large that incremental additions have minimal impact. Similarly, they are so well run that most operational efficiencies have been obtained. The returns from these companies are very stable and among the lowest in the industry. The share price volatility of these stocks largely will be a function of the underlying real estate fundamentals. Over the long term, these stocks should trade fairly close to the underlying net asset value.
On the other hand, many well-run small REITs have special niches that they are uniquely qualified to exploit. These REITs are quick on their feet — like gazelles. Whether operating in a geographical or property-specific niche, these REITs have strong developmental capabilities that can be implemented quickly. Frequently, they can acquire newly developed properties at a much lower cost than existing assets because they assume some development risk. Because these companies are smaller, new acquisitions have a greater impact and the stocks can be more volatile. If management is good and a REIT sustains an exceptional growth rate in relation to REITs trading as index funds, the gazelle’s share price should exceed the underlying net asset value.
As 2000 approaches, virtually every industry is consolidating and REITs — along with other real estate operating companies — are no exception. When REITs went public earlier this decade, their stock was sold on the premise of sustained growth. Because opportunities for traditional positive spread investing no longer exist, the new positive spread most likely will reside in the stocks of the have-not REITs.
If gazelles’ stock trades at a premium to net asset value because of the management expertise, it stands to reason that the stock of a poorly run REIT will trade at a discount to net asset value. Consequently, the greatest opportunity for index funds and gazelles alike could be to acquire the stock of poorly performing REITs that trades at a discount to net asset value.
One very important caveat exists to the consolidation phenomenon. The combination must make sense: It must add value to the REIT’s shareholders and synergies must result. If, for example, an office REIT were to acquire a multifamily REIT, management may not understand the nuances of residential property and chaos could result. In order for consolidations to work, the combined entity must be worth more than the sum of its predecessors.
It would be naive to assume that all consolidations will occur solely between REITs. For instance, opportunity funds and other institutional investors likely will seek to acquire REITs that are going private through methods such as leveraged buyouts.
After all, many institutional investors have the same degree of infrastructure at their disposal as successful REITs. However, because an institutional investor’s cost of capital may be lower than that of public REITs, it may be able to outbid competing REITs. Moreover, an institutional investor may not be subject to the same kinds of tax constraints as REITs with respect to the disposition of properties.
What’s more, many REITs that are precluded from issuing equity because of their current depressed share prices may consider forming joint ventures with institutional investors. Because joint venture equity is not convertible into REIT shares (or is not otherwise denominated by a REIT’s share price), this infusion of equity into a REIT’s portfolio does not dilute the existing shareholders. The joint venture can be structured so that the REIT receives incentives if certain investment objectives are attained.
Publicly traded real estate securities are a relatively new phenomenon in the United States. Although REITs have been around since the early 1960s, they were relatively obscure until the 1990s. Yet in other industrialized nations, up to 30 percent of the income-producing real estate is owned by publicly traded real estate companies because of the efficiencies of the public marketplace.
Recent estimates have REITs owning less than 10 percent of all U.S. commercial property, according to various studies by Wall Street investment banks. Because of the increasingly efficient nature of global capital markets, a strong case can be made for increased public ownership of real estate through REITs over the long term. As domestic REITs become bigger and more liquid, they will attract a wide variety of investors from around the world.
Concurrently, domestic REITs probably will find a way to invest outside of the United States. The biggest impediment to this trend thus far has been foreign taxes. Domestic REITs pay no corporate-level income tax in the United States. However, most foreign jurisdictions do not provide a mechanism for REITs to avoid a foreign corporate-level tax.
Therefore, in order for REITs to invest in a foreign jurisdiction, the after-tax rate of return there must exceed the pretax rate of return on a domestic investment. Proactive tax practitioners undoubtedly will devise creative structures to close this gap. Ultimately, to remain competitive in the future, foreign jurisdictions will have to provide tax incentives to attract real estate investment capital.
REITs’ Future Role
Over the past year, many real estate observers have indicated that the importance of REITs in the real estate marketplace will diminish.
However, while REITs have been relatively quiet recently, they still are very much alive and will continue to play a major role in U.S. real estate capital markets. They will continue to shape the way that real estate is owned and operated. The efficiency of the public capital markets resulting from the emergence of REITs has raised the bar for all real estate operators.