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Portfolio > Alternative Investments > Real Estate

Danger & Opportunity: REITs on the Rise

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It looks as though the REIT market is poised for growth. A recent report by global consulting firm Mercer titled “Recapitalization and Recovery in the REIT Market,” says that REITs will be able to take advantage of the best investment market in 20 years.”Over the last two quarters there has been an incredible amount of new equity issuance in the REIT market …. over $17 billion in capital raised,” says Michelle Reuter, senior associate in the manager research division of Mercer Investment Consulting, Inc. in Chicago, who co-authored the report.

Bryan Case, VP, research and industry information for the REIT industry group NAREIT, agrees that the “outlook for REITs hasn’t been this positive since 1991, at the start of a bull market that lasted seven years during which REIT returns averaged more than 20% per year.” Just as in 1991, Case says, “over the next few years we’re going to see a tremendous number of high-quality properties on the market at screaming-bargain prices, thanks to private-side real estate investors who got themselves in trouble by paying too much for properties, and using too much debt in the process, during the combination debt and asset-price bubble.”

REITs, Case continues, “didn’t share in that mass hysteria, and because of that they’re practically the only real estate investment managers that investors will trust with their money now. REITs have provided very strong returns over the past 30-plus years even through the downturns, so they have access to capital now and can buy; other investment managers produced poor returns even during the bull market, so they don’t have access to capital now and will have to sell.”

Washington Bureau Chief Melanie Waddell spoke with Mercer’s Reuter by telephone in early November.

You say the REIT market is in the beginnings of a growth stage, but that it’s different than the REIT cycle of the 1990s.

The biggest difference is that [the one in the 1990s] was born out of an oversupply problem where everyone was gung-ho and building rapidly. In this cycle, the problems have been born out of the capital markets; we haven’t seen the same oversupply problem. That’s not to say that we might not, because if the housing market and consumer spending markets don’t come back, then the oversupply problem definitely could exist.

When talking about the downturn in the commercial real estate market–how does that affect this growth stage?

There is such a credit crunch in the real estate market, so a lot of the private real estate investors and private real estate funds don’t have capital. So there has been a standstill in the transaction market because no one has money with which to buy any new properties. No one is selling, either. There’s been a really wide bid/ask spread. There’s a lot of anticipated distressed opportunities in the commercial real estate market; one of the big questions is when [those distressed properties will] come to market.

There hasn’t been pressure from banks for foreclosures, a lot of them are more willing to extend loans, so the distress has not come to fruition yet, but when it does we think that REITs are going to be in a unique opportunity because over the last two quarters there’s been an incredible amount of new equity issuance in the REIT market–over $17 billion in capital raised. Now all of these REITs are sitting on a lot of cash. In the short term, most of the opportunities are going to be on the debt side just because the distressed acquisitions aren’t out there yet. Some well-capitalized REITs could be in a position to take advantage of debt transactions and will ultimately help to alleviate the ominous debt maturity problem in the commercial real estate market.

But in the long term we think the distressed acquisitions are going to be the way in which REITs can take advantage of the unique dislocation in the market.

Will that growth come in both traded and non-traded REITs?

We are talking primarily about publicly traded REITs.

The study also talks about the challenges ahead for the REIT market.

There’s going to be a delicate balancing act for REITs that have turned to the equity markets. So far the increase in share price has offset any dilution of shareholder value, but if REITs do turn back to the equity market, there’s a possibility that they won’t get that same rise.

Also, as I mentioned before, there could be a supply problem if the housing market and consumer spending markets come back smaller than before because we won’t see a lot of tenants having to move back into vacant spaces. While there isn’t a supply problem now, if we continue to see bankruptcies in the capital markets then there aren’t going to be any new tenants to fill those spaces.

What about the instability in the market for real estate?

Other issues that the REIT market has been facing for quite some time is that there’s been a lot of volatility because of uncertainty in the underlying real estate market–in the actual commercial properties. There’s been a lack of transaction activity, so it’s been hard for REITs to value those properties because there isn’t anything around it selling. They can’t really come up with a fair, comparable price for the property. That’s caused a lot of volatility because the public market has anticipated steep declines in the present market and there’s been a lot of speculative investing in the market from hedge funds and what we call non-dedicated REIT investors. A non-dedicated might be a small-cap value manager who normally wouldn’t invest in the REIT market but saw value opportunity.

As non-dedicated investors move in and out of the market there’s been so much volatility, which has been a concern for our clients. That volatility could continue as we’re waiting for the private real estate market to shake out. That market lags…the public real estate market. For a couple of quarters now the REIT market has been beaten up because of the anticipated declines in the private real estate market.

What else is significant about the REIT market?

There’s been a lot of talk about commercial real estate REIT IPOs–private REITs going public–and anticipation that there will be an uptick [in such public offerings]. We’re a little more cautious; we think that there will be REIT IPOs that are focused on distressed commercial real estate, but we’re not expecting a huge wave.

Washington Bureau Chief Melanie Waddell can be reached at [email protected].


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