Although real estate investment trusts are presently sailing in the stormy waters of the global credit markets, the global REIT market grew in 2007 against all key indices, including market capitalisation, trading volume, and total rates of return.
Worldwide, the sector’s capitalisation rose to $764bn compared to a total of $608bn for the previous year, according to accountant Ernst & Young. Asian markets were instrumental in this growth that, along with the inclusion of the new UK sector, has more than offset the contraction in the US REIT market.
Low interest rates have boosted average gearing from 34.24% to 40.29% in 2007. After this is taken into account, the amount of property owned by REITs globally is $1.273tr, says Ernst & Young.
In comparison, Asia’s REITs were strong performers, with stronger stock prices, total returns and dividend yields. Three of the top five countries by total return were Asian and the number of vehicles in the region rose more than in any other region.
Singapore’s attractive regulatory environment provided a platform for it to reach first place in E&Y’s rankings. And, despite South Korea’s relatively small market size, it achieved impressive stock prices and dividend yields.
The US REIT market segment was a loser. The country’s REITs performed poorly compared with their global peers, with lower returns that lagged behind other benchmark indices and yield-oriented investments, including the 10-year Treasury bond.
REIT numbers contracted markedly in North America last year as private equity deals took some REITs out of the listed markets in the US and Canada.
Ernst & Young says that the one-year total rate of return for the US REITs to June 2007 was 11.86%, the second-lowest across the 15 countries that the accountant studies. Three-year total rate of returns are higher, at an average of 16.09%, but this still represents the fourth-lowest of all REIT countries over the three years.
The US segment is still the world’s largest. It is trading at significant discount to net asset value and the bottom of the property market is proving hard to call.
“Experts here have given up predicting what will happen,” says Michael Frankel, E&Y’s global director of REITs. “Every time things look to have bottomed out, the bottom keeps going deeper.”
He warns that some companies may be relying too much on rental growth in the property market to provide some future comfort. “This might not happen and some REITs may have to adjust their viewpoints,” says Frankel.
The present credit squeeze is giving REITs some bad headaches. For example New York developer Macklowe Properties is having problems refinancing a $7bn portfolio of prime Manhattan skyscrapers it bought from Equity Office Properties in February 2007.
Macklowe Properties was served with a notice of default as talks with lenders to refinance the $7bn in debt on the deal stalled. The default set into motion a process that could lead to foreclosure by lenders Deutsche Bank and other senior debt holders. But junior debt holder Vornado Realty Trust opposed the foreclosure plan because VRT would be forced to write down its investment if the buildings were sold for less than their purchase price in the softening market.
“When they bought, Macklowe thought they could refinance easily in a year. And guess what? They can’t,” says Frankel. He predicts that eventually debt markets will settle down. “Some of the hysteria will disappear and we will get back to some fundamental underwriting in real estate lending, which in the past few years went out the window.”
Frankel is a veteran of property crashes. “Real estate prices don’t always go up. Since 1992 prices were going great guns but there will be some losses now as the whole notion of what asset values are is in flux. Those of us waiting for a workout period have been wondering just when it would happen,” he says.
Contraction in the sector will throw up opportunities for mergers and acquisition. Frankel says: “There are a couple of REITs that are buyout targets right now, either by management or outsiders. In some cases, there will be REIT-to-REIT consolidation.” The number of REITs listed in the US fell in 2007 to 169 from 253 in 2006.
Other trends will be REITs repositioning themselves by selling assets and using the proceeds to pay down debt or buy back stock. Pension funds, private equity and sovereign wealth funds will be buyers of their stabilised assets.
Also, many of the larger firms continue to branch out overseas as developing countries become more prosperous and so require more shopping centre development and logistics space to serve the retailers. Examples of these firms include Prologis and First Industrial Realty Trust.
The credit squeeze has hit the Asian REIT sector, which is trading at NAV discounts of up to 30-40%. Stuart Crow, head of capital markets Asia at property consultancy Jones Lang LaSalle, says: “This is because of a combination of a global stock market correction and the rising cost of debt, particularly for REITs that have a higher debt ratio.”
About financial liquidity
“It’s less about the direct property market and more about the financial liquidity in the markets. Economic fundamentals are strong and there is a big arbitrage between the direct and indirect property market. In Singapore REITs are trading at 6.5% and direct property at 4-4.5%.
Like in the US, Asia will be undergo a lot of consolidation in the REIT sector because it is relatively immature, says Crow. For example, in Singapore some will be taken private. Around 10 to 15 new REITs were planned for 2008 but, Crow says, many companies are standing on the sidelines at the moment.
“REITs are looking cheap now. A huge amount of capital is coming into Asia and chasing property as companies have boosted their global allocations to the region.”
But he says that investors looking to take advantage of a possible yield compression play in the higher leveraged markets such as Singapore and Japan will be disappointed and that it probably won’t happen. However, the region’s fundamentals are strong and rents are still rising owing to undersupply of suitable real estate. “We think that prices will hold firm for six months. Once the debt market gets moving again, prices might move up again,” says Crow.
Australia’s REIT sector is the second-largest market after the US market, and it is still growing. Over the 12 months to June 2007, the market capitalisation leapt from $77bn to $112bn, a 45.5% rise. Compulsory superannuation payments by employers of 9% of wages supports the large and growing REIT segment.
Their growth has also been boosted by a willingness for REITs to invest overseas. They have invested successfully in US real estate, mainly in commercial property more recently they have extended their reach to European markets, including the UK, as well as into Asia.
A big trend last year was a rise in IPOs of REITs on the Australian Stock Exchange that invest entirely in the Japanese office and retail property markets.
By borrowing in Japanese yen, REITs have taken advantage of the spread between interest rates in Japan compared to property yields. Gearing up in this fashion has supported REITs income returns compared to dividend yields in the Australian markets.
The volume of trade in the home market has also increased. The average REIT posted $1bn in trade in its stock in 2006 but this rose to US$1.6bn last year. In addition, yields rose from 6.5% to 7.05% over the same period – the second-highest jump globally in E&Y’s ranking.
However, the Australian property sector is not immune to global trends. Crow points out the mismatch in Australia between yields for direct property of 5-5.5%, while the same listed vehicles that hold the real estate are trading at 9% yields.
The UK is a newcomer to the REITs party. The vehicles certainly picked a bad time to arrive – they came into being at the top of the property market against a background of a strong all-share sector.
Real estate values, along with all equities, have fallen and many UK REITs are trading at up to 30-40% discount to NAV now.
Nine REITs were created at the start of last year, and over 2007 another eight joined them, including the first specialist company Local Shopping REIT. And Britain’s biggest REIT, Land Securities, is planning to demerge and specialise.
The total number of UK REITs is 17, with a combined market capitalisation of around £26bn, making the UK market the fourth-largest in the world after the US, Australia and France.
Despite many rumours of imminent conversions, corporate conversion activity has remained limited. Major retailers with big property portfolios opted not to convert. According to Jones Lang LaSalle, around five groups are making moves towards REIT status, including Rugby Estates and Terrace Hill Group.
JLL’s head of capital markets, England, Justin Stocks, comments: “I don’t see the sector being very acquisitive this year. Rather, there will be more property vendors that are preparing to reinvest later this year.”
But significant corporate activity could be about to commence. In February, the UK government confirmed that a buyer of a UK REIT would have a major tax advantage, clearing the way for REIT takeovers.
Any capital gains tax liabilities that were payable when a property company converted to a REIT will not be borne by a third party that takes the vehicle private.
In the past few months lack of clarity on this point acted as a major barrier to M&A activity within the sector, the value of which has almost halved since it was launched.
Charles Beer, real estate tax partner at accountant KPMG, says: “Anyone taking a REIT private will incur no hidden or inherent tax gains on the property, so no unrealised tax. This is hugely important, because buyers get the assets at current value. They can sell them without tax.”
REITs have spread to Italy. But late delays and tweaks plagued the advent of the first vehicle and some final changes have made it less attractive than it at first appeared. However, it is hoped that a new vehicle, called a SIIQ, will go live in April.
Italian Bank SanPaolo has applied to list the first REIT in Italy, a 471,500 m2, 285-building portfolio worth €1bn. The bank intends to retain a 49% stake in the REIT with the maximum permitted being 51%. According to the REIT regime introduced on 1 January, a REIT must be listed on a regulated Italian stock exchange and at least 35% of it must be held by shareholders with less than 1% stake.
Germany got its own REIT in March last year, introduced retroactively from January 2007, but the model has failed to take off. So far, Alstria remains the country’s only REIT. German property company IVG has amassed a €3.5bn portfolio and is ready to go live, but has pushed back its plans owing to poor market conditions. DIC is looking at converting REIT status too, but also does not seem to be in a rush. Some closed-end property fund managers are looking at REITs to give their vehicles a new lease of life.
Obstacles to a pan-European REIT
Last December, a coalition of property investors called for a pan-European REIT. But, although the idea is popular and has advantages, it will be difficult for all Europe’s countries to agree on the structure of such a vehicle. Land law would have to be harmonised and European lease and landlord and tenant legislation would need to be standardised before an EU REIT could be structured.
Among the 27 EU member states, only 13 have tax-transparent regimes. Nine of them have official REITs. Austria’s version is an open-ended structure under which funds do not have to pay corporate tax. Spain, Poland, Italy and Malta have REIT-like structures. Luxembourg’s version has beneficial corporate tax treatment and Finland’s is under development.
Presently, the uncertainty in capital markets is creating new prospects for the REIT sector. Global capital flows will shape its future landscape. Frankel says: “As capital becomes increasingly fluid, the money will move to the best opportunities -be they in the US, the UK or Australia. We will see more of this.”
