Magazine article Mortgage Banking

Where REITs Gather

Magazine article Mortgage Banking

Where REITs Gather

Article excerpt

A look at where REITs have concentrated their investments reveals some interesting findings. The apartment sector has the greatest percentage ownership by REITs. What does REIT market concentration mean for other players in the commercial real estate markets?

How much of the Dallas office market is in publicly traded hands? Can one get exposure to the Milwaukee warehouse market through the public markets? Where are the REITs (real estate investment trusts) concentrating new investment opportunities?

Investors in equity real estate, via either the public or the private markets, must be knowledgeable about both the concentration of REIT investments and the flow of REIT capital. This knowledge is needed to make intelligent choices about how to participate in a particular market cycle and how to develop sharp strategies for creating and disposing of private equity in the context of a very active REIT market. With the recent increased securitization of real estate, greater (but not yet great) information is available to investors.

Of the four quadrants of real estate investing (public equity, private equity, public debt and private debt), public equity is the smallest. Today, the total market capitalization of the quadrant is roughly half the size of public debt, the next smallest.

Private investment continues to dominate all equity investment in real estate. However, the rate of growth of public real estate equity capital during the past five years has been tremendous, capturing much of the attention of today's real estate investors.

Recent REIT expansion has been ad hoc and grown at an unsustainable rate. The sector has grown for growth's sake, with little thought given to real estate cycles or the diversity of the portfolio.

As an emerging investment market in a mature industry, REITs provide an opportunity for intelligent investors to make informed decisions and make a significant amount of money. This was done fairly easily from 1995 to 1997, with tremendous industrywide annual returns. However, thus far in 1998, REIT performance has been disappointing to those who have come to expect 20 percent total returns. Is it possible that the underlying real estate performance now matters to investors in public real estate?

This article will demonstrate where the REITs have focused their marginal investment dollars during the past five years. It will also review the markets in which REITs had an early impact in order to more completely understand the implications of the growth of REIT ownership in individual markets.

While it is important to note trends in real estate cycles at the national level, it is becoming increasingly apparent to the investment community that individual markets perform very differently from one another. For these reasons, we will study trends in REIT investment at both the national and local levels.

Methodology and calculation of exposures

The REIT research done at Property & Portfolio Research (PPR) concentrates on the real estate markets in which REIT properties are located and on the fundamentals and performance of those markets. We forecast individual REITs' performance based on the theory that markets (and the combination of markets) matter. By first estimating each REIT's exposure to individual markets and property types and then applying our forecasts for each market, we discern if a REIT is fighting an uphill battle to increase funds from operations (FFO), or if the public market should be rewarding growth that results from being in the right place and combination of places at the right time.

PPR uses its proprietary historical and forecast time series of market performance, which are driven by the interaction among supply, demand and the influence of capital markets. We model net operating income and capital value separately, so we are able to estimate the value of real estate in each of 60 cities and four property types over time and into the forecast period.

The other data required to examine the REIT's degree of penetration in a market is that pertaining to individual REIT portfolios, including the date of acquisition, date of disposition, location, square footage, percentage of ownership and type of each property. This data is based on that gathered by SNL Securities and published in its REIT Datasource product. Combining our time series of property exposures to individual cities and property types with that of capital values and the market capitalization numbers noted earlier, we can create a time-series of REIT exposures to each city and each property type.

While the absolute numbers showing how much of each major market is owned by REITs are interesting, the relative allocation of capital is even more informative. Rank ordering the markets in terms of where REITs are provides a significant amount of information about the flow of capital since 1993.

The national level - Trends to watch for

Since 1993, a massive wave of real estate investments has been converted from private to public ownership. Figure 1 shows REIT ownership as a percentage of total market capitalization of the 60 major metropolitan areas for each of the four property types since 1993.

The apartment sector has seen the greatest percentage of property converted to public ownership, growing from a 3.3 [TABULAR DATA FOR FIGURE 3 OMITTED] percent share at the end of 1993 to 11.1 percent by the end of 1997. The retail sector, which in 1993 had the greatest percentage of property in REIT hands, has grown comparatively slowly because of reduced acquisitions and generally declining values, from 4.6 percent to 8.7 percent. (This situation may be reversed in 1998 with several major portfolio acquisitions such as Simon DeBartolo's purchase of Corporate Property Investors (CPI).) The warehouse sector has increased dramatically, from a mere 2.0 percent share to 9.3 percent. Finally, the wave of office REIT initial public offerings (IPOs) during the past two years, as well as the "nationalization" or "super regionalization" of those office REITs via acquisitions, has increased the amount of office space held publicly from 1.t percent to 7.9 percent of the total in the 60 major markets.

The timing of these acquisitions by property type on an aggregate level demonstrates some interesting and disturbing trends. The apartment and office sectors provide two opposite and extreme examples of REIT acquisitions and market timing, as shown in Figure 2. Each chart plots the quarterly annualized change in the increase in REIT ownership of the aggregate market vs. the total return a private equity investor would have received.

The apartment REITs, on an aggregate level, appear to be making the most optimal timing decisions, represented by the fact that when returns are low (and, therefore, pricing is less aggressive) they have increased the pace of investment. The retail and warehouse REITs also appear to grow the most when markets are soft. Overall, it appears there may be evidence that REITs are skilled at buying low (the ancillary, selling high, has yet to be seen).

On the other hand, the wave of office properties entering the REIT format has increased concomitantly with the increase in returns, further evidence that supports the plethora of anecdotes about office companies paying higher prices. The office sector is clearly the most volatile of the four sectors we track in terms of total returns and values. If an investor is capable of timing the market, high-risk assets can best be taken advantage of using a trading strategy. However, the legal structure and financial constraints of the REIT format make this more difficult. The worst possible thing to do is to load up an office portfolio with property at the peak of the cycle, exactly the cliff that office REITs are headed toward. While the near-term fundamentals in the office market suggest a few more years before development completely overwhelms demand, clearly office REITs now look to be a recipe for disaster not too far down the road.

The local level - Where the rubber meets the road

Differentiation becomes more apparent and the analysis is even more profound at the individual market level, especially to those who believe that investment capital is a significant driver in real estate cycles. The 10 markets with the largest percentage of REIT ownership by property type as of year end 1997 are shown in Figure 3.

Among the cities for apartment investment, it is not surprising that each of the top 10 are in the rapidly growing Southeast or Texas. There has been a heavy concentration of apartment REITs in this region since the beginning of the cycle. Since the recession of the early 1990s, each of these metropolitan areas has experienced outstanding employment growth and strong net in-migration - two of the key ingredients that apartment investors rely on.

While the office sector has provided a stark contrast, with total REIT ownership significantly lower and recent growth rates of acquisition much higher, the list of markets where REITs are the most prevalent is again dominated by the Southeast. Somewhat surprisingly, Philadelphia and Bergen-Passaic, New Jersey, make the list, reflecting the strength of a handful of "super-regional" companies in the area and their appetite for suburban office space.

The retail sector is second only to apartments in terms of the number of cities with greater than 10 percent REIT ownership, with 18 cities surpassing that benchmark. More [TABULAR DATA FOR FIGURE 4 OMITTED] geographically spread out, retail demonstrates a much less discernible regional trend. In addition, a relationship with a national retailer is more beneficial to an owner of retail properties in multiple metropolitan areas.

Finally, in the warehouse sector, in which there are relatively fewer REITs, the markets that make the list generally fall into two categories: major national distribution hubs where the REITs have a huge development capability; and smaller subregional hubs where the REITs can dominate the market.

For each of the sectors, the 10 markets with the lowest percentage of REIT ownership are shown in Figure 4-Across the board, the cities tend to fall into three groups: markets with large market capitalizations, those markets traditionally dominated by non-REIT investors and underdemanded markets.

In the very large markets, such as Los Angeles apartment and Denver retail, it would take an enormous amount of absolute dollar investment to generate a marginal increase in the percentage of ownership. Others, such as the Boston apartment and the Kansas City office markets, have been traditionally dominated by other types of real estate investors.

Most of the markets in Figure 4, however, fall into the last category - the underdemanded. The Hartfords, Honolulus and Milwaukees of the world continue to suffer on the demand side of the equation, even as the rest of the nation experiences a tremendous demand for real estate. Occupancy rates have not moved much in these markets (and in many cases have moved in the wrong direction), and rent levels have not provided the story that is necessary to attract REIT capital. When faced with daily pricing in the public markets, REITs are forced to grow FFO as fast as possible and, therefore, refuse to dilute any of today's growth with acquisitions in markets that will detract from current income.

Interestingly, at year-end 1993, the REIT universe had no exposure in 25 markets. Today, there are only eight: Albuquerque warehouse, Hartford warehouse, Honolulu apartment, Honolulu office, Honolulu warehouse, Milwaukee apartment, Newark apartment and New Haven-Stamford office. Only in the retail property type can an investor get some exposure to all 60 major metro areas.

While the apartment sector is often considered to be the most mature in terms of the public markets because of the number of companies that went public in the 1993-1994 period and also because of recent mergers, three major markets still have no REIT investment. Most of the eight markets with no REIT investment are not large markets but that certainly does not mean good investment opportunities are lacking there. Nor does it mean that an investment in one of these markets may not be beneficial to a REIT. The addition of a countercyclical investment, one that is not highly correlated with those already in the current portfolio, can be very helpful in managing (smoothing) cash flow over time. This will become more important and more apparent to REITs as we enter the later stages of the cycle.

This analysis concentrates only on those portions of REIT portfolios within the 60 major metropolitan areas. Data on the market conditions within each of these cities and property types is available. While real estate investors have historically lacked the information required to make educated bets, a fact which remains true in many smaller metropolitan areas, data on the market conditions within each of these larger cities and major property types is widely available.

Therefore, investors can make educated decisions regarding the real estate fundamentals and expected performance of those investments. However, hundreds of properties in smaller MSAs (metropolitan statistical areas), and many that do not even lie in a defined metropolitan area, also exist in the REIT universe.

In addition, many REITs traditionally focus on "non core" property types such as hotels, self-storage, golf courses and increasingly even more unusual types of properties. These investments clearly add to the "accidental" collection of assets that happens to be publicly traded and likely overrepresent those asset classes.

Taking one of the most extreme examples, REIT investors who are underweighted in hotels may only be underweighted when compared with a REIT index, but could be severely overweighted when compared with the true universe of investable real estate. Tracking the REIT index is not at all the same as tracking the true real estate investment universe.

Why these markets?

The above data begs the question, Why are these particular markets the ones that have attracted heavy REIT investment? What are REITs looking for? The answer is clearly that these companies are publicly traded and must meet today's earnings expectations. Earnings are driven by rapid growth in occupancies and rent levels. These, in turn, are driven by demand relative to supply.

A wave of apartment REITs went public in 1993 and 1994, at a time when nationwide a tremendous amount of new demand occurred. As a result, continued acquisitions at reasonable capitalization rates were accretive to FFO and thus spurred a tremendous amount of REIT investment, especially in faster-growing cities. Figure 5 illustrates those markets where the increase in percentage ownership by REITs since 1993 has been the greatest. In general, the list again comprises those markets with robust demand for apartments.

However, real estate is still a cyclical business, and strong demand begets a response in construction. New supply generally overresponds to the signal, and, the cycle ensues.

In addition to the overall growth, the historical standard deviation of each market's returns to the market has been calculated and ranked by property type. Note that most of the markets in Figure 5 rank very poorly in terms of risk (lower ranks are better). Especially in the office and apartment sectors, there is a concentration on more volatile markets.

As we saw in 1997, when it became apparent to everyone that Atlanta was overbuilding, the public market began looking only at the supply side of the equation and responded by beating down the stock prices of those companies that were heavily concentrated in the market. Markets that experience strong waves of demand, such as Atlanta and Dallas, tend to overreact by generating the most new construction, and as a result they are more likely to have greater volatility in performance.

Wall Street has given REITs a mandate to grow, and apparently not much instruction on what else will be rewarded. This has two major implications for REITs and their choice of markets.

First, with a significant amount of capital to allocate, REIT investment tends to be in those markets with the greatest liquidity. Liquidity is minimal at the cyclical trough when assets are cheapest. While pricing is very favorable to new investments, the real estate fundamentals are poor, investors are nervous, and the flow of investment capital is frozen. Liquidity also is poor at the top of the cycle when performance is the most robust. Investors are pleased with the high returns they have been receiving, tend to discount the cyclicality and oncoming downturn of real estate, and continue to hang on to assets that should be sold. The greatest amount of trading tends to occur on the way up the cycle - as a result, most of the cities with the largest percentage of REIT investment are those that are well into the recovery phase.

Second, once the cyclical peak is approached, and pricing becomes too expensive to continue to make acquisitions that are accretive to FFO, REITs are forced to take on extra risk. This risk can come in the form of opportunistic investments or in the form of increased development. Risk is a double-edged sword, and while it can be a powerful tool when used at the right point in a cycle, excess risk taken on at or near the peak is more likely to be harmful.


Implications for investors

Both public and private equity investors can benefit from the knowledge of market cycles and asset allocation when setting investment strategy. Regardless of the form in which real estate is held, or how often it is priced, the long-term driver of performance will be the underlying property and the market in which it is located. REITs provide investors access to (slightly) more liquid assets, daily pricing and the benefits of portfolio effects. However, as we have demonstrated, the REIT universe is clearly not even a close proxy for an index of the U.S. real estate market.

Because of their need to meet expectations today, REITs have less flexibility when it comes to managing tomorrow's portfolio. This does not suggest that they should ignore the cycles of the markets they are invested in but rather that they need to pay extra attention to those markets and their respective cycles. In particular, they need to pay attention to the interaction of those cycles so that when one market suffers from overbuilding, other exposures in the portfolio are in the "sweet spot."

This means two very important things to REIT investors. At this point it is probably not possible to hold "core" real estate in the public form. As shown earlier, the REIT universe is heavily overweighted in a number of markets, and there are a number where it is heavily underweighted. Also, the public markets have excess risk in terms of the markets in which REITs happen to be invested and of the sectors that are represented. Recall from Figure 5 that there is an excess exposure in the REIT universe to markets that have historically experienced overbuilding and to property types that have more extreme cyclical highs and lows. This excess risk is above and beyond the extra volatility associated with daily pricing and the overall impact of the stock market.

Investors in private equity, who continually run up against REITs in attempting to acquire property, should think about several factors, depending on their investment strategy. First, in terms of acquisition/disposition strategies, excess capital is flowing into a number of cities, probably pushing cap rates lower than would be suggested by fundamentals. Concentrate acquisition on those markets where supply relative to demand is in check and the REITs are underweighted, and focus disposition in those markets where demand is strong and the REITs are increasing their exposures.

Second, for a development strategy, those markets where REITs are ramping up their exposures appear to be excellent target markets. Finally, when considering swapping properties for REIT shares, an investor must consider where the company's portfolio is concentrated, the risk of the portfolio and what the additional properties will contribute in the context of the overall portfolio.

REIT investments and capital continue to play an increasing role in the real estate market. As an emerging market in an old industry, educated investors will continue to be able to take advantage of arbitrage between the public and private markets through a better understanding of the REIT universe.

Bret Wilkerson is the director of REIT research at Property & Portfolio Research in Boston.

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