By Robert Lehman, Global Leader of REIT Services, Ernst & Young
Looking at the public equity REIT market in the U.S. today, you would be hard put to tell that in 2008 — at the height of the global recession and financial crisis — the market had crashed, and some market analysts questioned whether it could survive.
The market gradually recovered over the 2009–10 period, and in 2011, it returned to robust growth. The total returns of public equity REITs increased more than 8 percent in 2011, compared with about a 2 percent gain for the S&P 500. REITs raised a record $37.5 billion of equity last year — the most since the $32.7 billion of 1997
Total market capitalization increased to $632 billion, the highest since 2006, when it reached $412 billion. REITs continued to reduce their debt. As of September 2011, the listed U.S. REIT industry’s ratio of debt divided by total
market capitalization stood at 41.6 percent, approximately its historical average.
U.S. REITs continued to outperform the broader equity market through the first seven months of 2012. According to the National Association of Real Estate Investment Trusts, the FTSE NAREIT All Equity REITs index was up 13.72 percent through July, compared with the S&P’s gain of 9.13 percent. Led by retail, most sectors of the U.S. REIT market delivered double-digit gains through July 2012
Of 140 REITs tracked by SNL Financial, about one-third raised their dividends in 2011, compared with 17 percent the previous year. Commercial property markets are continuing to improve, although the recovery has been uneven. Occupancies and rents generally are rising in the strongest markets, and REITs’ property cash flows are increasing. Even so, it’s uncertain whether as many REITs will raise dividends in 2012 as in 2011. Some may elect to take capital that would have gone into higher dividend payments for investment in property improvement acquisitions.
Despite their strong performance in 2011, REITs did not launch as many IPOs as had been expected. Five equity REITs completed IPOs, raising about $1.8 billion, compared with nine IPOs in 2010 that raised about $2 billion. Japan’s tsunami and earthquake, the European debt crisis and other global events created turbulent stock market conditions worldwide, and some sponsors were hesitant about taking REITs public.
While fewer IPOs were launched in 2011, REITs raised a record US$37 billion in secondary offerings. This year, some market analysts say IPO activity could increase, among other reasons, because raising equity in the public market is less expensive than raising it privately, and REITs are offering relatively high yields that are attracting investors. Two
IPOs were completed in the first quarter, and, as of early April 2012, more than a dozen companies had filed. Empire State Realty Trust, a company that owns and manages retail properties, most famously the Empire State Building, filed in February 2012 for an IPO of up to US$1 billion. Some sponsors remain cautious about taking REITs public, as new REITs face challenges in demonstrating to REIT analysts that they are able to match the performance expectations of established REITs. As of the end of February 2012, only one of the REITs that completed IPOs in 2011 or 2010 had managed to outperform the SNL US REIT Equity Index on a total return basis. Seeking additional sources of capital, more REITs are raising equity in at-the-market, or ATM, transactions. ATMs enable REITs to access capital relatively
quickly and at lower costs than with IPOs; however, ATMs account for only a small slice of REITs’ capital-raising.
The growth of non-traditional REITs has continued to gain momentum, as companies look to achieve greater tax efficiency and value for their shareholders. Recently, companies that have successfully sought private letter rulings from the IRS to realign their operations as REITs have ranged from timber, health care, data storage, cell
tower operation and energy transmission businesses. While there may be limits to the IRS’ appetite for this trend, the market has responded favorably because of REITs’ ability to generate consistent yield and most that have successfully completed a reorganization have enjoyed a 20-35 percent bump in their stock prices.
From the organizational standpoint, however, the process of realigning as a REIT is long and highly involved. Recent cases have taken the better part of 18 months to determine whether the business is comprised of a sufficient amount of real property that can generate rental income and how to treat segments that are not.
The initial challenge is understanding how the IRS defines “real property” since this is not always intuitive, and unlike timber and cell towers, many asset types have not been ruled on. This is why most will not pursue REIT conversion without a private letter ruling. Then a company must plan how to delegate operations and restructure or spin off any substantial “bad income” producing portions of the business, which can be a costly process.
Given the efficiency of the structure, however, firms that effectively align their services within a REIT format enjoy a significant advantage over their non-REIT competitors from the cost of capital standpoint. Indeed, in rapidly growing sectors, like health care and data storage, there are now enough examples of successful REITs that the market is rewarding businesses for merely considering a conversion.
A challenge for public equity REITs is to make investment decisions and manage assets in an uncertain economic environment. Among other factors, high unemployment, a slow rate of hiring and high gasoline prices have raised concerns about the durability of the US economic recovery. Tenant demand for space is uneven, and the risks for REITs in investing in and owning properties vary considerably across geographic markets and property sectors. Demand is strongest for institutional-grade assets in metropolitan markets on both coasts and in some other cities and certain property sectors, such as multi-family. The office market has been recovering in fits and starts. In the second quarter of 2012, a rebound in sales of U.S. office properties turned into a decline. Sales of U.S. office buildings fell 10 percent from a year earlier to $14.8 billion, according to Real Capital Analytics.
Over the past few years, REITs have restructured their balance sheets, reduced their debt and raised fresh capital in the equity and debt markets, and they are well positioned to make property investments. Credit is more available — in the 2011 fourth quarter, banks increased commercial property lending for the first time in two years. The market for commercial mortgage-backed securities is recovering, helping to inject more liquidity into the commercial mortgage market. Among property sectors, the multi-family sector’s low vacancies and rising rents are attracting more multi-family investment from REITs and other investors. But competition to acquire properties is driving up prices, and multi-family construction has accelerated in some markets, raising concerns about overbuilding. Self-storage has been the strongest REIT sector: rising demand for storage space has far outpaced supply. REITs that own industrial and lodging properties or regional malls have been performing well based on recent earnings results. Some U.S. REITs are investing globally and others might follow.