REIT market likely to slow down in 1994.
"There" for developers, in particular, would include: new sources of investment capital; sufficient cash to finish and stabilize projects, regardless of short-term dips in the real estate market or overall economy; and a way to renegotiate or refinance mortgages during the entire life cycle of a project.
In this context, Real Estate Investment Trusts (REITs) - a child of the Eisenhower years showing some new wrinkles in early middle age - have gained renewed popularity, both with yield-hungry investors and debt-ridden developers.
Since Congress authorized REITs in 1960, three forms have emerged: equity, mortgage and hybrid. Among the ground rules that permit REITs to "pass through" income to individual investors without paying corporate income tax: Management by a board of directors or trustees. A minimum of 100 shareholders. No more than 50 percent of shares may be held by five or fewer individuals during the last half of each taxable year.
At least 75 percent of total assets must be in real estate, with at least 75 percent of gross income derived from rents or mortgage interest on real property. Dividends must be at least 95 percent of REIT taxable income.
Currently, equity REITs are the darlings of Wall Street. They have been buoyed by cash flow from the ownership and management of "quality" properties plus the potential for appreciation should real estate values rebound significantly.
This is far different from the 60s and early 70s when REITs were borrowing as well as investing, creating over-leveraged balance sheets of their own. Real estate went bust, trusts slashed dividends, and share prices - and favor - fell. REIT totals plunged from a mid-70s peak of nearly $25 billion to less than $7 billion from about 1977 through 1983.
By 1987 - helped no doubt by the Tax Reform Act of 1986's end to real estate limited partnerships as an alternative finance raising vehicle - REIT assets had rebounded to more than $23 billion. Today, there are more than 200 REITs operating in the United States, with total assets of nearly $50 billion. An early headline grabber in the current boom was the Taubman Centers, Inc. REIT, formed by Michigan's Taubman family. Two new SEC filings by Southeast Michigan-based manufactured-housing developers were recently reported and more are on the way.
Why are REITs once again so appealing to investors? There are several factors, led by the sustained low interest rates and corporate returns that send institutional investors, including pension funds, scurrying for higher yields.
* Yield: While yields in general on corporate securities and bonds are down, REIT returns have been attractive. According to the National Association of Real Estate Investment Trusts (NAREIT), dividends in 1992 averaged 7.88 percent. Count out some poor-performing REITS based on hospitals and other health care properties, and annual yields have approached 20 percent.
* Liquidity: REITs are a form of real estate securitization that can be traded like a stock. The New York and American stock exchanges feature over 60 issues each, with a healthy number also listed on NASDAQ. Pension funds can also get around statutory restrictions on direct investment in real estate.
* Efficient pricing: Because REITS trade on a daily basis, their value can be determined on a daily basis. Compare this to traditional, heavily-subjective real estate appraisals and valuations. This feature appeals to institutional investors and especially their advisers, since compensation is directly tied to performance.
* Corporate governance and professional management: Two more features that appeal to institutional investors. Expect this area to become more contested, however, as more and more "family-base" developers look to REITs for financial help - not to relinquish control of projects.
* Diversification: As a pool of real estate properties, REITs have many of the popular attractions of mutual funds. There is also a "REIT for each season." Investors can zero in on most any market or type of real estate property - from apartment complexes in the South or California to shopping malls or hospitals.
What could put a damper on the REIT picture? Several things. Higher short-term interest rates, with investor dollars fleeing out of REITs. Pension funds balking at the 5 investor-50 percent rule. New issues that go sour, especially as the quality properties have been "cherry-picked." Rebellion on the part of developers, once used to ruling their roost, now subject to corporate boards, shareholders votes, audits and the like.
Nationally, there is a general feeling that the best properties, those fundamentally sound, quality projects with good tenants and reasonable cash flow, have been scooped up at bargain prices. These relatively solid performers, it is felt, have nowhere to go but up. It will be much more difficult to sustain the second wave of REIT offerings. No one wants bank and insurance company "fire sale" properties. In light of overbuilding and poor market conditions, no REIT can magically turn failed projects into good ones.
Despite these caveats, we can expect more and more developers, including Southeast Michigan veterans, to look to REITs to solve short and long term financing problems.
Right now, there may be no other recourse. Banks and insurance companies, deterred both by regulators and the bitter experiences of recent years, are playing limited roles in the commercial real estate market. In contrast, REITs may provide the "guaranteed" pool of capital needed to start projects, as well as the means to renegotiate terms and rates as they fluctuate, just as homeowners are now doing.
REITs represent a reasonable path to capital and financial flexibility for developers, especially longtime developers with established portfolios. They are also a sounder way to capitalize real estate than the once-popular Real Estate Limited Partnerships. With REITS, the fundamentals of cash flow and market forces will determine value, rather than the subsidy of tax benefits. Projects should once again have to make both financial and commercial sense to get built.
Further down the road, local and regional banks need to develop new, long term real estate strategies with developers, so we don't repeat the mistakes of recent years. Until then, this is the REIT time.
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|Title Annotation:||Annual Review & Forecast, Section I; real estate investment trust|
|Publication:||Real Estate Weekly|
|Date:||Jan 26, 1994|
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