Research indicates that US real estate investment trusts are corporate animals. By Helen Arnold.
US REIT performance in 1997 is well on its way to another year of high returns. Some industry analysts are predicting the NAREIT Index of REIT performance could achieve returns exceeding 20%, although they note that it will probably not match last year’s historic high of 35.7%. By comparison, direct equity real estate returns as measured by the NCREIF index appeared lack lustre at 9.6% for 1996, and stock market returns measured by the S&P 500 were an excellent 23%.
This disparity in performance fuels a continued debate in the US direct equity real estate community about the degree to which REIT investment performance is related to securities or to the direct equity real estate investment. However, REIT investment advisors (many of whom have been in the business for decades) and REIT industry analysts at securities firms are emphatic that REITs have to be analysed as securities. Investors have to learn to understand the different concepts of analysis and accounting required to adapt a real estate oriented revenue stream to the stock market pricing system.
REIT experts emphasise that REITs must be viewed as companies with dynamic growth characteristics, not as a collection of real estate assets to be valued separately – which one expert called “a mortician’s view”. The bulk of REIT revenues must come from the rents for income-producing properties. Now, not only are REITs actively trading their properties and going into property management and development for fees, but their ingenious managers are pushing REITs into new activities. Joseph Harvey, head of investment research at Cohen & Steers Capital Management, notes that increasingly “the portfolio is viewed as the conduit to business, tenants and customers.” REITs are making forays into providing venture capital, utilities, telephone and cable, offices services, shipping and credit activities.
This emphasis on the “corporate” characteristics of REITs is reinforced by academic and real estate industry investment research. REIT total return performance measured by the NAREIT index is more highly correlated with the stock market performance indices than with the direct real estate investment index, although in the last three years, REIT correlations have crept slightly closer to direct equity investment.
Because REITs are sold on the major stock exchanges, they are considered to be part of the “public” market in the US, in which pricing is set by an open auction, trading occurs minute by minute, and the pricing is known instantaneously to all. The “private” market is one where property is sold through agents; the sales are confidential, and comparable sales occur with long time stretches in between. On pricing disparities, research results show that REIT share prices, analysed through the market capitalisation component of the NAREIT index, lead the private market by one or two years. If this relationship continues to apply, it would argue a strong leap in US real estate prices in 1997 and 1998.
The impact of the public market auction structure on pricing trends for REITs and direct equity real estate has also been examined by the US investment research community.
Michael Giliberto, managing director at Lehman Brothers, developed an innovative way to simulate the pricing trends that would have ensued in the last two decades if the revenue stream and properties in the NCREIF index portfolio of direct property investments were converted into shares and sold on the stock exchanges.
If the NCREIF properties were sold through the stock market mechanism, their pricing would have been much more volatile with higher upside returns and lower downside returns, and the synchronicity with the REIT return trends would have been greater. Ken Cambell of CRA Real Estate Securities notes that a property placed in a REIT has a 20% premium added on to its value, due to the benefits of ready access to the capital markets, low cost of capital, and the benefits of liquidity.
REIT pricing involves concepts different from those to which US direct real estate investors are accustomed, or indeed, the concepts used by quoted property companies in the UK. An appraisal professional examining a typical property in the NCREIF index of direct equity investment performance will calculate net operating income over a 10-year period, using actual income and expenses according to the current lease structure, probable rental growth when leases roll over, probable increases in operating expenses, etc, and will apply a market capitalisation rate to estimate the property price if it were sold. There is considerable controversy about the usefulness of this ten year projection, given market and economic uncertainties in such a time frame.
In the UK, the process used to calculate property values for buildings in a quoted company portfolio divides the estimated rental value (ERV) for an individual property by the appraisal-based investment yield. This assumes the building is leased at current market rent, which often it is not, and this methodology is often criticised. These individual property valuations build up to an estimate of total asset value for the company. In both the US direct equity appraisal process above and the UK process there may be a dearth of comparable sales within a suitable time frame from which to derive the market capitalisation rate or yield.
By contrast, REIT investment advisors have proprietary models for REIT analysis, typically with short time horizons and they know to the day where the REIT share prices are because of the stock exchange trades occurring.
The revenue stream from all activities is calculated for the present, and forecast for the short-term future. This does not involve real estate appraisal methodology applying a derived market capitalisation rate to that revenue stream to attain a dollar per square foot “hypothetical” price of each building.
The market price of the whole REIT is the number of shares outstanding multiplied times the dollar price per share. Today, revenue streams and market pricing are being estimated through 2000 or 2001. Actual revenues for 1998 are known with a very high degree of accuracy and estimating revenue for an additional few years is more “forecastable” than predicting a 10-year revenue stream. Industry analysts say that this approach, combined with the immediate knowledge of REIT prices, increases the probability that an investor would achieve his expected return on a REIT share purchase.
Some key terms in understanding REIT analysis are funds from operations (FFO), cash available for distribution (CAD), and earnings before interest, taxes and depreciation (EBITDA). In the last two years FFO has taken precedence as REITs have worked at standardising their accounting practices, although all three measures, plus others, are scrutinized by REIT analysts. FFO is the net income from all REIT activities, excluding gains or losses from debt restructuring and sales of property, plus depreciation of real property, and after adjustments for unconsolidated investments in which the REIT holds an interest. Essentially, it is the revenue stream described above, and FFO growth is one of the important characteristics to look at in a REIT.
Another important concept is FFO multiple, which is the market value of the any REIT divided by the FFO. For example, an apartment REIT might have an equity market value of $900,000 and an FFO of $85,700, giving a multiple of 10.5. Currently, these multiples usually range between 8 and 12. The higher the multiple, the more optimistic the market is about the REIT’s growth potential and/or security of revenue stream.
But to analyse a REIT properly, the interrelationships of debt and equity, growth characteristics and revenue must also be examined in detail. NAREIT’s own white paper on FFO emphasises that it is not intended to be used as a measure of cash generated by a REIT, nor of its dividend-paying capacity.
Many US real estate analysts believe that the current success of REITs is part of a larger capital restructuring that will change the US real estate industry forever. The low cost of capital is critical; economies of scale exist in raising REIT capital, while the high liquidity of the vehicle reduces certain kinds of investor risk, and both debt and equity can be used more creatively. The debt component of REITs ranges from 20% to 50% of market capitalisation. Certainly the low cost of capital gives REITs an advantage in the acquisitions market, and all the signs are that the investment vehicle will continue to expand, both in number and in the size of the individual REITs.
REIT detractors are sceptical about the expectations for future revenue growth, which they say can only be sustained by continued acquisitions at prices under replacement cost. Should the cost of capital increase, and should rental growth not achieve expectations, the sceptics look to price declines and other upheavals in the REIT market.
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The REITs universe Neither REITs or the NCREIF index look at more than a very small slice of the immense US real estate market – estimated to have a total value of $1.2 trillion. By comparison, the most recent estimate of the REIT market capitalisation was $93.5bn for the 198 publicly quoted ones as of the first quarter of 1997. This is almost twice the size of the $53bn worth of real estate tracked in the direct market index, NCREIF. But REITs do provide the investor with more of a representative slice of America. Their properties tend to be much smaller than those included in the index which tracks direct real estate – they are half the size on average, and located in the smaller cities scattered throughout the US. These holdings are more representative of the average structures built during the US property boom of the 1980s Today, the very largest REITs have a market value of over $1bn, and good-sized REITs exceed $500m. Share prices tend to cluster in the $20 – $30 per share range, although the spectrum is as wide as $7 to $50. Much of 1996’s leap in the NAREIT index came from rapid share price increases during the last part of the year. The dividend yield for the year averaged 6.22%, which is fairly close to the historic income yield component of the NCREIF index, which measures the returns to direct property investment. According to Dan Fletcher, senior REITs analyst at Lehman Brothers, many investors saw REITs as a “defensive play” in the volatile stock market: they were providing good dividend yields, which seemed based on a highly forecastable revenue flow. Ken Campbell, head of CRA Real Estate Securities, notes that “earnings realised exceeded estimates by 20%” and this provided a strong lure to investors at the turn of the year. Improved earnings in the hotel and office REITs contributed strongly, echoing the behaviour of the wider hotel and office market in the US. |
