Given that high unemployment, uncertainty about tax policy in 2011 and beyond, and consumer and institutional balance sheets overhauls are underway to lighten debt loads, one thing still remains quite clear: Cash is still King… and now is a great time to look at opportunities to invest in hard assets at reduced valuations.
So the question now is, if I’m looking to add hard asset exposure to my portfolio using an allocation of real estate, does it make more sense to invest in a real estate investment trust, or REIT, that can be bought and sold daily on an exchange like the NYSE, or should I consider some of the REITs that are similarly registered and regulated though are currently not traded on an open exchange?
Today there are well over 170 REITs that are bought and sold daily on exchanges. Many of these REITs are seasoned, having actively invested in real estate ventures for a number of years now. As you can see in the chart below, as denoted by the yellowish line, these Traded REITs enjoyed some wonderful success from 2000 through 2006. During that time, the MSCI US REIT Index1 gained a total of 331%2.
What are REITs?
A real estate investment trust (REIT) is a company that owns and, in most cases, operates income-producing real estate.
- Created by Congress in 1960
- Many REITs are public companies
- Typically Income Vehicles
- Enables individual investors to make investments in large-scale, income-producing real estate
- Offers transparency and public reporting
- Most REITs do not pay corporate income tax
- Must annually distribute at least 90% of taxable income to shareholders
Real Estate’s incredible performance during the first half of the decade was due in part to the following factors: 1. Interest rates were reduced to deal with economic slowdown caused in part by the ongoing stock market correction following the end of the dot com boom. 2. Lending standards were softened to allow more individuals access to the residential real estate markets. 3. Exponential growth of the securitized debt markets allowed lenders to fund tremendous amounts of mortgages before quickly selling off the loans as securities in large pools3. 4. Real estate, which includes REIT stocks, had become recognized as a distinct asset class separate from stocks and bonds. Moreover, investors worldwide had decided to maintain a bigger share of their total assets in real estate, including REITs, than in the past.
This was a great time to own traded REITs, though it must be noted that prices rose due to the tremendous inflows of investment capital into these funds. By 2001, Public REITs had reached a total value of $155 billion. Over the next four years, the total market cap of REITs more than doubled to $331 billion. That’s an average gain per year of $44 billion, or 113% over four years4.The tremendous capital inflows into the public REIT sector was the catalyst for the exceptional investment performance during that period but also created a war chest of cash that had to be deployed into buying more real estate assets during the heights of the bubble, with the unintended consequence of potentially buying lots of properties at much higher valuations than are common today.
Above: The Chart above tracks and compares the performance of Private Real Estate, Stocks, Bonds, and Publicly Traded REITs. Please note each line tracks the annualized return of each asset class at that point in time. These are not aggregate performance percentages. For clarification, the return for each asset class was positive during all periods where their respective line trends above the 0% center line. Conversely, the asset class showed negative annualized performance during the periods when the trend line crosses below the center line.
The Pendulum Swings Back
As the sentiment toward real estate shifted in early 2007, investors began to take notice of the asset bubble that had formed. We saw the beginning of the slow-down in real estate financing which by mid 2008 had stagnated to a virtual crawl5.From February 7, 2007 to March 6, 2009, the REIT Index1 had dropped by over 76%, leaving it just a hair above the levels we saw at the beginning of the decade.
Since the spring of ’09 the index has rallied over 150%1 as you can see illustrated again by the ascending yellow line on the graph on the previous page (REIT valuation growth illustrated by the trend line crossing through the graph’s center line near March ’09).
I say all of this because this story should sound quite familiar as it mirrors the experience of the overall equity markets during that same time period.
Prices Rebound, Yields Fall
We’ve seen yields in the traded space drop from around 10% during the Spring of ’09 to less than 4% today6.The influx of capital in the traded REIT market over the past year has been largely spent reducing the leverage in the portfolios or helping out troubled legacy assets that are facing the struggles of tenant delinquencies and reduced rents, and most importantly little has been spent buying more buildings to expand the portfolio.
Let me be clear, the issue of addressing the struggles of legacy assets in a portfolio is not unique to existing public REITs. There have been numerous non-traded REITs that entered the market place, raised capital from investors during the sector’s dramatic run-up, and now also face these same struggles. Some of these “seasoned” non-traded REITs have been forced to lower or even suspend dividends in order to support the solvency of their respective portfolios.
Location is Important but Timing is Essential
If I bought an office building that had tenants whose leases were signed during the market highs of 2004-2006, I would have owned an asset that was likely generating some nice net operating income (NOI) right up until those leases began to expire. Now fast forward to today… many tenants are renewing those leases at significantly reduced rents while others are struggling to even remain solvent. If my property’s NOI is dropping due to tenant delinquencies and lower rents, you can infer that the value of my building is likely being impaired.
How then can you explain the 150% increase2 in the index of publically owned real estate since the spring of ‘09?
Note the graph above showing prices paid in actual transactions of commercial real estate during that same period – if prices continued to fall and then stagnate, why did traded REIT prices soar?
Starting with a Clean Slate
There is a distinct difference between these seasoned or legacy REITs and those new issuances that are raising capital from new investors today in order to seize on the reduced valuations and operational issues that plague the current property owners.
The many challenges facing real estate owners today including the abundance of mortgage debt outstanding that may have little to no real means of refinancing, as has well as the potential tenant issues I just mentioned, lead to the undeniable fact that real estate prices are likely to remain subdued in the near-term.
This period of weak fundamentals has reduced prices throughout the country across the spectrum of property types and has created a window of opportunity for investment vehicles to that raise capital now to acquire properties at lower cost and sometimes even below replacement value. This reduced cost of entry also creates the potential for very competitive current yields.
These public, non-traded REIT programs come with the same oversight and regulation as their listed and traded cousins. Rather than see their stock prices fluctuate daily with the ebb and flow of the equity markets, non-traded REITs have their share price reevaluated 18 months after the close of the equity offering with subsequent evaluations completed every 18 months thereafter.
Have you answered the REIT question?
Please make no mistake, non-traded REITs are just that… not traded on an open exchange and therefore carry the risk of illiquidity. However, if you have a longer time horizon, and if you’re looking for an investment vehicle that can provide comparatively strong yields, pass-through of the depreciation to reduce the taxable portion of that cash flow, non-correlation to the equity markets, no issues of legacy assets with high debt and declining tenant fundamentals, and purchase prices reduced to reflect the current state of the economy, you may want to take a second look at the world of public, non-traded REITs.
Posted by Kelly
Citations and Disclosures:
- The MSCI US REIT Index (^RMZ) is a free float market capitalization weighted index that is comprised of Equity REIT securities that belong to the MSCI US Investable Market 2500 Index. The Index is an unmanaged index reflecting performance of the U.S. real estate investment trust market. The REITs included in this index are publicly traded.
- The index is calculated with dividends reinvested on a daily basis and is not available for direct investment.
- The information being provided today is not investment advice. Past performance is no guarantee of future results. Before making any investment decisions, we recommend you consult with South Coast Investment Advisors.