The US real estate investment trust (REIT) sector has been flying high for several years, but began to show signs of a slow-down in the two months leading up to the celebration of its 45th birthday at end-September.
With a modest beginning back in the 1960s, the US REIT market has grown from a little known sub-sector of the securities market to become a key component in the portfolios of institutional and individual investors.
According to Washington-based NAREIT (National Association of Real Estate Investment Trusts), REITs currently own more than 24,000 commercial properties in the US. And their combined assets of $475bn (e394bn) represent up to 20% of all investment-grade properties in the country. As of October 1, the 196 REITs that make up the NAREIT index had equity market capitalisation of $331bn.
NAREIT chairman David Simon said: “During the past 45 years, our industry has experienced tremendous growth, generated exceptional long-term performance, gained acceptance by the investment community and financial press, and demonstrated that it belongs in every investor’s diversified portfolio.” Mr Simon heads Indiana-based regional mall REIT Simon Property Group.
Over the last five years, REITs have outperformed the broader equity market, outpacing the S&P 500, the Nasdaq and the Dow Jones Industrial Average. In the last three years, the S&P REIT Index has risen 63%, against 43% for the S&P 1500 Financials Index and 50% for the S&P 1500 Index.
The factors behind the buoyancy of REITs include the continued rise in prices of the property owned
by REIT-structured companies, the previous undervaluing of REIT stocks when investors were crazy about high-tech and media stocks, the continued economic rebound after September 11 and the accompanying rise in demand for office, retail and industrial properties.
Another measure of REITs’ recent robustness has been the more than 9% growth of the sector’s funds from operations (FFO) - net earnings minus depreciation, amortisation and property sales’ gains and losses - in 2004, and the expected 8% growth in FFO in 2005 and 2006.
On the whole, investors have swarmed to REITs because of their good dividends. By law, REITs maintain their trust status and corporate tax exemption by distributing 90% of earnings as dividends. Yields for the sector were 4.97% at end-2004, 5.75% at end-2003 and 7.32% at the end of 2002.
However, REIT stocks suffered in August and September amid rising short-term interest rates and rising speculation over the bursting of the real estate bubble. The NAREIT composite index was up only 4.7% for 2005 through September, after posting rises of 30.41% in 2004 and 38.47% in 2003.
Investors heard more bad news in October when US mortgage insurer PMI issued its US market risk index, showing that real estate prices in some large markets are poised for a sharp reduction. PMI sees the biggest risk of price correction in Boston, San Diego, Long Island, Santa Ana and Oakland.
Does this portend a continued slump in REITs? Analysts and asset managers do not show a clear consensus on the question. Robert Sweet of Dow Jones Forecasts said in a recent column in Forbes that “REITs look risky”. He questioned the total-return potential of REITs and said stocks looked expensive. However, he countered that REITs still provide investors with a way to diversify portfolios, and recommended a REIT exposure of 5% to 10% of their overall portfolio.
KeyBanc analyst Richard Moore said in a note recently that the recent correction in REIT shares has been “much sharper than that of the other major indices”, and actually presents a buying opportunity to investors. The REIT market remains fundamentally healthy, he said, naming six office, mall and apartment REITs that were hit exceptionally hard during the pullback and now offer “compelling value”.
Don Cassidy, senior research analyst at Lipper Inc, acknowledges that REIT stocks are no longer the bargains they once were, but he dismisses “all this talk of bubbles”. Housing my be overpriced in certain local markets, “but that’s not the stuff that REITs deal in. They don’t buy the homes of the rich and famous.”
The recent rise in US mortgage rates is actually “a plus for apartment REITs,” he said, noting that potential first-time buyers of homes are now having to stay in their apartments.
Mr Cassidy and other analysts note that many commercial property owners refinanced their debt during the long period of record low interest rates in the US, and locked in those low rates for the long term.
Not all asset managers are as fired up about apartment REITs. Samuel Lieber, chief executive of New York-based Alpine Management and Research, says that “a lot of people like apartments right now, but we’re not so sure”. He said that the rosiness of the apartment sector will largely be limited to the east and west coasts of the country. Alpine’s two real estate equity funds currently have exposures in the apartment sector of 2% and 10%.
According to Mr Lieber: “Regardless of the REIT class under discussion, the fundamental issue is: where is the population growth?” In the US, this is the so-called “Sun Belt” states of the west and southwest.
Like the apartment sector, Mr Lieber believes the
hot markets for office REITs are likely to be limited to the coasts, particularly Los Angeles, New York and Washington.
He said the sector is being hurt by vacancy rates of 15% and lease structures that feature long contracts.
Of the near- and long-term outlooks that S&P has
for each of the eight REIT sectors, only its near-term outlook for office REITs is negative; all the rest are stable.
Alpine Management & Research remains “generally positive” about the retail sector, where it expects
gradual growth over the next few years. While there is a risk that consumer demand could soften and hurt shares of big mall REITs, there is “always a queue”
of quality retailers waiting to get in a new mall, said Mr Lieber.
Another sector that Alpine likes is hotel REITs. In the wake of September 11 and the severe fall-off in travel worldwide, hotels did not expand. But with less than 1% growth in supply, occupancy rates for hotels have rebounded.
US REITs are also keen to expand overseas, particularly as the UK and Germany are about to create their own REIT markets. One company that is ahead of the curve is ProLogis, now a global provider of warehousing and distribution facilities. With the help of international expansion, ProLogis has grown from $475m in assets at the time of its 1994 initial public offering to nearly $17bn today. The group entered China last year.
For its part, NAREIT intends to promote growth of the REIT structure outside the US market. NAREIT president and chief executive Steven Wechsler says the association will work for REIT expansion abroad in conjunction with the European Public Real Estate Association and the Asian Public Real Estate Association.

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