Why REITS Have Been on a Tear

Depressed prices, limited supply and a feverish quest for yield are just some of the factors that have propelled real estate to outperformance

Real estate investment trusts were last year’s strongest asset class, yielding a nearly 20% return and besting the broad market S&P 500 index by four percentage points.

In fact, REITs have surpassed the broad market for several years in a row now. What’s more, a different dynamic seems to be at work in real estate these days. With private equity and hedge funds scooping up residential real estate in bulk, it appears that Wall Street is crowding out what historically has been primarily a Main Street business run by mom-and-pop investors.

Indeed, Bloomberg reports that the Metacapital Mortgage Opportunties hedge fund returned 38% to shareholders in just the first 10 months of last year—a substantial gain for private investors even as the public continues to bear the massive mortgage losses of Fannie Mae and Freddie Mac.

And at the street level, some odd things are happening in the till-recently moribund sector. The Washington Post  reported two weeks ago on one ordinary-seeming house in the Capitol Hill area that received 168 bids and ultimately sold for $400,000 above its $337,000 asking price.

To get a global picture of real estate investing, AdvisorOne turned to Stephen Blank, a senior resident fellow with the Urban Land Institute, a Washington, DC-based real estate think tank established in the Great Depression era. In Blank’s view, there are multiple reasons for real estate’s appeal to investors today:

“Real estate has proven itself over the past couple of years to be a solid economic performer,” he said. “If you look at NAREIT versus the S&P 500, it’s four years in a row that REITs have outperformed stocks. Investors start to notice that.

“Also, REITs pay dividends; people notice that. And they’ve been able to obtain reasonable amounts of leverage at historically low interest rates. People notice that.

“Normally, real estate shoots itself in the foot by overbuilding,” Blank adds, noting that property construction over the past five years has fallen—and remained—at the lowest rates in a generation.

“All of that starts to get noticed,” Blank continues, adding that real estate has also proven valuable as a means of diversifying investor portfolios.

“And now hedge funds, buyout funds, smart and savvy global institutional investors have gotten into the market,” generating a lot of press in the process.

Blank says a wide array of investment structures is another advantage of real estate investing. “You can own the equity, you could buy the debt, you could invest in a fund that buys commercial mortgage-backed securities,” he says.

“You add all that up and it makes real estate look attractive.”

Indeed, there is fresh evidence of this investor appeal. In the first deal of its kind at a major wirehouse, Merrill Lynch is now offering its clients exclusive access to a nontraded REIT managed by Jones Lang LaSalle, a global real estate investment manager.

Nontraded REITs have long been a staple of the independent broker-dealer world, so the Merrill deal would seem to suggest pent-up demand among more affluent investors.

“Investors have been clamoring to buy nontraded REITs. They’ve invested billions of dollars in these REITs. They’ve been primarily sold by non-wirehouse advisors,” says Blank, adding the asset category has not been without controversy.

“One side says they’re illiquid, that they’re pushed out by brokers who want high commissions” and that questions persist about whether their valuations can be relied on.

“On the other side of it, a lot of these sponsors are proving themselves to have done a very good job,” Blank continues. “Like anything else, the verdict won’t be out till we’ve gone the full cycle.”

Blank says that Merrill and the other wirehouses distanced themselves from these products because of their resemblance to the limited partnership investments sold in the 1980s as well as their lack of liquidity. He says their jumping into this fray, and doing so on a proprietary basis, suggests very high client demand and a desire to ensure a quality product. “They rather control this, control the fees—that is, keep them low—and do the due diligence to give clients a deal they can be comfortable with.”

A key reason for REITs’ recent outperformance and future prospects lies in today’s interest rate environment. The same zero-rate environment that has prompted investors to search for yield also provides a low cost of funding for financing or refinancing real estate portfolios.

Importantly, this state of affairs implies that income, more than capital appreciation, is where today’s opportunity lies.

“For real estate to produce large amounts of appreciation means that cap rates have to get lower,” says Blank, referring to the ratio between a property’s net income and cost. “I’m not sure how much lower it’s possible to get.

“Normally, when interest rates go up, cap rates go up with them. You’re going to have to have an incredibly large amount of net income growth to offset the drag of higher cap rates” should rates rise, Blank warns.

That said, in its latest, third round of quantitative easing (and subsequent comments), the Federal Reserve has reiterated its intention to maintain a near-zero federal funds rate.

“Every statement they’ve made, they say they’re going to keep rates at low levels to 2015, maybe longer. So I’ll take Mr. [Fed Chairman Ben] Bernanke at his word,” Blank says, adding that investors should nevertheless make contingency calculations.

“I think you add it [the possibility of rates rising sooner than expected] to your analysis,” he says. “At least have a fire drill so you’re not sitting there like Chicken Little worried about the sky falling [if rates should rise]. That’s just good business sense.”

Asked about an exogenous event such as a credit ratings agency downgrading U.S. debt, Blank was quick to note: “The last time they did that, there was a global rush to buy our Treasuries.”

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