Market Data

REITs Rally

Real Estate Investment Trusts Adapt to Changing Market Conditions.

An extraordinary reversal of fortune has occurred in the real estate investment trust market this year, particularly compared with the broader equity market, which has solidly outperformed the REIT market for much of the past three years. In large part, this reflects the market's slow but growing acceptance of the compelling relative value of REITs compared with most other sectors of the equity market.

The National Association of Real Estate Investment Trusts Equity REIT Index showed a year-to-date total return of almost 13.2 percent through the end of June. In contrast, the NASDAQ Composite Index recorded a year-to-date loss of nearly 2.5 percent through June 30 and a decline of 21 percent from its March 10 peak. In 1998 and 1999, the NASDAQ Composite recorded total returns of 40.2 percent and 86.1 percent respectively, while REITs suffered setbacks of 17.5 percent and 4.6 percent.

All property types within the NAREIT index showed positive year-to-date returns, an encouraging sign. The lodging sector was the clear standout in the index, posting a total return of 19.7 percent while health-care REITs and free-standing shopping centers lagged behind with total returns of 2.3 percent and 3.1 percent respectively.

This year's REIT rally is broad based, with 112 of the 123 companies in the Morgan Stanley REIT Index posting positive total returns. On a company-specific basis, 2000's best performing REITs represent an interesting cross section. Indeed, nearly two-thirds of the companies in the index posted double-digit returns through the first six months.

Some of these success stories are easy to understand, such as Cornerstone Properties, which agreed to be acquired by Equity Office Properties Trust earlier this year. Other stories, such as Pinnacle Holdings, are more involved. Pinnacle acquires communications sites and then constructs rental towers and leases space to a broad base of wireless communications providers. While the company is organized as a REIT, its business is largely technology related and it has traded like a technology company, soaring through late 1999 and early 2000 before declining 29.6 percent since peaking in mid-March. Despite the decline, the company's share price on June 30 was approximately 27.4 percent above its year-end 1999 level.

REITs Regain Ground The supply-and-demand fundamentals for the nation's property markets have changed little during the past six months. If anything, expectations for future property market performance are weaker today. With most property markets at or past equilibrium, experts predict gradually rising vacancy rates and flattening - and eventually declining - rental rates across all property types in most markets nationwide during the next two to three years. New supply is increasing, albeit at slower rates than in the last cycle, and demand growth is slowing despite the robust economy.

Against this backdrop, investors have driven REIT share prices up an average of nearly 9 percent, with many REITs rising by significantly greater amounts. The financial press perceives that REITs have rallied in response to the declines in technology shares and other growth-oriented companies. While this is at least partially true with respect to retail investors, it does not fully explain the behavior of institutional investors, particularly pension plans and college and university endowments.

Institutional investors typically take much longer to make their investment decisions and are equally slow to change course once a new direction is established. But anecdotal evidence and data indicate that their interest in REITs has been building steadily during the past six to 12 months. According to data compiled by the Vickers Stock Research Group and reported by SNL Securities, institutional investors continue to own about 50 percent of the REIT market as of year-end 1999, a level virtually unchanged over the past few years despite the poor performance of 1998 and 1999.

More importantly, however, the Vickers data shows the beginnings of a significant change in the kind of institutions that held REITs during 1999. Between June and December of last year, the total value of pension funds' direct holdings of REITs increased more than 50 percent and endowment holdings increased in market value by more than 15 percent. Over this same period, REITs posted total negative returns of approximately 9 percent and share prices declined by an average of 14 percent, indicating even higher levels of new investment by these two groups.

In contrast, investment funds and insurance companies' REIT holdings declined by about 8 percent, roughly in line with the total return for the period. This suggests that these two groups did not introduce any new money to the sector but also did not actively withdraw any capital.

The increase in pension funds' interest in REITs reflects two complementary factors. First, REITs offer numerous advantages to many plan sponsors relative to direct private investment in commercial real estate. Chief among these advantages are true daily pricing, significantly greater liquidity, and far greater property-type and geographic diversification.

Second, and perhaps more importantly, REITs have been trading at a substantial discount to their underlying asset value during most of the last 12 to 18 months. This means that plan sponsors struggling to reach their real estate asset allocation targets have been able to invest in REIT securities at lower prices than they could invest in directly owned properties, indicating that property has been cheaper on Wall Street than on Main Street.

REITs in the Multiasset Portfolio Historically, real estate has been included in the multiasset portfolio for at least three distinct reasons: diversification, inflation hedging, and attractive risk-adjusted returns. For a growing number of investors, REITs have matured to the point where they now are viewed as providing some or all of these benefits to the broader portfolio. Unfortunately, as currently configured, the REIT sector has not existed long enough to rigorously test the ability of REITs to fill all of the roles once reserved for private direct holdings of real estate. However, several empirical observations about REITs can be made.

First, the diversification benefits for the broader portfolio are obvious. The modern REIT era started around the end of 1992 with the initial public offering of the Taubman Centers and the introduction of the UPREIT structure. At that time, the correlation of REIT returns with the Russell 2000 Index and the Standard & Poor's 500 Index were about 0.8 and nearly 0.7 respectively. By mid-1997, these correlation coefficients had fallen to historic lows of approximately 0.4 and 0.2. The severe financial market turmoil of late 1998 resulted in a sharp increase in correlation coefficients as the entire world capital market strained under a massive "flight to quality."

Despite the severity of the problems in the capital markets at that time, REIT correlation coefficients did not rise as high as the 1992 level and have since fallen considerably. As of the end of June, the correlation of REITs with both large and small cap stocks was less than 0.5, more than adequate to provide significant diversification benefits to the broader portfolio.

With respect to inflation, the evidence is less clear. Historically low levels of measured inflation have distinguished most of the modern REIT era, and REITs have recorded periods of relative out- and underperformance over this period. Most recently, with heightened concerns about future inflation confounding the capital markets, REITs have performed well in both absolute and relative terms. This is expected given the much higher dividend yields REITs offered relative to other equities. In the parlance of fixed-income investing, REITs have a much shorter duration than other equities because of their higher dividend yield. As a result, their value as an income instrument is less sensitive to changes in interest rates than other equities. This does not mean that REITs will act as an inflation hedge, but it does suggest that they will hold up better than lower yielding, growth-oriented investments in a rising rate environment.

Finally, in terms of risk-adjusted returns, REITs again have demonstrated meaningful differences, particularly with respect to return volatility. The extreme volatility in the equities market is viewed even more clearly when the daily movements are broken down. For the NASDAQ Composite, 79 percent of all trading days through June 30 recorded a price movement greater than 1 percent (positive or negative). This compares to only 9 percent of all trading days for the REIT market. At the extreme end, NASDAQ share prices moved more than 3 percent on roughly one-third of all trading days while the REIT market recorded no extreme movement days.

Recent Developments Under greater pressure than ever to create value for investors, the leading REITs are pursuing several new initiatives. In particular, companies are seeking opportunities in conjunction with one or more of the megatrends that widely are accepted as reshaping the world: securitization, technological innovation, globalization, and rapidly changing demographics. These efforts include new ways to access previously untapped capital markets and efforts to grow earnings by providing services previously not provided by property owners and operators.

Recently, a leading group of REITs banded together to form a technology-oriented consortium known as Project Constellation to fund and incubate real estate-related technology companies and service providers. The founding investors - AMB Property Corp., Equity Office Properties Trust, Equity Residential Properties, Kaufman and Broad, Simon Property Group, Spieker Properties, CB Richard Ellis, Jones Lang LaSalle, Morgan Stanley Dean Witter, Chase H&Q Capital Partners, and Trammell Crow Co. - have committed $135 million to the project. At present, this initiative is largely symbolic, because the operational specifics have yet to be worked out, but the very fact that major companies are coming together to try something new is an encouraging sign.

Finally, on a somewhat ironic note, amid a rallying REIT market, Bradley Real Estate, the nation's first REIT, has agreed to sell itself to a private REIT, Heritage Property Investment Trust. Bradley agreed to a price of $22 per share, nearly a 20 percent premium over its current price and a value that roughly is in line with consensus estimates of the company's net asset value. Despite the extreme problems in the REIT sector during 1998 and 1999, only five leveraged buyouts of REITs have occurred over the past two years. In addition to structural, anti-takeover impediments, net asset value now has been firmly established as the minimum price most boards and shareholders will accept. This only increases the need to monitor developments in private asset market pricing going forward.

The Outlook As noted previously, the near-term prospects for the nation's property markets look less positive than they have during the past several years. However, this does not mean that the prospects for REITs and other publicly traded real estate operating companies are grim. Long term, REITs should deliver returns of about 10 percent to 12 percent per year.

The public market is by definition a forward-looking opinion of value. Over the past two years, investors have collectively driven down the prices of REITs to reflect their belief in slower future earnings growth. The current rebound in REIT share prices suggests that the public market perhaps has overcompensated for weakening fundamentals.

Private real estate, by definition, trades at net asset value. The private market has not yet fully integrated weakening fundamentals into its pricing. REITs, as operating companies, trade above and below asset value as the prospects for external growth beyond that of the existing portfolio are diminished or enhanced. Today, even after the rally in REIT shares, the typical REIT still is trading at a discount of 10 percent or more to its underlying asset value. This certainly is an improvement over the nearly 20 percent discount recorded at the beginning of the year, and it does leave room for some future, albeit reduced, upward price movement. The limiting factor on future share price appreciation largely will reflect the extent to which asset prices in the private market decline as private market investors begin to fully incorporate less optimistic projections for net operating income growth into their projections.

As this occurs, it will be illuminating to watch the behavior of REIT management as their share prices approach previous peaks and private market asset prices soften. Will REITs retain the discipline that was forced on them over the past two years and pursue prudent growth through the existing portfolio and economically defensible acquisition and development programs? Or will they revert to the baser instincts that led them and their Wall Street bankers down the road to near irrelevancy? The course each pursues will say much about which companies will lead the industry into the next phase of real estate securitization.

Michael J. Acton

Michael J. Acton, is a vice president with AEW Research, the in-house research team of AEW Capital Management in Boston. Contact him at (617) 261-9577 or macton@aew.com.

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