REITs have very specific uses, more than is commonly realised. The euphoria surrounding them requires an equal measure of caution. John Glascock and Abraham Park report
Over the past 20 years in the US, the commercial real estate market has experienced a dramatic transformation with significant amounts of capital flowing from private to public real estate ownership. By the end of 2006, the real estate investment trust (REITs) market in the US had grown to over 180 companies with market capitalisation of $438bn (€325bn).
Within the last few years, the international market has experienced a similar transformation. Institutional investors have poured capital into the global indirect property market, and as a result the global REIT industry has experienced exponential growth. At the end of 2006, the total market capitalisation of global listed property securities had reached €687bn and in Europe, €153bn.
By 2006, the market size essentially doubled from 2004 and tripled from 2003. This remarkable development was in large part due to significant overall capital flow into European real estate in the last few years (an estimated €270bn in 2006). Although listed property companies have a long history in Europe, tax-transparent vehicles (REITs) account for less than 10% of the global total compared with European direct market that accounts for over 30% of the global market.
In 2007, the European REIT market gained momentum as UK, Germany and Italy all adopted REIT regimes. These countries comprise three of the top four European countries in terms of total real estate market size. The potential significance of the introduction of a REIT regime in Europe has been demonstrated by the case of France, which introduced SIICs in 2003. The introduction of the REIT regime in France dramatically increased the scale and liquidity of the market. With much room for growth in securitisation and with the introduction of REITs in UK, Germany and Italy, many experts anticipate a European version of the REIT revolution experienced by the US in the late 1990s.
The positive aspects of REITs include transparency, liquidity, low debt, and high income payouts. Furthermore, the portfolio and diversification benefits of REITs have been well-documented, as well as historically strong risk-adjusted performances.
But how far will the REIT revolution go? Is REIT the right structure for all commercial real estate to be owned and managed? The following section summarises some of the key elements and limitations of the REIT structure and explains why REITs are still a niche in the real estate market.
With the benefit of the lessons learned from the US REIT experience, the European REIT regimes are becoming more unified with the general framework and key elements essentially the same. Although distant, even a Pan-European REIT is conceivable within the real estate industry. While general euphoria surrounds the REIT market globally, it is advisable for investors to recognise that in a broad sense, investment into the REIT market is equivalent to investing within a narrow spectrum within the real estate market.
This market niche is defined by a set of key parameters or elements that comprise almost all REIT regimes around the world:Income distribution: High payout requirement for REITs (usually 90% of net income) generally means long-term passive investments that ensure steadier and more stable income to the investors. However, this requirement also means that it is more costly for REITs to raise capital. As REITs are in a capital intensive business and are prohibited from retaining most of their earnings, they need funds from external sources to grow. Typically, companies prefer internal sources of funding since these are more flexible and less costly than issuing new debt or equity securities. However, private real estate firms can grow more efficiently than REITs as they are not under pressure to pay high dividends, thus making cash available for additional acquisitions. Management requirement: When the US Congress originally created REITs, they were intended to be passive vehicles similar to mutual funds. As such, REITs were required to hire external managers to provide management and operations services. These external managers did not have ownership shares in the REIT. Further, the board of directors could hire or fire the adviser, but not the employees who worked directly for the managers in running the REIT. In the early 1970s, the misaligned incentive structure of external managers, who were paid a percentage of the total asset value, led to REITs investing and financing many questionable projects. The restriction was removed in 1986. Thus by effectively allowing REITs to directly hire and compensate internal managers, the conflict of interest that existed between the REIT and the shareholders was eliminated.
This incentive alignment, however, does not necessarily mean that REITs have the flexibility to extract maximum performance from their internal managers. REIT regimes that are intentionally structured to impose passivity and narrow bandwidth of operational activities for managers do not allow for pay structures that will motivate mangers to hit ‘home runs'. In baseball terms, the REIT structure is like a baseball coach who requires their players to hit singles or base-hits to stay in the game or else they are out. The REIT managers are not paid to squeeze out maximum profit from every deal. Instead, they must think constantly about how to convert even a home-run opportunity into four singles.
Leverage limitation: One of the concerns of using debt is that it increases the leverage of REITs. This can be profitable when the interest rates are low and real estate yields are high, but can be risky during declining markets when interest rates rise and margins disappear. Through the years, the US REIT industry experienced several painful lessons on leverage and as a result underwent significant structural changes. Thus, some REIT regimes have imposed restrictions on leverage. In addition, it is generally inadvisable for REITs to use too much debt because they have to compete in the debt market with tax-paying firms, whose interest payments are tax deductible. In 2006, North American REITs had an average gearing ratio near 55%, while REITs in other global regions were in the low 30% range. From a risk-and-return framework, REITs are considered to be between core and value-added within the wide range of real estate investment strategies. This is due in large part to the low average debt levels of REITs.
The flipside of limitations on debt is that sometimes high leverage is warranted. Also, low leverage does not necessarily indicate low risk. Practically speaking, the leverage restrictions imposed on REITs could prevent them from acquiring highly attractive assets with high-quality tenants and long-term leases where the right financial structure involves 90% gearing rather than the customary 50% REIT gearing. Private investors, on the other hand, often utilise a much higher debt-to-equity ratio in order to maximise returns while balancing the risk of higher interest rates with the quality of tenants and lease terms.
Development/asset limitation: As an indirect real estate investment vehicle, the REIT's primary purpose is to invest and hold income generating real estate assets. This requirement makes REITs prefer acquiring income-generating assets while not preferring high option value properties. The rise of the REIT industry only makes the competition for REIT-suitable assets more intense, which drives up prices and lower yields on such properties. As mentioned previously, the management also lacks the incentive to seek high option value assets that could potentially be ‘home runs' for the REIT shareholders.
REITs are efficient and effective vehicles to hold and manage established real estate assets - from quality offices to industrial property. But REITs are not development-oriented, nor are they fast in terms of making the deal. Thus, we expect that REITs will hold the cash-flow-oriented market in Europe and Asia as well as has been true in the US - REITs will be a yield play and their prices will be based upon a spread over Treasuries or gilts. If a deal requires structured elements and high gearing, REITs cannot and should not compete - it is not their market. The recent private buyout of Equity Office (and before that of CarrAmerica) showed that clean quality assets can be geared more effectively in the private market - and that in such deals there is still tax transparency (and more management flexibility).