history And Mythology P A R T C H A P T E R REITs: MYSTERIES AND MYTHS S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 T here’s no question about it: In spite of their growing acceptance, there have been lingering mysteries and myths that REITs haven’t been able to shake off. This chapter addresses these misconceptions and lays the fading myths to rest once and for all. C H A N G I N G A T T I T U D E S T O W A R D R E I T S For many years, REITs were regarded as odd and uninteresting investments. Even their unusual name—REIT—implied that the standard criteria applicable to most investments didn’t apply to them. Bruce Andrews, the former CEO of Nationwide Health Properties, noted that the term trust, as in real estate investment trust, implies that REITs are oddities, that they are not like normal corporations whose shares are traded on the stock exchanges. One of the main reasons that REIT stocks were suspect for so long is that many people who traditionally invested in real estate didn’t really understand—or trust—the stock market, while most people who invested in the stock market were uncomfortable with, or had little understanding of, real estate. REITs just didn’t fit into either category and therefore fell between the cracks. All this has finally changed. In October 2001, Standard & Poor’s admitted the largest REIT, Equity Office Properties, with an equity market cap at that time of $12 billion, into the S&P 500 index. Equity Residential Properties Trust, the largest apartment REIT, was admitted soon thereafter, and at the end of 2004, there were seven REITs in the S&P 500. At the end of 2000, when the equity market cap of all REITs was $139 billion, many REIT observers believed that, within ten years, REITs’ total market cap would reach $500 billion. Well, at the end of 2004, that figure had already exceeded $300 billion. Of course, the growth in the REIT industry will wax and wane from time to time. And there are lots of good reasons why many investors might want to own real estate directly, not via an invest - ment in a REIT. Nevertheless, the advantages of ownership through a REIT are very substantial, and the size of the REIT industry will continue to grow with increased investment by both individuals and institutions who appreciate REITs’ liquidity, substantial informa - 92 I N V E S T I N G I N R E I T S 93 R E I T S : M Y S T E R I E S A N D M Y T H S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 tion disclosure, and opportunity for wider diversification among property types and geographical locations. And, it seems, public scrutiny of some of the largest commercial property owners in the U.S., the REITs, may be causing real estate to become less cyclical and thus more valuable. Weakness in most real estate markets and property sectors from 2001 through 2004 resulted from a major slackening in demand due, in large part, to a national recession, a subsequent boom in single-family residences, and severe cutbacks of capital spending by businesses, not the overbuilding that’s been the main culprit in prior real estate cycles. Perhaps operating in a fishbowl, as public REITs do, imposes substantial development dis - cipline, which even carries over to the private markets. THE B IAS OF TRADI TIONAL R EAL E STATE IN VESTORS Traditionally, most real estate investors have chosen to put their money directly into property—apartment complexes, shopping centers, malls, office buildings, or industrial properties—and not in real estate securities like REITs. In other words, bricks and mortar, not stock certificates. Direct ownership historically has provided the opportunity to use substantial leverage, since lenders have tradi - tionally been willing to lend 60–80 percent of the purchase price of a building. Leverage is a wonderful thing—when prices and rents are going up. Since the Great Depression, real estate values pursued a profit - able upward bias, notwithstanding a few potholes along the way. Appreciation of 10 percent on a building bought with 25 percent cash down would generate 40 percent in capital gains. In addition, owning a building directly provided the investor with a tax shelter, via depreciation expenses, for other operating income. As a result, real estate continued to appreciate and provide easy profits, and most real estate investors tended to focus on what they knew— direct ownership. Many individual real estate investors harbored a distrust for public markets (REITs included), which they saw as roulette tables where investors put themselves at the mercy of faceless managers— or worse, speculators and day traders whose income depended on volatility. These investors saw REITs as highly speculative and wouldn’t touch them. 94 I N V E S T I N G I N R E I T S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 Then, of course, there was institutional investment in real estate. Originally, institutional and pension funds earmarked for real estate were invested in properties either directly (where their own property managers and investment managers were retained), or through “commingled funds” in which big insurance companies and others used funds provided by various institutional investors to buy portfolios of properties. Who managed these properties, supervised their performance, and answered for their results? The same sort of real estate investors who, of course, didn’t trust the stock market—or, if they had no such qualms about equities, didn’t believe that the performance of REIT shares would match that of direct real estate investments. Furthermore, since REITs are traded as common stocks, the result was—catch-22—that a decision to invest in REITs could be made only by the “equities investment officer” rather than the “real estate investment officer” of the institution or pension fund. The institutions’ common stock investment funds were placed and monitored elsewhere. Furthermore, various investment guidelines often precluded the equities investment officers from investing in REITs—even if they knew about them and wanted to pursue this sector of the market. And why should they bother? After all, REITs have always been a very small sector of the equities market and were not included in the S&P 500 index until 2001. A further discouragement has been volatility. Real estate inves - tors have complained that REITs, even though traditionally less volatile than the broader stock market, nevertheless do fluctuate in price. However, to be fair, any asset fluctuates in price. With illiquid assets that were held, not traded (and by relying upon occasional appraisals), the private-fund managers could maintain the illusion that the values of their assets were “steady as a rock,” despite the continuous ebb and flow of the real estate capital markets. Every asset fluctuates in value, but owners are sometimes unaware of these changing valuations until they try to sell the asset. Finally, institutions buy and sell stocks in large blocks, and it’s been only recently that REIT shares have had sufficient liquidity to attract institutional investors. In fact, one of the most oft-quoted reasons why pension funds have been reluctant to invest in REITs is their lack of liquidity. The REIT market was so thinly traded prior 95 R E I T S : M Y S T E R I E S A N D M Y T H S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 to 1993–94, when the size of the REIT market began to expand geometrically, that it would have been extremely difficult for an institution to accumulate even a modest position without disrupting the market for any particular REIT stock. THE B IAS OF COMMO N STO CK INVES TORS What discouraged common stock investors from buying REITs? The flip side of the coin is that REITs’ only business is real estate and stock investors didn’t invest in real estate; they focused primarily on product or service companies. Real estate was perceived as a dif - ferent asset class from common stock; this problem was particularly acute in the institutional world. REITs have also been perceived as real estate mutual funds, and not as active businesses—a perception precluding REITs from being admitted to the S&P 500 until 2001. An IRS ruling at that time confirmed that REITs are active businesses, but old percep - tions die hard. In addition, the public perception—wrong as it was—was that REITs were high-risk but low-return investments. There were many investors who had bought construction-lending REITs and real estate limited partnerships in the 1970s and 1980s and gotten badly burned. These investors did not take the trouble to distinguish between these ill-fated investments and well-managed equity REITs. Also, for years investors had been told that companies that paid out a high percentage of their income in dividends did not retain much of their earnings and therefore could not grow rapidly. Since, to most common stock investors, growth is the hallmark of success - ful investing, they didn’t want to invest in a company that couldn’t grow. Finally, some of the blame for lack of individual investors’ interest in REITs can be laid at the feet of stockbrokers. REITs for a long time were perceived as stocks by real estate investors, and as real estate by stock investors. Until about fifteen years ago, most major brokerage firms did not even employ a REIT analyst. And, since individual investors generally bought individual stocks only when their brokers recom - mended them, the REIT story fell on deaf ears. Mutual funds have 96 I N V E S T I N G I N R E I T S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 been popular for many years, but only a handful of mutual funds were devoted to REIT investments—and those did not advertise widely. Many of those investors who did their own research and made their own investment decisions quite likely felt that REITs were too much of an unknown territory for them to venture into. Even income investors, for whom REITs would have been particu - larly suitable, invested primarily in bonds, electric utilities, and convertible preferred stocks. REITs, of course, given their favorable investment characteris - tics, were bound to be noticed sooner or later. They are gradually but inexorably becoming well known to real estate and common stock investors alike, and REITs’ long period of being neglected is now ancient history. Interest in REIT stocks will ebb and flow with changes in investor fads and preferences, but they are now firmly recognized as strong and stable investments that help to diversify a broad-based investment portfolio. T H E M Y T H S A B O U T R E I T S In addition to—and sometimes because of—the other obstacles REITs have had to overcome, some myths exist, myths that in the past scared off all but the bravest investors. Although these myths were based on misunderstandings of the investment characteristics of REITs, they discouraged many would-be investors. Let’s confront them, one by one. M Y T H 1 REI TS ARE PACKAG ES OF RE AL PR OPERTIE S This myth, which probably sprang from investors’ experience with the ill-fated real estate partnerships of the late 1980s, may be the single most significant reason for REITs’ failure in the past to attract a substantial investor following. Although at one time REITs may have been only collections of properties, or “real estate mutual funds,” they are much more than that today. REITs are more than just portfolios of real properties. Organizations that merely own and passively manage a basket of properties—whether they be limited partnerships, trusts, or 97 R E I T S : M Y S T E R I E S A N D M Y T H S S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0 even corporations—must contend with several specific investment concerns. Management is generally not entrepreneurial and thus is often unresponsive to small problems that can, if left unattend - ed, develop into big problems. Also, management does not usu - ally have its compensation linked to the success of the properties and therefore has no particular incentive to be innovative despite today’s competitive environment. Often, there is no long-term vision or strategy for creating value for the investors. Finally, inef - ficient management rarely has access to attractively priced capi - tal, making it difficult for the entity to take advantage of “buyers’ markets” or attractive purchase or development opportunities. An investment in such a passive company, although perhaps provid - ing an attractive dividend yield, offers little opportunity for growth or expansion beyond the value of the original portfolio. Conversely, a large number of today’s REITs are vibrant, dynamic real estate organizations first, and “investment trusts” second. They are far more than collections of properties. Their management is savvy and highly motivated by their own ownership stake and other equity incentives. They plan intelligently for expansion either in areas they know well or in areas where they believe they can become dominant players, and they frequently have access to the capital nec - essary for such expansion. They attempt to strengthen their rela - tionship with their tenants by offering innovative and cost-efficient services. To categorize highly successful real estate companies, such as AMB Property, Alexandria, Archstone-Smith, Avalon Bay, Boston Properties, the “Equities,” General Growth, Kimco, Home, Macerich, Reckson, SL Green, Simon, Taubman, Vornado, or Weingarten, to cite just a few examples, as just collections of properties, or “mutual funds of real estate,” is to underestimate them seriously. Yet this myth still persists, even among some institutional investors. M Y T H 2 REA L EST ATE IS A HIGH- RISK INVESTM ENT It’s amazing how many people believe that real estate (other than one’s own home, of course) is a high-risk investment through which investors can be wiped out by tenant defaults or declines in prop - erty values. And, they surmise that if real estate investing is risky, then REIT investing also must be risky. Let’s analyze risk here. [...]... BOOM The REIT industry was revolutionized by a tremendous boom in 6.5 REIT initial public offerings (IPOs) that began in 19 93 That year, according to NAREIT, 100 REIT equity offerings were completed, raising $ 13. 2 billion, including $9 .3 billion by fifty new REITs and $3. 9 billion by fifty existing REITs An additional $11.1 billion was raised in 1994, including forty-five new REIT IPOs raising $7.2 billion... market in REIT shares First, lots of “hot money” was invested in REITs in 1996–97 by non– real estate and non-REIT investors, riding the wave of REITs new popularity as they did in 19 93 “Momentum investing has been a popular investment strategy since the latter part of the 1990s, and REIT shares certainly had lots of momentum in 1996 and well into 1997 Near the end of 1997, when it appeared that the party... willing to pay a higher multiple for every dollar of operating income if they perceive that accelerating inflation will lead to higher rents The counterargument is that cap rates may indeed be influenced by inflation, but in reverse Higher inflation will often drive up interest rates, which in turn will increase the “hurdle rate of return” demanded by investors in a property, and have the effect of increasing... increasing the required cap rate and thus decreasing the price at which the property can be sold Conversely, property values may rise even with no inflation whatever, as interest rates decline in a zero-inflation environment Property values certainly increased in 20 03 04 when interest rates and inflation were at very low levels Consider the following example: If the demand for apartment units in San... owning real estate By the late 1980s, real estate was in big trouble During the 1980s, when investors were seeking the tax shelters offered by limited partnerships, real estate prices inflated to unsustainable levels As early as 1985, year-to-year growth rates in FFO for most REITs were peaking and beginning to decline By the second half of the 1980s, the growth rate for the representative group of REITs. .. offerings by existing REITs raising $3. 9 billion The offerings in 19 93 alone surpassed the total amount of equity that REITs had raised during the previous thirteen years, according to Merrill Lynch’s August 1994 report, Sizing Up the Equity REIT Industry At the end of 1990, the estimated market capitalization of all publicly traded equity REITs was $5.6 billion By the end of 1994, it exceeded $38 .8... not be until 19 93 that a large number of new, high-quality REITs would become available to investors 1991– 93: THE BULL RETURNS A combination of factors caused equity REITs to do exceedingly well from 1991 through 19 93 According to NAREIT data, total annual returns for 1991– 93 averaged 23. 3 percent This outstanding performance was ample reward for the patient investors who had stuck with REITs through... conflicts of interest The REITs portfolios were miniscule, ranging from $11 million for Washington REIT (one of the few survivors) to the $44 million REIT of America Industry-wide real estate investments were very small at the beginning, amounting to just over $200 million (For comparison, by late 2004, REITs owned real estate assets of approximately $ 535 billion.) These early REITs were small in size,... of 19 93, it had fallen to 3. 1 percent High-yielding REITs presented an irresistible lure to investors Since REIT shares were providing such high yields, investors renewed their romance with REITs during this period Indeed, they were seen as an antidote to the puny short-term yields available on CDs and T-bills These investors may not have known much about REITs, but that didn’t stop them from buying... evidenced by the Consumer Price Index (CPI), increasing 6 .3 percent in 19 73, 11 percent in 1974, 9.1 percent in 1975, and 11 .3 percent by 1979 Not content with such external hardships, the REIT industry was busy creating problems of its own Between 1968 and 1970, with the willing assistance of many investment bankers, the industry produced fifty-eight new mortgage REITs Most of these used a 112 I N V E S . inflation whatever, as interest rates decline in a zero-inflation environment. Property values certainly increased in 20 03 04 when interest rates and inflation. operat - ing income growth in line with inflation, REITs should remain very solid investments—competitive with other asset classes. Furthermore, many REITS