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Conservatism During The Expansion Is Paying Off For REITs So Far

For real estate investment trusts, falling share prices, dropping real estate values and shrinking rent payments may feel like deja vu to 2009. But with the scars from the Great Recession still fresh among executives, many experts say REITs are in better shape today to weather the downturn.

Conservatism During The Expansion Is Paying Off For REITs So Far
Empty streets and empty commercial buildings are wreaking havoc on REIT performance.

“[There's] one thing I think is very positive for REITs right now,” said Jay Bernstein, a chairman at law firm Clifford Chance specializing in REITs and specialty finance. "REITs have been very moderately leveraged compared to other real property owners."

Prior to this year, publicly traded REITs had been performing well. From 2010 to 2018, the total value of the FTSE Nareit all equity REITs index doubled in value to $16,595. Last year, the index broke beyond $21K, according to Nareit, giving investors an average return of 28%. In the first quarter of this year, REITs on average nearly wiped away all of 2019's gains.

REITs on average have a debt-to-asset ratio of 32%, down from 45% prior to the 2008 Great Recession, Hoya Capital Real Estate officials said in a March 12 report. REITs raised $109B in 2019, including $61B in long-term unsecured debt, according to Hoya Capital.

Many REITs, especially those with publicly traded shares, have taken on longer-term loans at better rates than in the past, giving them more of a buffer against short-term distress.

“Owing to the harsh lessons learned during the financial crisis, most REITs have been exceedingly conservative with their balance sheet and strategic decisions in the post-recession period,” Hoya Capital officials said in the report. "With the scars still visible enough to be daily reminders of more dismal times, REITs have been 'preparing for winter' for the last decade, perhaps to the frustration of yield-hungry investors that have turned to higher-leveraged and riskier alternatives in recent years."

Some REITs have fared worse than others. Retail REITs tracked by Nareit's composite index were down more than 51% so far this year, with regional mall REITs falling more than 60%. Hospitality was down more than 54%. But so far, market shocks have yet to prompt any sudden distresses among REITs.

“I personally haven't advised any REITs who are in serious jeopardy,” Stroock & Stroock & Levan partner Michelle Jewett said. "We're still kind of in the early stages, particularly for REITs in certain sectors."

The longer the downturn carries on, especially with vast shelter-in-place orders or even a potential second wave of the coronavirus later in the year, more REITs — especially those focused on retail and hospitality — could fall victim to distress.

Vert Asset Management CEO Sam Adams said private real estate companies could certainly be in the market to take REITs private at some point. Vert is a mutual fund that invests in REITs.

“The private guys have lots of dry powder and could use it to pick up assets at distressed valuations,” Adams said. “Blackstone took several REITs private last year, and if they find [net asset values] discounted to their liking, it's likely they'll do more of this.”

On an April 23 call with stock analysts, Blackstone executives indicated that they are looking for potential acquisitions in light of the pandemic recession, but don't expect any soon.

“There will be opportunities. You’ve seen some of those deals recently in terms of rescue financings. We would expect to deploy significant amounts of capital in some of those areas,” Blackstone President Jon Gray said. “The challenge is, it’s to be disciplined, particularly if this recovery is going to take a bit of time.”

U.S. Treasury
The U.S. Treasury Department building in Washington, D.C.

Echoes of the Great Recession

REITs are required by law to shell out 90% of their net income to shareholders. It’s what makes them an attractive investment vehicle for 87 million Americans — 44% of all U.S. households — whether through the stock exchange, privately through broker-dealer networks or indirectly through retirement plans.

Since the economic nosedive, some REITs have already warned investors of delaying or cutting distributions.

“The current COVID-19 has significantly impacted all REITs, but most severely in the lodging, retail, and health care sectors. Many REITs have reduced their dividends because the rents they expect to receive are declining dramatically because of the restrictions put in place or suggested by federal and state authorities,” Nareit Senior Executive Vice President Tony Edwards said in a March 18 letter to the Treasury Department.

That letter was requesting that the Treasury Department consider enacting a rule it put in place during the financial crisis in 2009, which allowed REITs to increase the amount of stock, as opposed to cash, they could disperse to shareholders to 90% of their income.

REITs by law can distribute up to 80% now. If the IRS and the Treasury Department do institute such a change, that would help REITs preserve even more cash to weather the storm, Bernstein said.

The industry may see one repeat from the Great Recession, when struggling REITs issued more stock at depressed prices to help them through the downturn, REIT analyst Tom Catherwood said.

“If the revenue and demand crunch lasts for an extended period of time, we might see a repeat of the financial crisis where companies had to raise highly diluted equity capital to shore up their balance sheets,” said Catherwood, who is a managing director at BTIG.

M&A? Not Today.

Public and non-traded REITs have been active in mergers and acquisitions for the past few years. Last year, U.S. REITs spent $25.9B on M&A deals, including Cousins Properties' $2.3B purchase of TIER REIT, Park Hotels & Resorts' $2.6B purchase of Chesapeake Lodging Trust and Prologis’ $12.8B purchase of Liberty Property Trust.

In 2018, REITs were even more active, spending more than $76B in purchases, including Brookfield Asset Management’s $27B acquisition of GGP.

REITs' asset values made them appealing to buyers, and premiums buyers offered over share price made some REITs amenable to takeovers. When REITs are struggling in downturns, they're less likely to want to sell when as their net asset values suffer, Catherwood said.

“I think it's so turbulent right now that major M&A events are probably less likely in the near term because the recovery is so uncertain,” Green Street Advisors Senior Analyst Eric Frankel said.

The industry saw a similar drop in M&A activity during the last recession. In 2007, REITs were involved in more than $97B in transactions, according to Nareit data. In 2008, as the credit crisis led to one of the worst economic downturns in modern history, merger and acquisition activity dropped to just $5.6B. And in the following year, no deal activity took place at all.

“I think we're going to see similar trends now,” Catherwood said. “It's very possible that a very large REIT will buy a smaller REIT at some point, [but] it’s kind of harder to see a larger REIT pick off a smaller REIT at a discount."