Many bankers, service providers, and investors have been enjoying the recent resurgence in the REIT market, but as the saying goes, "all good things must end" or at least slow down. * The REIT industry continues to evolve through a maturation process that provides industry watchers with only one sure bet -- expect more change.
After two years of unprecedented growth, the industry hit the proverbial brick wall at the beginning of the fourth quarter. 1994. Most of the theories for why this happened place the blame on rising interest rates. But it's a bit more complicated than that.
A market slowdown had started as early as the third quarter. 1994, when we saw that:
* Few new equity offering were completed. Those that were in process were being postponed or pulled indefinitely.
* Few secondary offerings were completed. Similar to the initial public offerings (IPOs), many that were in process were either pulled or significantly scaled back.
* REIT stock prices declined 10 to 25 percent.
* Acquisition activity declined, primarily because many acquisitions became dilutive in relation to the stock price.
What caused the wall?
* Interest rate increases created alternative investment opportunities that diverted capital from the IPOs and secondaries, and caused selling pressure for the public stock prices. The increases in interest rates in 1994 gradually eroded the difference between the REIT dividend yields and the return on risk-free investments. As this occurred, a significant amount of capital left the REIT market and was placed into alternative investments.
* Withdrawal of mutual fund investments caused selling pressure for the public stocks and, in turn, pushed public REIT stock prices down. The withdrawal was due to the interest rate increases, but the poor performance of the mutual funds holding REIT shares was a factor to some extent. This theory is supported by the decrease in institutional holders of REIT stocks during the fourth quarter, 1994.
* Lack of retail support of REIT stocks also caused downward pressure on stock prices. REIT stocks needed solid retail support to maintain stock prices. This support, albeit growing, is not yet able to sustain a stock price. As retail investors become more sophisticated, they will serve as more of a stabilizing factor.
The REIT market appears to be very cautious about 1995 and beyond. Judging from the economic conditions and market activity of early 1995, the following predictions could apply to the next 12 to 18 months:
* Capital markets will continue to slow through mid- 1995. This slowdown could continue beyond this time frame if we have more than a 100 basis point increase in interest rates during the first three quarters. The one product that may see capital market activity in 1995 is self storage REITs. Similar to the apartment market, self storage is largely a mom-and-pop business with low capital cost requirements. which lends itself nicely to the REIT structure. Industrial REITs also will be active in the next wave. Apartment and retail sectors, on the other hand, will have few new IPOs as most "REITable" portfolios already have been taken public.
* As the capital markets slow, the REIT lines of credit will be absorbed, causing a need for either permanent debt financing or the obtainment of other sources of capital. Accordingly, secured debt financing (securitization) will become an even more significant financing vehicle for REITs in the future.
* Although there are a small number of office REITs, the uncertainty of lease roll overs and high capital costs reduce the likelihood of office REITs coming to market.
* Mergers and acquisitions will increase with Wall Street playing marriage broker to the REITs that they recently brought public.
* U.S. and foreign pension funds (especially U.K., Dutch, and German) will begin investing in REITs as these institutions have only recently allocated money for real estate investments--both directly and for the purchase of REIT shares.
* The biggest question mark for 1995 is: Will the institutions be buyers or sellers? In 1993, institutions bought 50 to 70 percent of a REIT issue. After June, 1994, they began selling. The institutions will return to the REIT market in 1995 only if alternative investments have lower yields than REITs. If REIT and alternative investment yields are comparable. REITs could lose for two reasons:
1 There is a risk premium associated with REIT investment; and
2 Gains through appreciation are no longer part of the REIT equation.
The Silver Lining
The REIT market is reaching a point of greater sophistication and investors are becoming more selective. At the same time, the consolidation in the REIT industry should be mutually beneficial to the market and REIT companies because it provides a better basis for investment. These mergers could eventually allow companies to procure better credit ratings while concurrently producing new avenues of capital, independent of interest rates. The restructuring of REIT companies can only secure and stabilize their future.
"There's no question there will be consolidation over the next five years, but we're not going to see an explosion of M&A activity," says Mark Decker, president of the National Association of Real Estate Investment Trusts. He believes investors have a new comfort level with REITs and that there is ample investor interest to support at least four or five good quality IPOs this year.
Clinton D. McDonnough is a member of the E&Y Kenneth Leventhal Real Estate Group, Dallas, TX, (214) 969-8801.