In the past half century, real estate investment trusts (REITs) have transformed the commercial real estate industry. They’ve matured from simple investment funds into sophisticated property owners and managers while taking transparency to new heights for investors. A financial powerhouse with a total market capitalization of more than $300 billion, U.S. REITs own as much as 15% of all institutional-quality commercial real estate in major markets.
In the midst of one of the deepest financial crises in the post-World War II era, they have managed to raise more than $27 billion in debt and equity capital in the U.S. in 2010 alone. That kind of firepower has propelled commercial real estate into the financial big leagues, and REITs are poised to lead transactional activity as the economy continues its slow recovery.
As the U.S. REIT industry celebrates 50 years of triumphs and challenges, the rest of the world is following its lead. “Over the last decade, 30 countries around the world have adopted REIT laws,” says Steven Wechsler, president of the National Association of Real Estate Investment Trusts (NAREIT), which was founded the day after the initial REIT law was signed. “They are emulating our policies.”
The legacy
When President Dwight Eisenhower signed the Real Estate Investment Trust Act into law on Sept. 14, 1960, his intention was to give individual investors the opportunity to own a piece of the commercial real estate industry through stock-based companies. In return they would receive a steady, consistent dividend.
Over the past 50 years, REITs themselves have seen some pretty dramatic changes. “In their basic DNA they’re the same, but 50 years is a lot of evolution,” says Adam Markman, managing director at Green Street Advisors, an independent research and consulting firm specializing in publicly traded real estate companies.
One of the greatest tests of the REIT industry’s evolution has been the recent financial crisis. For example, by early March 2009, the Dow Jones REIT index had plunged 76% from its high in February 2007.
“The REITs did make it through,” says Christopher Lucas, managing director and senior REIT analyst with investment firm Robert W. Baird & Co. “Through access to the capital markets they’ve been able to raise gobs of capital at much lower cost. Getting through that tough time frame was a great and critical test for the industry.”
That access allowed REITs to raise more than $40 billion in equity and debt offerings in 2009, an avenue that was not available to their private-company brethren.
The early days
Like many investors in the 1960s, Ralph Block was searching for companies with a conservative mind-set but which produced consistent, reliable returns. He fell in love with REITs and has been a self-described “REIT nut” ever since. Thanks to some early backing from NAREIT, Block turned author with the book The Essential REIT, first published in 1997 and soon to appear in a fourth revised edition under the title Investing in REITs.
The early REITs were more akin to mutual funds than the recognized operating companies they have become today, says Block. Their portfolios included a diversified mix of commercial real estate assets, with no particular focus on a property sector or geographic area.
“There was no coherent business strategy. They farmed out all of their property management and leasing,” says Block of the early REITs. “They maybe had a corporate headquarters with three people in it.”
Only two of the original REITs founded in 1960 — Washington Real Estate Investment Trust and Pennsylvania Real Estate Investment Trust — are still around today (see sidebar).
For much of the 1960s, REITs gained little attention from investors or Wall Street. But in the late 1960s, Wall Street began to steer new REIT initial public offerings into the mortgage arena.
By the early 1970s, REITs accounted for the bulk of the mortgage capital that fueled the building boom. But during the mid-1970s economic recession, an estimated $20 billion to $40 billion in mortgage REIT equity was lost, which painted all REITs with a black stain.
A seminal event
That very checkered past played to their advantage after the 1980s building boom and crash, as REITs were left largely on the sidelines when it came to the development game. Instead, thanks to Uncle Sam, REITs were about to explode in popularity with the dawn of the 1990s.
Congress passed the Tax Reform Act of 1986 largely to close tax loopholes and curtail abusive tax-advantaged limited partnership investments. The act was the seminal event, the turning point, for the industry. Congress recognized the viability of the REIT model, and granted REITs the ability to manage and lease their own properties, something that was not part of the original REIT Act in 1960.
“On a long-term basis the act put the entire industry on a far more economic footing where the focus is increasingly on income and capital appreciation,” says Wechsler. “The internalization of management for listed REITs provided the boost in investor confidence that at the time was necessary to create critical mass for the industry.”
Unfortunately, the act also helped trigger a severe economic recession that put all commercial real estate firms on shaky footing heading into the 1990s.
Kimco goes public
By most accounts, the birth of the modern REIT era began with the initial public offering (IPO) of Kimco Realty Corp. in 1991, led by CEO Milton Cooper. The shopping center owner/operator went public out of necessity because, like a lot of real estate firms in the early 1990s, it was financially strapped.
“It was another of those credit crunch times when commercial real estate owners couldn’t buy a loan anywhere,” says Block. “A lot of these real estate organizations really needed to re-equitize because they’d gotten extended and the property markets were weak. Some sold out, some of them got foreclosed. But there were a lot of pretty good organizations that decided they would go public, solve their problems and expand their sources of capital.”
The Kimco move started a wave of REIT IPOs, with eight firms going public in 1991, raising more than $800 million. That led to the true watershed year of 1993 when 75 REITs went public, raising more than $11 billion.
Investors suddenly had more choices than ever before in terms of selecting stocks in real estate operating companies, which were more focused on a single property type than on disparate assets.
“Before then, any serious investor who wanted to own shares of a public company couldn’t really buy malls or office buildings. There weren’t really a lot of choices, but they brought scale to the table,” says Block.
Revolution in disclosure
Thanks to Wall Street and a wave of IPOs, modern REITs have not only provided liquidity to the commercial real estate industry, they have also upped the level of sophistication of financial reporting.
“We think that the amount of information you can pull out of these publicly traded companies is helpful for the whole industry,” says Markman of Green Street Advisors.
Block agrees. “There has been an absolute revolution in disclosure and that’s true for most public companies. There is a lot more information available about not only the company, but also the properties.”
Of course, all of that information creates challenges as well. “One of the issues for investors is how deeply do they want to drill into how each specific property is performing. Sometimes you can see the trees but not the forest,” says Block.
Despite the peaks and valleys that have marked the industry’s 50 years, REITs have outperformed all of the major stock indices since NAREIT started maintaining performance records in 1972.
“They have done that by providing investors with measurable performance that is largely reliant on the dividend on the current income, and that is the anchor for the return,” says Wechsler.
As of August 2010, the average dividend yield for publicly traded REITs was 4.66%. “If there is a secret sauce in the REIT formula it is the dividend,” emphasizes Wechsler.
While REITs account for only a small percentage of the total commercial real estate market, they control a large percentage of institutional-quality assets. As such, REITs act as bellwethers for the entire commercial real estate industry.
“They are at the forefront of where trends in commercial real estate are headed and that wasn’t the case some years ago,” according to Block. “Anybody who was into private commercial real estate and was holding out for 10% capitalization rates in the spring of 2009 should have been paying attention to the REIT industry. REIT prices bottomed out in March 2009 and anticipated, when nobody else was talking about it, that prices were going to be firming up.”
The road ahead
One of the biggest challenges facing the REIT industry is attracting more investment from institutions, including pension funds that spend billions of dollars on direct investments in commercial real estate properties.
Another daunting challenge is the continuing specter of federal intervention through legislation. “How national tax policy may be reshaped, revised or refashioned, we’ll be part of that conversation when it comes,” says Wechsler.
The greatest challenge facing REITs is delivering consistent earnings and dividends to investors. Their track record in recent years been spotty at best. Many REITs were forced to cut their dividend during the most recent financial crisis.
Mall owner CBL & Associates, for example, cut its quarterly dividend three times from mid-2008 to early 2009, to 5 cents a share, from a high of 55 cents.
“That was a significant hit to the individual investor’s trust in the vehicle and in the operations, and it’s going to take some time to earn that trust back,” says Lucas, the REIT analyst with Robert W. Baird.
“Now they have to rebuild the trust that investors placed in them to manage their balance sheet and their dividend much more consistently.”
Ben Johnson is a Dallas-based writer.
Survivors thrive as local sharpshooters
Only two real estate investment trusts (REITs) still exist from the original 1960s vintage, and both have stuck firmly to a well-defined geographic focus that has served them well. Their longevity is proof that real estate is still a local business.
As the name implies, Washington Real Estate Investment Trust (NYSE: WRE) owns and manages a portfolio of office, industrial and retail properties in the Washington, D.C. area. Through its initial public offering in 1961, the company raised $3 million, and its first purchase was an 87-unit apartment property for $900,000.
Today, the market capitalization of Rockville, Md.-based Washington Real Estate Investment Trust (WRIT) is approximately $3 billion, or 1,000 times the original IPO. “To me that says how the REIT industry has grown,” says CEO George “Skip” McKenzie.
One of the company’s claims to fame is that it has never cut its dividend. “Unlike most of the other peer REITs who have a geographic diversity and property focus, ours is really the flip side of that,” says McKenzie.
“We have a property type diversification strategy and a geographic focus in what we think is the best market in the country,” continues McKenzie. “When you’re the only REIT that’s paid a dividend for 48 years, it’s actually a fairly easy story to sell.” WRIT currently pays a dividend of 43 cents a share.
While the majority of larger REITs have a high concentration of institutional shareholders — in many cases above 90% — in the case of WRIT, individual investors own about 35% of the shares. That appears to be almost a throwback to the original idea behind creating REITs in the first place.
“We think that helps insulate the stock price because retail shareholders tend to stay with the stock. If you’re true to them with your dividend, they tend to stay true to you,” says McKenzie. WRIT’s stock closed at $32.04 on September 20, up 12.5% over a year ago.
Virtually unrecognizable
Another of the original REITs, Pennsylvania Real Estate Investment Trust (PREIT), also has maintained its geographic focus on the East Coast, but the company is virtually unrecognizable from its early beginnings.
Company founder Sylvan Cohen, a lawyer, built the firm to handle financing for his developer clients. “PREIT was really a financial intermediary for active developers,” notes Edward Glickman, president and chief operating officer of Philadelphia-based PREIT (NYSE: PEI).
Thanks to several mergers, including one with office developer The Rubin Organization in 1987 and another with mall owner Crown American in 2003, the company went through major strategic shifts, finally settling on its present-day retail property focus.
“We are an opportunistic retail real estate company,” says Glickman. “We are a company that appreciates the power of knowledge of your geography, and the kinds of mistakes you can make if you don’t understand your geography.” PREIT stock closed at $12.55 on September 20, up 31% from a year ago.
Industry analysts tend to agree that the local strategy works for WRIT and PREIT.
“There’s something about being a local sharpshooter that allows you to see the storm a bit sooner and then likely weather it more successfully,” says Adam Markman, managing director at Green Street Advisors, an independent research firm specializing in publicly traded real estate companies.
The impact that Washington Real Estate Investment Trust and Pennsylvania Real Estate Investment Trust have had on the REIT industry can’t be overstated, says Glickman, despite the modest size of their portfolios. “They are companies that have weathered a lot of different business cycles, who never missed a dividend over 50 years. It’s just part of the way we think about the world, part of the discipline of being a REIT.”
—Ben Johnson
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