The US association for REITs is aiming to work closely with the new government to ensure the sector safely navigates the current downturn. Martin Hurst talks to NAREIT’s Steve Wechsler about the need for candour over complexity when it comes to regulation
The steel grey sky and bitter cold wind of winter in Washington, DC provide a fitting backdrop to a discussion about an industry in crisis. In contrast, however, the offices of the National Association of Real Estate Investment Trusts (NAREIT), newly refurbished with cream tones, glass dividers and reassuringly solid wood furniture, project an air of clarity, confidence and optimism.
This is the message of Steven Wechsler, chief executive officer of NAREIT, an industry veteran with an impressive CV. Real estate investment trusts (REITs) have been through a torrid time of late, but Wechsler sees clear opportunities in the current crisis.
Former president and CEO of the Real Estate Roundtable, the national real estate industry lobbying group, Wechsler stresses NAREIT will work closely with the new administration and Congress to progress real estate issues, from tax to the environment.
Given the prominence of the sub-prime debacle and its role in sparking the current crisis, real estate has received a good deal of attention. More than its fair share?
Wechsler underlines the need to view real estate’s current woes in perspective: “The difficulties real estate and REITs are facing due to the dysfunction in the financial system are no different than the difficulties being faced by other parts of the economy,” he argues. “I think it is important to underline this because often, when we talk about real estate, we have a tendency to be very inward-looking.”
He believes there are a number of key lessons to take out of the current crisis. “The market requires less leverage, more liquidity, greater transparency and more effective regulation,” he explains.
“Overarching all of these factors will be a bias in favour of simplicity over complexity.” Wechsler’s central point is that REITs fulfil these objectives, strengthening their case for inclusion in the investment toolbox.
“REITs use less leverage than other forms of real estate, and I have no doubt that further reductions in leverage will follow,” he says. “As for liquidity, in the publicly traded (also by far the dominant) REIT space we have liquidity because these REITs are traded on the New York Stock Exchange and other major exchanges - some $5bn (€3.8bn) of real estate is traded every day, even while the direct property markets are frozen.
“We will also see a demand by investors for more transparency. The most transparent approach to real estate investment is the publicly traded REIT market. The wealth of information provided through SEC requirements is substantial, and many REITs offer more information than required. As for the simplicity initiative, I think by and large the concept of a REIT, in terms of its structure as a company that invests in real estate, is relatively easy to comprehend, as opposed to complex structured investment products based on real estate assets.”
One of the main reasons investors give for not investing in REITs and other listed real estate is their volatility. But current market conditions have also raised questions over the apparent lack of volatility of private real estate. In the US, the private real estate market is measured by the National Council of Real Estate Investment Fiduciaries (NCREIF), whose actual measurement for the 12 months preceding October 2008 was, as Wechsler notes, “a zero-change in commercial real estate”. His view is that private real estate is less volatile “only because it is being measured by NCREIF”.
Real estate professionals know only too well about the lack of transaction data and its inter-relationship with the huge spreads between what the buyer is prepared to pay on the one hand and the expectations of the seller on the other. “We are seeing that disconnect every day in the public market, and the product of that disconnect is volatility,” Wechsler explains.
“Every day, people in the public market are having that debate, yet listed real estate is being bought and sold because it is a liquid market for real estate. Meanwhile, in the private market, the potential seller is there waiting to sell at a six cap rate, but the transaction doesn’t take place because the potential buyer with cash in his pocket wants to buy at nine.
” We have of course seen huge volatility in the markets of late, which has made investors nervous about real estate, particularly listed real estate. But Wechsler is upbeat and believes that “in general and in the long-term real estate as an asset class both private and public will continue to be less volatile than the broader markets”.
He adds: “In the greatest meltdown of the financial system in 75 years I don’t think it can be shocking to anyone that real estate that can be traded publicly shows great volatility. In retrospect, much of the increase in volatility in the REIT market came about in the last few years at what will increasingly be viewed as the top of the market and a bubble. That is exactly when you would expect to see volatility, because the certainty attached to that price level is diminishing every day. The great debate in the property market today is: where are cap rates?”
Liquidity is another issue that has taxed investors as the downturn has taken hold, and it is an area where Wechsler believes REITs have much to offer, particularly in the current market. “There will be times when you need to raise money,” he says. “You will be better prepared for this eventuality by having more of your real estate liquid.
“Coming out of this downturn, we will see a much more balanced approach to real estate exposure, utilising a combination of direct real estate investment and public real estate investment through REITs. It is never going to be completely one way or the other, nor should it be, but our view is that unlisted and listed real estate are very complementary. Institutions will start to take a good look at the optimum allocations of direct real estate and REITs in a blended real estate portfolio.”
Does more need to be done to educate investors about listed real estate? “Yes, all the time,” Wechsler says. “We have a team dedicated to that in our investor outreach group. They are on the road every week meeting with institutional investors.”
Investor education is one of many areas in which NAREIT works closely with its counterparts in Europe (EPRA) and in Asia (APREA). NAREIT also helped to found REESA - the Real Estate Equities Securitisation Alliance - together with EPRA, APREA and others such as the BPF (UK), REALPAC (Canada), PCA (Australia), and ARES in Japan. “Part of our mandate is to cooperate on investor outreach activities because our stories and aims are so similar,” Wechsler notes.
Could NAREIT do more to work with associations representing non-listed real estate? The bigger portfolio picture is high on Wechsler’s agenda, but he stresses that the process is gradual. “When we go out on the road we are talking more than anything else about the benefit of using real estate in a diversified investment portfolio,” he says.
“Only once we have done that can we discuss where listed real estate fits in. We would welcome talking with other organisations such as PREA, which are focused on the broader portfolio, and cooperating with them in an investor outreach programme.”
One of the key future issues for Wechsler is the need for reform and more effective regulation of the financial system. “That is where the ball was dropped,” he says. “Part of the problem in the financial system was the proliferation of unregulated and unexamined financial instruments, such as credit default swaps, which were not cleared on exchanges and which were not disclosed and monitored in an effective way. Underwriting standards in the commercial mortgage-backed securities (CMBS) market also became more and more lax as the years went by.
The new template will require less debt, more equity, more liquidity and more transparency, not just in real estate but in the financial system as a whole. Over the long-term this will be very constructive, but in the short-term it will be very painful.”
So what do we need to get banks to lend again? Wechsler points to the growth in excess reserves in the US banking system from around $4bn at the beginning of January 2008 to $600bn dollars at the end of last year. “As of today, the banks have money,” he says. “The question is: what are they going to do with it? Will it be used to take more writedowns, to increase their capital levels or to make new loans? At present, this is an unknown.
“Much recent bank lending has been the product of companies drawing down pre-existing lines of credit. Getting new financing or refinancing existing loans is exceedingly difficult.”
It is well known that the phenomenal growth in commercial real estate came about through the expanded roles of banks and the CMBS market, which, as Wechsler points out, together came to account for 70-80% of commercial real estate financing in the US at the industry’s peak. The rest was accounted for by pension funds and life insurance companies. “The CMBS market is finished for now. The origination in the last six months of 2008 was zero, and we expect that situation to continue in 2009 unless the federal government plays a role to change the situation,” he says.
“The banking system has been compromised, it is contracting and there is consolidation. Banks are trying to rebuild their capital base and they may take more writedowns, so investors will struggle to raise capital.”
Some $400bn of commercial mortgages will be due for refinancing in 2009. Wechsler considers the prospects. “The life insurance companies and pension funds both took big losses in this market, and their capacity is down. So, who will make this work? It will have to be banks and some kind of securitised debt market. How do we get banks to be comfortable in originating commercial mortgages and refinancing commercial mortgages in the future, and how do we jump-start the CMBS market?
This has been the focus of our activities and we view this as the most important first step to restore some normality to the real estate credit markets. We have been talking to senior officials in the new administration, the Congress, the Federal Reserve and other organisations to see what ideas can be developed and supported.”
In terms of leverage, REITs are still relatively well placed. “In the last few years REITs were paying down debt and selling assets while the broad real estate market was rising,” Wechsler notes. “Meanwhile the private real estate market bought those assets and took on more debt. So, the distress taking place in the public commercial real estate market, all of which we can see because of its transparency, is less than what is happening in the private market, most of which we can’t see.”
REIT prices are down 40% in the US and Wechsler beleives that the reason for this is a lack of confidence in the financial system. “An interesting example is the apartment REITs. There is financing available for these because of Fannie Mae and Freddie Mac, the recently nationalised agencies that provide financing for housing loans, including multi-family housing loans.
Comparable financing is not available for any other kind of commercial real estate. Today, apartment REITs are one of the best performing REIT sectors, so my back-of-the-envelope sense is that half of the pressure on real estate and REIT pricing is coming through the refinancing problem and the other half through asset repricing and concern about the economy.”
When considering possible roles for government to play in this crisis, Wechsler is keen to stress that much has been done for banks and the money and commercial paper markets through a variety of liquidity facilities developed by the US Treasury and Federal Reserve. Similar liquidity facilities could help reignite the commercial real estate credit markets. “We hope that some amount of money from the Troubled Asset Relief Program or other facilities that might be created can be used to regenerate the CMBS market,” he says.
“To the extent that we see a reduction of value due to the repricing of risk generally and as a result of deteriorating economic fundamentals, there is nothing that the government could or should be doing about it, and we would not be asking it to do anything about it. But to the extent that value is eroding day by day, because the credit system in this country and other parts of the world has become dysfunctional, we can ask the government to take on a role that is appropriate and necessary.
A very heavy weight on real estate today is coming about through the repricing of risk, deteriorating fundamentals and the collapse of the credit system. “The one thing we have seen over the years is that more flexibility is better than less flexibility, but the boundaries have to be known and established.”