March 2, 2001

Is It Safe?

No, it's a not a reference to the "The Marathon Ma

Remember Canary Wharf? Throughout the Industrial Revolution it served as a hub of waterfront commerce along the Thames River in London. At its height, 60 million tons of freight passed through the area each year under the watchful eyes of 150,000 workers. But as the shipping industry shifted to larger, container-friendly docks, the area slowly became obsolete.

Enter Paul Reichmann and his Toronto-based Olympia & York Company, possibly the largest real estate firm the world had ever seen. Reichmann formulated a grand plan to build sprawling office complexes and skyscrapers that would rival the World Financial Center in Manhattan --which, not coincidentally, Reichmann helped build several years before.

So, beginning in the 1980s--with the real estate and stock markets soaring to new heights--Reichmann borrowed over $1.8 billion to bring his colossal vision to fruition. The fact that he neglected to sign up prospective tenants to reside in the buildings and that there was no subway line to connect the docks to the rest of the city were merely minor details.

But in 1992, a worldwide recession sent his as-yet-unsigned tenants running for cover, leaving him with no way to generate the revenue needed to pay off his loans. A consortium of Canadian banks that had financed the deal came calling, and Reichmann, having no way to pay them, had to declare bankruptcy.

Why bring up such a dour vision in the midst of what many think is the greatest run in the real estate market in some time? After all, didn't Reichmann recover from his precarious position in 1995 to lead a group of investors to repurchase Canary Wharf, now valued at exponentially more--$4 billion--than the amount of original capital he put up for the plan? The story is relevant, say many in the industry, because it reflects the way that individual investors and financial planners view the real estate market. Just mentioning a possible investment in a commercial real estate endeavor brings up visions of the many ego-driven, speculative real estate debacles of the late 1980s and early 1990s. Debacles like Canary Wharf.

Despite Gains, Net Outflows

Some would argue that those memories are justifiably fading. They could point to the stellar performance over the last year of publicly traded real estate investment trusts (REITs), the principal way that the individual investor can put his or her own money into real estate. The National Association of Real Estate Investment Trusts (NAREIT) Index itself rose 26% last year, an impressive performance in a year when most other major market indexes fell.

But to focus on short-term performance would be a mistake, say many in the real estate business. For instance, Bob Steers, co-founder and co-portfolio manager for REIT investment firm Cohen & Steers Capital Management, says that last year's gains did not reflect any grass-roots movement of individual investors and advisors to invest in real estate. In fact, he says that his largest REIT fund, Cohen and Steers Realty Fund, which is also the largest in the industry with $1.3 billion in assets, saw a net outflow of funds in 2000.

"I'm looking at redemptions for our funds, and last year was the third consecutive year that you saw financial advisors and individual investors pulling money out of REITs," he says. "And I think it's safe to say that since we are the largest REIT fund, you can take ours as a proxy for the industry."

Instead, Steers points to two factors that resulted in the massive gains recorded last year by the NAREIT index. First, while significant money was flowing out of his retail accounts, Steers says his firm saw meaningful new funds allocated by institutional investors for REITs. "That's where the money came from last year: pension funds, college endowments."

Also, Steers points to the thinning equity market for REITs--something he says was lost in the ballyhoo created by the 26% gain. Indeed, $4 billion worth of REIT shares was repurchased by REITs themselves with only $1.2 billion in new equity being issued. Throw in a whopping $13 billion in mergers and acquisitions, in an industry with only $139 billion in total market capitalization, and Steers argues that it's not hard to see where the gains came from.

"I think REITS are fundamentally misunderstood by financial advisors and individual investors," Steers remarks with a hint of regret. "We're constantly disappointed by the [lack of] discipline on the part of investors for this asset class. While the Nasdaq can go down 50% in a year, and no one loses faith, REITs have a bad year or two and investors totally abandon their confidence in the sector. It's a big point of irony here that financial advisors seem more comfortable with biotechnology and telecommunications than simple real estate."

Steers readily admits that he isn't quite sure why individual investors and financial advisors have shown such a lack of patience for REITs over the last decade. "There have been some rough patches but the industry had been doing quite well over the long term," he says.

And the numbers seem to confirm his confidence. The NAREIT Composite Index has yielded a very respectable 12.74% annually--including dividends--over the past 10 years. Over the last 20 years, the index yielded a more modest, yet still solid, 10.19%. Bu comparison, the S&P 500 produced returns of 17.3% and 13.7% over those same 10- and 20-year periods, respectively.

So What's the Problem?

In light of these numbers, many say that the problem is not really with REITs but rather with how they compare with the long bull market of the Nasdaq and Dow. "Real estate and REITs just aren't as sexy as stocks," says Peter Calfee of Calfee Financial Planners in Cleveland. "You have to sit back and patiently collect your dividend and hope for modest growth when people have been seeing enormous gains with stocks."

This is a position often repeated by many to explain the lack of public interest in REITs despite their impressive long-term record. But there is another, less frequently voiced reason for the general avoidance of REITs. Michael Hoeh, senior REIT portfolio manager at Dreyfus Corporation, claims that it's the memory of Canary Wharf and similar missteps that the industry has never recovered from.

"I think when people think about real estate and REITs, to a certain extent they go back to the savings and loan scandal and the other problems the real estate industry had in the late 1980s and early 1990s," Hoeh says. "A lot of people got burned and they don't want it to happen again."

Hoeh is not alone. Nancy Holland, senior vice president for ABN Ambro Asset Management Inc., which manages several REIT funds, says real estate is still a very scary thing for many investors. "They think of real estate investment and they conjure up visions of properties that were purchased with these grand designs, but when the market collapsed, they had no tenants in place to generate revenue to pay off the loans used to build these things."

Paying Cash
Leo Wells shares his unique take on real estate and investing

It seems that Leo Wells was made for this real estate market. In an era when financial advisors and individual investors are still frightened over memories of the speculative and highly leveraged real estate deals of the late 1980s, Wells's philosophy seems tailor-made to allay their fears.

All of the properties that Wells purchases for his nearly three-year-old REIT, Wells Real Estate Investment Trust, are purchased in full, and in cash. "My grandfather had a saying," the 65-year-old Wells says. "If you don't have enough money to pay for something in cash, then don't buy it."

In addition, Wells carefully picks his tenants so as to safeguard the investment of the more than 7,500 investors in his privately held REIT. "We limit ourselves to only the best corporations as tenants," he says. "We have Lucent, Motorola, GE. Those types."

Furthermore, these companies are nearly always locked up for 10-year leases that would allow Wells to weather any storms that might be on the real estate horizon. "If things go bad for these companies, they still have to pay their rents. It's called surety of income. We get our money before the shareholders, and even the people who own bonds."

At first glance, one would think that Wells had to have commissioned an army of marketing firms first to gauge the concerns of people in today's market and then to develop the ethos that governs his REIT. Indeed, when billion-dollar REIT funds like Cohen & Steers Realty Shares have seen a net outflow of money in the last three years despite a roaring market, Wells's firm seems to have hit the problem right on the nose. "I've met so many financial advisors who tell me they will never again get into real estate after what happened in the late '80s and early '90s," he notes. "They're just too scared."

But after spending some time with Wells, it becomes apparent that his fund is by no means the product of some contrived marketing campaign. Instead, his investing style is an offshoot of his own personal experiences. Indeed, the native of rural Georgia said he heard about the Great Depression so often from his grandfather that he came to feel that he had lived through it himself. Then there is the religious upbringing that he has made a part of his adult life as an active member of Fellowship Bible Church in Rosewell, Georgia. "It says in the Bible that if you owe a man you become his slave," he says in his Southern drawl, perhaps advancing the first-ever scripture-based argument for REITs.

"Look," he says, "I'm not in the real estate business, I'm in the retirement business. I want to preserve people's assets so they can retire with dignity. I'm not going to make you rich, but you'll get 6% to 8% a year, easy. That's what I'm all about."

For further information on the Wells REIT, call 770-449-7800 or go to the Wells Web site, www.wellsref.com.

Perception and Reality

Hoeh and Holland, however, are quick to follow up their comments with the argument that such misgivings are no longer merited. Both point to a number of significant changes that have taken place in the real estate and particularly the REIT industry that have improved the investment environment since the late '80's.

New technology, new legislation, and a more open and highly scrutinized process by which loans are granted and business is conducted have substantially changed the shape of real estate and REITs for the better. "Things have changed," Holland says. "The REITs you have now are not the same ones that were around even 10 years ago."

Topping the list of changes are the new technology and in-depth research that allow real estate companies to track easily the number of construction starts, as well as vacancy and delinquency rates in any given area. "Overbuilding was a major factor in the real estate meltdown of the late 1980s," Hoeh says. "Builders just didn't have any idea of who else was building in the same area, and what the vacancy rates were for existing buildings."

Such problems are now handled by a slew of traditional and online media companies dedicated to giving builders a firm grasp of what is happening in the market. Just go to such sites as FWDodge.com, where developers can access any one of a number of market-analysis tools, or pick up a copy of Harrison Scott's most recent edition of the newsletter "Real Estate Alert."

In fact, the abundance of available information is such that it leads Lehman Brothers' REIT analyst Stuart Axelrod to echo Hoeh's assertion. "There is no oversupply in real estate today," Axelrod says. "Supply and demand is managed to a point that would have been foreign to those in the business 10 years ago. This time, if there is a recession, it won't be real estate's fault. It will be excesses in other areas."

A Closer Look

Technological advances are not the only changes the industry has seen. Insiders are quick to point to the far greater degree of scrutiny to which real estate companies are subject in today's market. Indeed, about 10% of the total U.S. commercial real estate market is controlled by publicly traded REITs, compared to just 2% at the end of the 1980s.

Also bringing a new air of public awareness to the real estate industry is developers' burgeoning reliance on the commercial mortgage-backed security as the principal form of financing a project. Using a CMBS requires that loans to developers are securitized, divided, and then sold like bonds to mutual funds and brokerage houses. The process, Hoeh says, requires a much greater degree of disclosure on the part of the developer.

"In the late 1980s, you just didn't have commercial backed securities," Hoeh argues. "Most of the financing would come from private sources like insurance companies and large banks so that the details of a loan and the development were very rarely known by the public."

In contrast, last year some $60 billion worth of CMBS was sold. "When deals come to the public market, there is more control over the risk and other variables," Hoeh says. "Because of this I don't think what happened in the late 80s and early 90s is still possible."

Holland has her own take on the reasons for the REIT market's newfound stability. When asked if REITs still go out of business, she quickly replies, "Not anymore. Things have changed." Holland then springs into a discourse on what she believes was the single most important legislative change for REITs since the legal groundwork was laid for the entire industry in an amendment to the Cigar Excise Tax Extension of 1960.

Holland says that when REITs were first created as a way for the public to participate in the commercial real estate market, the REITs were not allowed to manage the properties they owned. This, she said, often caused fundamental conflicts of interest between the REIT, which wanted the value of its property to increase, and the management company, which was paid a percentage of the gross revenue generated by the property. "Let's say I own a strip mall with several high-end retailers, but there is one empty store," she explains. "If I'm the management company, I would allow any store to set up in that empty spot, even a pawn shop. That would increase the rent and gross revenues, but drag down the value of the property."

A REIT Primer
What are REITs, anyhow? And why do they carry so much debt?

In 1999, the National Association of Real Estate Investment Trusts (NAREIT) initiated a nationwide marketing campaign meant to raise awareness of Real Estate Investment Trusts (REITs) among the investing public. There were print, radio, and television advertisements, but it was the spots that ran on CNBC that perhaps best captured what NAREIT was trying to get across.

The ad showed a father and son walking through an office park with the son eventually looking up to his father to ask, "You mean we actually own a piece of all this, Dad?" The father then answered, "You could say that, son, you could say that."

While the spot could be considered simplistic and saccharine, the message was clear. The general public indeed has a way to invest in some of the most lucrative and coveted properties in the entire country, through REITs--whatever they are.

"It was amazing," said Jay Hyde, senior director of communications for NAREIT, referring to the responses of focus group members who viewed the ad prior to the start of the campaign. "Very few people knew what REITs were and even fewer were familiar with what they do. People thought real estate was something that only the very wealthy--like a Rockefeller or Donald Trump--could invest in."

How They Work

A REIT works just like a regular company, but limits itself to primarily real estate investments. Think of any publicly traded company like GE or IBM selling off all its regular businesses and deciding just to buy properties, develop them, take in rents, and maybe sell them once the value of the property has appreciated sufficiently.

It's not that simple, however, since REITs are bound by several federal laws that date back to when Congress made them possible in the early 1960s. REITs must have at least 100 investors, and are able to avoid corporate income taxes so long as they pay out 90% of their earnings in the form of dividends to their shareholders. Until 2000, REITs had to restrict 75% of their business dealings solely to real estate transactions. There are about 300 REITs in the country, some of which invest strictly in commercial real estate, some industrial real estate, and others solely in residential properties. There are even REITS that focus on shopping centers, hospitals, and such unorthodox ventures as timberland and prisons.

There are a few details that advisors should know before investing in real estate in general and REITs in particular. For instance, one unfamiliar with REITs would be shocked to discover the high amounts of debt that REITs carry on their balance sheets. The figures are staggering enough relative to normal companies that one would think the entire industry was teetering.

Such isn't the case, though, says Steve Sakwa, head REIT analyst for Merrill Lynch. Sakwa said that since REITs must pay out 90% of their earnings, the only way for them to grow is to either make a new equity offering or take out loans. But this isn't unique to REITs, since Sakwa notes that real estate by its very nature is a fairly leveraged game.

"You don't see many real estate firms financing the development of a property with 100% of their own capital," he says. "It's just not done that way. A company may put up 40% of the capital to build a building and then borrow the other 60%. In fact, if they're doing their jobs right, they might not have any equity in the project."

Sakwa uses the example of a real estate developer (it could be a REIT) drawing up plans to build a skyscraper on a particular property. He borrows 60% of the capital and then borrows the rest. The developer would then try to sign tenants whose rents would generate a 10% to 14% return on the capital, yielding what is known as a "pre-leveraged return." The developer would then pay the interest on the loan and pocket the rest for himself.

Because of this reliance on debt and outside financing, Sakwa says it is not uncommon to find upper-echelon REITS with debt levels equal to 50% or even more of the value of their entire assets. For example, top-tier REIT Boston Properties has a NAV of around $8 billion, yet the company is carrying over $3 billion in debt on its books. "That's normal," Sakwa says.

The highly leveraged nature of the real estate industry creates other nuances for the potential investor. Instead of debt-to-equity being the Holy Grail as it is with conventional corporations, industry analysts say that the "interest coverage ratio" is what's most frequently referenced. This ratio shows how easily a company would be able to pay off the interest from its debt relative to the free cash flow it is generating. Boston Properties, for example, racked up $205 million in interest payments for 1999, yet had a cash flow from operating activities of $303 million. "This is what you want," Sakwa says in reference to the Boston Properties' figures. "You want two or three times coverage."

Dealing With Debt

The severe debt load has other implications. Since REITs and other real estate companies are seemingly eternally in debt to other institutions, whether they be banks or other lenders, there is particular reason to worry about a recession that might derail cash flows. As many who were involved in real estate at the end of the 1980s are aware, a dent in cash flow hinders a real estate company's ability to pay off the interest. From there it's not far to forced sales at prices fractional to the intrinsic value of the property. In light of this, particular import is given to what is known as a REIT's "turnover ratio," or the number of leases that will expire at any one time. "If the real estate market goes bad, it's really not that dangerous if 90% of your clients are locked up in long-term leases," Sakwa adds. "They're still going to have to pay their rents no matter what happens to them. In this case, it would take a long time for a company to have its cash flows eroded, and hopefully by the time that happens, the real estate market will have stabilized."

Sakwa says to look for "turnover ratios" in the 5% to 10% range.

Additionally, REITS are insulated from the effect of real estate recessions by the quality of their properties. For instance, if a company has above-market leases in desirable markets like Boston, Chicago, San Francisco, or New York, it would be easier for it to attract tenants in down periods. "A company can lower its rent in a first-tier city and still survive," Sakwa explains.

In the end, everything basically comes down to debt levels. If investors can inure themselves to the highly leveraged nature of real estate and REITs, they could prosper in the industry. If not, say industry insiders, it's probably better to go with bonds as a hedge to the more volatile stocks in a properly diversified portfolio.

This may sound like a very unlikely scenario, but Holland as well as several other industry experts says that the tax reform act of 1986--which allowed REITs to manage as well as own their properties--signified a fundamental shift in the industry. "REITs don't go out of business any more because of this," Holland repeats. "It's big."

Looming equally large, others say, is the passing of more recent legislation, specifically the REIT Modernization Act of 2000. The law has a twofold effect, first allowing REITs to extend their business activities beyond the traditional scope of real estate.

"Now REITs can become involved in other businesses beside merely owning and operating properties," says Steers. "They can own the soda machines in their buildings, build the networks in their hotels. There are all sorts of opportunities for new revenue. It's one of the reasons that I believe the sector can continue to grow at comparable rates as last year."

The other aspect of the bill is the legislative permission for REITs to retain 10% of their earnings rather than just 5%. In the past, in order to qualify for REITs' unique tax benefits--dividends are only taxed once--they had to pay out 95% of their earnings to investors. The additional five percent, many say, will allow for a slightly more rapid growth rate.

Getting the Word Out

With such changes for the better, many in the industry feel that the only remaining task is to get the word out, to educate the public about REITS as well as lay to rest such memories as those of Canary Wharf. "You should see my calendar for the next several months compared to what it was like last year," says Holland, who often speaks before advisors both in and outside of her own firm. "I have many more engagements to talk about REITs. After last year, people want to find out more about the industry. They are hesitant but interested."

For their part, NAREIT recently ended a $2 million nationwide newspaper, radio, and television advertising campaign aimed at educating the general public on REITs and their virtues. "This was the first time that we tried to do anything this large," says Jay Hyde, senior director of communications for NAREIT. "You just can't expect people to invest in something that they are unsure or uneducated about. This campaign was meant to address that issue."

Steers chuckles when the issue of Canary Wharf is raised. "I don't think that can happen again. There are just too many things that have changed. We need people to understand that."

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