Market Data

REIT Cycle Poised for Upswing

After posting impressive total annual returns of 35.8 percent in 1996 and 18.9 percent in 1997, real estate investment trust (REIT) total returns plummeted to a negative 11.4 percent during the first seven months of 1998. This sudden decline has left investors scrambling. However, on a historic basis, it is not exceptional for the REIT market to experience sharp declines after a strong prior year. In fact, from 1972 through 1997, four other years had negative total annual returns when the prior year’s total returns exceeded 11 percent.

The REIT market has been influenced by several issues. The highly volatile stock market during 1998 caused institutional investors to take positions in large cap stocks, which offer the greatest liquidity. However, a trade of a large number of small cap shares could cause other large shareholders to reevaluate their positions, leading to significant price swings. Most REITs fall into the small cap category. Consequently, some of the downward pricing movement can be explained by the outflow of capital from small cap stocks to large cap stocks.

Clipping Paired Share (Stapled) REITs. In July 1998, President Clinton signed into law the Internal Revenue Service Restructuring and Reform Act of 1998. The act froze the grandfather status of stapled REITs, which prohibits them from adding more properties under the stapled REIT structure. Stapled REIT prices then plunged as short-term investors rushed to unload their positions. Consequently, many institutional investors that had not been long-term players in the REIT market abandoned the sector entirely.

Self-Inflicted Wounds. According to National Association of Real Estate Investment Trusts statistics, $62.7 billion in new REIT securities were issued between 1996 and 1997. This exceeded the entire level of new issues between 1984 and 1995. Through July 1998, REIT security issuance totaled $27.7 billion. This continued high level of REIT issuance outstripped demand for new REIT securities, which put downward pressure on pricing. Many REITs have put on hold aggressive expansion plans due to a lack of demand for new equity.

Another factor in the tepid demand for initial public offerings or secondary REIT offerings is the prices that REITs recently have paid for properties. Properties with high vacancies and low values were snapped up in 1995 and 1996, leaving higher-value properties with stabilized cash flows for purchase. The frenzy of acquisition activity from 1996 to 1998 resulted in capitalization rates being bid steadily downward as owners entertained offers from multiple REITs. The good news is that some REITs capitalized on this trend by selling properties at above replacement cost and plowing the proceeds into new development.

1999 Prospects
The prospect for improvement in the REIT market is sound for 1999. This was an unusual year in which the REIT market was stung by both unfavorable legislation and capital flows. Such circumstances are unlikely to be replicated in 1999. From 1972 through 1998, there was only one experience, 1973 and 1974, when REIT total returns were negative for two consecutive years. Some of the strongest years for REIT appreciation have occurred after a year of negative total returns. In August 1998, many REIT stocks were priced at levels below the value of the underlying assets. This creates the potential for price appreciation. These factors point toward an improved REIT market in 1999. However, if the bear market continues into 1999, the level of improvement will be diminished significantly.

George Green

George Green is a policy representative/senior economist for investment real estate at the National Association of Realtors in Washington, D.C.

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