Real estate debt securities favored in first half of '98.

The first half of 1998 was a period of mixed performance for real estate securities, according to Deloitte & Touche LLP's Real Estate Services Group. While equity returns were down, debt securities issuance was very strong for the real estate industry.

"Real Estate Investment Trust (REIT) total returns for 1998 have significantly lagged the broader market," said Richard Carlson, National Managing Director of Real Estate Services for Deloitte & Touche. This has made it somewhat more difficult for REITs to issue additional equity to fund acquisitions. "The underlying real estate market fundamentals are still relatively strong," he added, which implies that the market capitalization premium to net asset value has become lower for many REITs.

In spite of share price weakness, the mean market capitalization for REITs in the NAREIT Index (National Association of Real Estate Investment Trusts) has increased by 11.2 percent since the and of 1997, said Carlson, who also observed that real estate development has increased noticeably since last year at this time, which may be causing REIT investors to worry about overbuilding.

Proposed REIT legislation in Congress has also generated some concern among investors, especially as it affects paired-share REITs. One holding company, which was formerly a paired-share REIT, has stated that because of current market conditions, it will not try to regain its REIT status.

David DeShong, a partner in the Deloitte & Touche's Atlanta Real Estate Services Group, said that some REITs are buying back their shares, taking advantage of current market conditions. Depending on a stock's trading multiple, a company's own shares may be the best investment available. A stock repurchase may have a higher yield, based on the current multiple, than available real estate investments. This has an added advantage of improving Funds From Operations (FFO) per share.

"Institutional investors found REIT unsecured debt instruments to be an attractive investment in the first six months of 1998," said John Barron, one of the firm's national REIT partners. "The average offering size increased 50 percent over 1997." He also noted that the debt market, in terms of volume, grew at an annualized rate of 85 percent when compared to 1997. Barron commented that preferred stock, due to its higher dividend yield, was an investment that investors also found attractive. This contributed to the 38 percent annualized issuance increase in the first half of 1998.

Barron also noted that even if the current market conditions are less favorable for issuing equity, acquisitions using partnership units are still feasible, as are stock for stock transactions. He cited the recent announcement of Equity Residential's acquisition of Merry Land & Investment as one example of stock for stock transaction.

"Mortgage REITs that invest primarily in residential mortgage securities have been hit hard by the failing interest rate environment and associated prepayments, particularly those that focus on adjustable rate mortgage (ARM) products," said Chris Dubrowski, a partner in the New York Tri-State Real Estate Services Group and a specialist in the mortgage REIT industry. As an example, he cited Apex Mortgage Capital, which recently announced a change in its investment strategy to de-emphasize ARM securities and increase its investment in fixed-rate mortgage-backed securities. Some of these REITs also are investors in interest-only strips, which plummet in value in high prepayment situations. While the REITs that invest primarily in commercial mortgage-backed securities (CMBS) and direct commercial mortgages are less impacted by prepayments due to higher prepayment penalties on commercial mortgages, the investing public has tended to group all mortgage REITs together, according to Dubrowski.

Consequently, established commercial mortgage REITs have seen their stock prices fall, and the recent flurry of IPOs in the commercial real estate sector (Anthracite Capital, Amresco Capital Trust, Chastain Capital and Clarion Commercial Holdings) have had to downsize their offerings and had soft subsequent stock prices, while others in the pipeline have deferred or canceled their IPO plans.

"The continuing health of the current real estate property market has persuaded real estate lenders to provide a significant amount of debt capital to the industry," said Claude Warner, Assistant Director of Deloitte & Touche's National Center for Applied Real Estate Research & Technology. "The trend has been toward lending with a goal to securitize the debt as quickly as possible once a viable pool size has been reached." As a result, conduit market share of CMBS issuance rose to 67 percent for the first half of 1998, as compared to 50 percent at year-end 1997. Alliances that have been formed between traditional lenders and securities underwriters will serve to accelerate the process and increase the slope of the trend line.

CMBS Issuance so far in 1998 has been $43.4 billion, which is nearly equal to 1997's total issuance of $44.3 billion. "Clearly, the CMBS market will have another record year in 1998; the only question is by how much," Warner concluded.