Strategies for Investing in Real Estate Investment Trusts (REITs)

By Scherrer, Phillip S.; Mathison, Timothy J. | Business Credit, November-December 1995 | Go to article overview

Strategies for Investing in Real Estate Investment Trusts (REITs)


Scherrer, Phillip S., Mathison, Timothy J., Business Credit


Investing in high yielding Real Estate Investment Trusts (REITs) became very popular in the early 1990s when returns on money markets and cash equivalent investments plummeted to three percent and the economy wallowed in a recession. Investors were hungry for yields and REITs offered attractive returns at a time when investors were sitting with low yielding investments in money markets and cash equivalents. In addition to their attractive yields, REITs offered liquidity through public trading, a hedge against inflation since they were tied to real estate, favorable tax treatment, and portfolio diversification. REITs were able to maintain their dividend streams through their capital rate arbitrages which were generated by their ability to raise capital on Wall Street at a cost which was several percentage points less than the capital rates generated from the properties they owned. In other words, the spread between Wall Street and Main Street was positive for the REITs. This positive spread was so substantial (5 percent in some cases) that even inefficient REITs prospered and paid attractive dividends.

Individual investors poured money into REIT's offerings and the capitalization of the REITs' market grew from $12 billion in 1991 to $64 billion by the end of 1994. Investment banks and money management firms created REITs mutual funds and designed portfolios of REITs stocks for their clients. REITs provided total returns that approached 10 percent which came from dividends of 5 percent to 7.5 percent and equity appreciation of 2.5 percent to 5 percent. Individual and institutional investors assembled portfolios of REITs to take advantage of the above average yields. The dividends and equity appreciation were coupled with the aggressive growth plans of the now cash rich REITs.

The REITs of the 1990s are quite different than their predecessor from the 1960s and 1970s. The new REITs are equity based with limited debt and provide a continual dividend stream and the potential for equity appreciation. Since the economy has improved and other forms of investments have rebounded, the flurry of REIT's initial public offerings (IPOs) has subsided and the REITs market is set for consolidation through mergers and acquisitions.

The improved economy has increased the returns on money markets and cash equivalents. Money is being moved from mutual funds and REITs back into money markets and cash equivalents. This shift of money is causing consolidation in the REITs market as the cost of capital for REITs increases. The increased cost of capital reduces the capital rate arbitrage REITs have relied on to produce their attractive yields. The capital rate arbitrage that REITs monopolized has atrophied. Only the more efficient REITs will be able to survive and pay their promised yields. REITs that desire to grow will have to offer additional securities, either debt or equity, to raise capital for acquisitions. As the cost of capital increases, the less efficient REITs will not be able to continue their capital rate arbitrage, their cost of funds will increase, their stock will be discounted, and they will be become merger and acquisition targets.

REITs can still be an excellent investment capable of providing above average returns and equity appreciation. Investing in REITs in the early 1990s was fairly simple since it was based on unidimensional modeling which only analyzed the financial structure of a REIT The investment decision making criteria analyzed the capital rate arbitrage and the ability of the REIT to pay its promised dividend. Now, successful investing in REITs requires more sophistication since the capital rate arbitrage has been minimized. REITs must be analyzed on multiple constructs: financial, management, real estate value, strategy, space market and cap rate.

The investor must be cognizant of the underlying fundamentals of REITs analyses in order to select a REITs' portfolio which matches the investment criterion. …

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