Concerns over daily pricing and a lack of confidence in stock market valuations are putting some pension funds off publicly traded companies and REITs, says Martin Cohen
The appraisal of a single property or portfolio is very easy to accomplish and is quite routine in the real estate industry. Put those assets into the wrapper of a publicly traded company, however, and it seemingly becomes much more complex.
The adoption of the REIT model by most of the leading economies around the world has resulted in greater pension fund investment in public real estate companies. The real estate investment trust (REIT) may well be the most elegant and efficient way to own a portfolio of real estate. Imagine owning shares of a company that confines its investment activities to real estate and is required to distribute essentially all of its pretax profits to its shareholders every year. The company pays no taxes, thereby allowing for a direct flow-through of those profits—a particularly efficient vehicle for tax-exempt investors like pension funds.
Furthermore, if management is successful at increasing profits and asset value, that too will be reflected in the price of the company's shares. While it can be an effective vehicle with respect to value realisation, the liquidity of the public market enables investors to make portfolio changes easily. It is for this reason that the market value of publicly traded real estate companies worldwide is now approaching $1.5trn (€1.1trn).
However, scepticism remains in some quarters as to the ability of the public market to deliver direct property investment characteristics through the REIT vehicle. It should be recognised that most of the factors that affect the value of REIT shares are identical to those that affect the private market value of real estate. Nonetheless, there are differences, and many added nuances. Some of these factors relate to the markets in general and others are related to the characteristics of REITs.
The state of the local economy is the most important factor influencing property fundamentals, whether the real estate assets are publicly traded or privately held. And, while some may believe that stock price behavior is often disconnected from the realities of the direct marketplace, there is no question that current and prospective property fundamentals are the strongest determinants of REIT valuation. In light of those property fundamentals, sentiment towards the asset class will affect capital flows. The recent popularity of real estate has been manifested by the record sums of capital being dedicated to it through both private and public vehicles. The REIT bull market of the past several years is nothing more than a reflection of the demand for real estate that has elevated property prices.
Two factors have made the public market behave somewhat differently from the private market. First, stock prices may exaggerate changes in property values because REITs are priced on a moment-to-moment basis and are therefore subject to stock market emotions. This spot market price volatility is in contrast to the appraisal of privately owned assets that may be performed as infrequently as once a year, may never trade, or for which there are very few comparables.
Therefore, private market value appears to be much more stable than a publicly traded counterpart. In addition, while appraisals tend to be more rearward looking, making few if any assumptions about the future investment environment, the stock market appraises and discounts future rather than current or historical fundamental trends.
Second, public markets value assets and securities in relation to all other available assets and securities (such as growth, technology, consumer, energy), thus making relative valuations all the more important. In the stock market, REITs compete for capital with all other traded asset classes, with capital flowing to the most undervalued.
In the direct real estate market, the constituency is much narrower, confined to buyers and sellers of property—real estate investors. Therefore, REIT stock valuations may appear to be different from those in the private market. As we will discuss later, there has been a major change in this premise due to private equity's influence on both private and public market pricing.
Because real estate is one of the most capital-intensive industries, interest rates, or the cost of money, are believed to be a critical factor in the valuation of both public and private real estate. Many investors believe that REITs are interest-rate sensitive, and that the prevailing level of interest rates is the single most important determinant of stock market pricing.
Long-term studies have shown this not to be the case. In fact, the circumstances under which interest rates rise are often the same circumstances in which real estate thrives as an asset class. Importantly, one cannot believe that REITs are interest-rate sensitive, but direct real estate is not. So, to the extent that interest rates exert any influence on REIT pricing, they must influence private market pricing as well.
More important than interest rates are credit conditions, or the availability of money. Since much real estate is purchased using debt, the unwillingness of lenders to provide financing may reduce asset values. The recent decline in REIT stock prices in the US and Europe are a reflection of current and prospective tightening credit conditions (consider that during this decline, interest rates were little changed).
Private equity investors have traditionally employed a higher degree of financial leverage than public companies, apparently willing to assume greater risk than their public counterparts. The low interest-rate environment enjoyed worldwide and the plentiful credit extended by financial institutions has enabled these market players to outbid public companies for property acquisitions and actually acquire entire companies. While it remains to be seen whether tighter credit conditions will impact private market pricing, we believe that it is only a matter of time until it does.
To invest in publicly-traded real estate companies with confidence, one must trust that the stock market will accurately value the assets of that company. We believe that market efficiency is one of the most important elements and positive features of investing in REITs.
Compare the private appraisal of an asset made by a single appraiser using limited and often non-market information, to the appraisal of publicly traded companies that are followed by armies of analysts and priced daily by millions of investors. It would certainly appear that the more efficient market most likely exists in the public realm.
The privatisation of REITs over the past two years has vastly improved the efficiency of markets. Companies trading at market prices that are materially below their net asset values are finding that gap narrowed or eliminated as private equity firms and other investors bid up stock prices or buy whole companies. Privatisation of public companies in the US over the past three years alone has removed nearly $200bn of enterprise value from the market. We believe that today's NAV discounts are unlikely to persist, and represent ongoing investment opportunities.
Properly estimating the value of a REIT requires consideration of the potential value of the company's value-added platform in addition to the value of its assets. Many companies today have a pipeline of development projects that, when completed, most likely will add cash flow and asset value that accrue to the benefit of shareholders. Better management teams should be able to actively manage a portfolio by trading properties to improve shareholder returns.
Furthermore, active financial management is a critical function of a public company that can also add enormous value. Access to the public market to finance its portfolio activities often results in plentiful equity and debt availability at lower cost.
While it may be difficult to place a finite monetary value on the platform itself, the market values management's ability to increase a portfolio's value as a whole and to improve earnings growth and increase shareholder distributions. This was indeed a factor in several recent private equity acquisitions of REITs, in which the acquirer was attracted to the company because it believed in its management's ability to add just as much value privately as it did as a public company.
When valuing REITs, the company's growth rate is a critical factor. This includes the inherent growth rate of the company's existing property portfolio as well as any enhancement that the management platform can provide. In short, a well-managed REIT can enjoy profit and asset value increases at a rate that is greater than any single property or portfolio. It is for this reason that some REITs trade at premiums to their NAVs; that premium is justified by their superior growth rates.
A crucial feature of the REIT vehicle is the disclosure of company and property information, or the transparency that it provides investors. Whereas a private investment in property assets may allow for total transparency, this has not always been the case for public real estate, and could be one reason that some pension funds approached REITs with caution.
An important change over the past decade has been the improvement in disclosure and reporting standards that have become commonplace. Indeed, this has been demanded by the marketplace. As a result, much of the mystery has been taken out of the public market by improved disclosure, regular investor briefings and the scrutiny by the teams of analysts and investors that continually illuminate new information.
While this improvement in transparency began in the US, standards of disclosure and other management practices are being widely adopted in Europe and Asia. It is our expectation that within a few years the level of transparency will be relatively equal around the world. REIT rules around the globe require companies to maintain standards of corporate governance that ensure proper representation of shareholder interests and management accountability. This too is improving pension fund confidence in the REIT vehicle.
Many institutional investors in the past have argued that merely owning shares of a company does not give them control of the outcome of their investment. In contrast, owning the physical asset gives investors, if they so desire, complete control over decision making, from leasing to disposition. Selling an asset is a costly, time-consuming affair and one whose outcome often can be delayed due to market conditions or unrealistic expectations.
It is now becoming understood that control of exposure to an asset class may be better achieved by owning its publicly traded shares. These shares can be purchased, sold, added to, margined, optioned or combined with a host of other strategies that can be employed with respect to ownership of those shares. In short, investors sacrifice very little, if any, control by owning real estate via a REIT portfolio.
REITs deliver the same desirable investment characteristics as private real estate, with the added features of liquidity and corporate governance. The public and private markets have become closely intertwined—a linkage that we believe is permanent, and that is strengthening around the world. The public/private arbitrage is no different from that which exists in every other industry. It is also a reason that institutional investors can invest with confidence in the REIT industry.
