Market Data

REITs Expected to Remain Steady

Since the early 1990s, the public equity market for real estate, primarily in the form of real estate investment trusts and real estate operating companies, has seen tremendous growth. However, a number of significant changes last year coupled with events this year presage both challenges and opportunities in this arena.

Clearly, large REITs have economies of scale: They have buying power and cross-marketing opportunities and can access capital expeditiously. Accordingly, REITs larger than $100 million with good growth plans will prevail, while small REITs may be liquidated or acquired.

Recent Developments In 2000, the composite National Association of Real Estate Investment Trusts index increased almost 26 percent after two years of losses. Institutional investors, who are big REIT players, were sobered by the recent NASDAQ decline and now are refocused on the stable income opportunities that REITs provide. Therefore, REITs are attempting to ramp up their incomes through sources such as management and service fees and expense reductions.

Nevertheless, like most public equities, REITs must provide growth in addition to income returns; thus, they have pursued aggressive growth strategies through development. A recent Green Street Advisors analysis reports that the current development pipeline for REITs and real estate operating companies is approximately $18 billion. The pipeline represents about 9 percent of the operating properties of these companies and, more dramatically, almost 20 percent of the REITs' market equity.

While development can provide accretive returns to funds from operations, the income benchmark for REIT multiples, many analysts are concerned that this accretive yield is not properly risk adjusted. Development includes market, financial, and property-related risks, such as extensive predevelopment time frames, significant related costs, multiyear construction periods, and varying degrees of lease up. Over the last five years, the strong real estate market has resulted in development projects being readily absorbed. If the United States faces a recession, however, demand for all product types may be affected and development projects coming on line may have difficulty competing with existing competitive supply.

Looking Forward This year's total returns for most REITs are expected to be in the 15 percent range, constituted by an approximately 7 percent dividend yield and 8 percent capital appreciation. REIT stock prices should increase because their shares trade at a considerable discount to the underlying real estate market value, known as net asset value. Currently, the discount is about 15 percent. The discount may be explained by anticipation of a sluggish real estate market in response to an economic slowdown.

In addition, the FFO also has room for growth. REITs currently have a multiple of their earnings of about 9.5 in their share pricing. The range of multiples has been from less than 10 to almost 18 over the past 20 years, indicating that, based on how the market views REITs, REIT shares could realize a considerable incremental multiple. The more FFO increases, the more REIT share prices increase.

REITs also should benefit from recent legislation. The REIT Modernization Act went into effect on Jan. 1. This act lowers the minimum amount distributed to shareholders from 95 percent to 90 percent of taxable income.

This cash can be used to build cash reserves, pay down debt, otherwise improve balance sheets, and provide capital for renovations or development.

The act also provides that REITs can own taxable REIT subsidiaries. These TRSs can perform active services — such as leasing, property management, providing concierge and day-care services, cleaning, and furniture rental — from which REITs previously were precluded (see “New Tax Rules Offer REITs More Flexibility,” CIRE , May/June 2000).

As such, REITs will have better operating economic fundamentals on an after-tax basis.

REIT Expectations Real estate is well positioned in the event of a soft landing or a recession. New supply has been minimal, vacancy rates are reasonable, cap rates reflect traditional risk-adjusted returns for real estate, and mortgage rates also are reasonable. In fact, with mortgage rates in the 8 percent range and cap rates exceeding this rate, further acquisitions can help realize positive leverage.

Recognizing that REIT earnings are tied to long-term leases, often with credit tenants, REIT earnings should be viewed positively if overall equity market volatility occurs.

REITs have a predictable dividend and an earnings stream secured by long-term leases and are at a discount to their real estate market value. This is coupled with the traditional negative correlation between REITs and other stock market equity indices, including the S&P 500, Dow Jones Industrial Average, and NASDAQ Composite. While the other markets fluctuate, REITs hold steady.

Thus, pension funds, the largest purchasers of equities in the United States, as well as individual investors, will continue to see REITs as a positive, diversifying factor in their portfolios.

Jack Barthell

Jack Barthell is partner in charge of real estate capital markets at PricewaterhouseCoopers in New York. Contact him at (212) 596-7280 or jack.barthell@us.pwcglobal.com.

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