What REITs Tell Us About the State of the US Real Estate Market
With the constant fear of interest rate hikes, no sector may bear more watching than REITs and other public real estate companies. In fact, a recent report revealed REITs dominated in total insider sales since January, selling $8.8B in stocks.
So where does that put us in this cycle? Beacon Economics founding partner Christopher Thornberg tells us we're in the second or third inning, despite the fact many industry watchers peg it to the seventh. People are naturally more cautious these days, he adds. "The last couple times we saw prices go up and cap rates get compressed, it blew up. People have a memory of that." Unlike previous cycles, the success REITs, and the rest of the industry, are enjoying right now is thanks to the fundamentals. Profit is up, interest rates remain low and there's nothing to suggest the economy is out of whack or that prices are not directly aligned with demand.
One company reaping the benefits is Rexford Industrial. Chairman Dick Ziman (snapped with UCLA Ziman Center director Stuart Gabriel) tells us "any rate increases will be slow and not in significant amounts, and the fluctuation of interest rates are not as much of a disadvantage to public real estate companies as the market may believe." Public companies today are also managing their balance sheets better with fixed interest rates. What's more, he says as interest rates rise, cap rates will rise, possibly allowing for more acquisition that could create a period of significant growth.
Rexford, an industrial REIT that went public in 2013, raising $224M in its IPO, is focused entirely on Southern California. Dick says there's in excess of 2.1B SF of industrial inventory in Southern California—the second largest industrial concentration outside of China and double the second largest US market, Chicago.
Indeed REITs are incredibly sensitive to interest rate fluctuation, as the ability to produce big returns is somewhat dependent on buying when the prices are down—hence the rapid growth of REITs as the market began recovering late last decade.
But REITs have had a colored history and have fallen victim to rate hikes and changing market conditions in the past. Dick has been a part of the REIT game since 1969, when he was part of a legal team doing an IPO for a company then called the Mortgage Investment Group. The total underwriting on the deal, he says, was $49.5M.
We can all thank then-president Dwight D. Eisenhower for the REITs. In 1960, he signed the REIT tax provision contained in the Cigar Tax Excise Tax. It would create a way for both equity and real estate investors to invest in big, income-producing real estate. This was only made available, of course, to institutions and people with money, the type we call "accredited investors" today.
The first wave of REITs in the '60s and '70s died as interest rates rose. The next wave of REITs came in the '80s, and they fell during a recession, though rising interest rates and changing times didn't help. In the early '90s, the next wave was born out of a very deep recession (sound familiar?).
Many of the largest companies today were deeply impacted by that recession, but they could not afford to go broke. As such, the IRS approved the structure of the UPREIT (umbrella partnership real estate investment trust) format, which allowed these embattled companies to reinvent themselves as Wall Street darlings. Those companies are the fathers of the modern REIT.
In 1990, the aggregate amount of all investments of all the active REITs was about $3B. Today, the aggregate assets of all stock exchange REITs in the world is about $1.8T in gross assets, with in excess of $1T in equity in the US alone. There are more than 300 REITs registered with the SEC, more than 200 on either the NYSE or the Nasdaq.
This great time for the industry has allowed for a consolidation of assets—a cause for celebration among REITs. NAREIT SVP Brad Case (here at REIT Week in 2013) tells us traded REITs control about 15% of the commercial real estate market, leaving a lot of room for more consolidation.
Brad thinks we're in the fifth inning, and says the most important thing that determines where we are is construction activity. The real estate cycle is much longer than a stock market cycle—about 18 years, he says. Whereas it may take only a few months for GM to retool a factory to adapt to the market, Brad says it takes four years on average to construct a building, ignoring often lengthy entitlement processes and appeasing the public.
He says we're in a balanced situation right now, where most acquisitions are by REITs. But we’re not at the top of a cycle, where you would see REIT privatization. The big difference between buying activity from public REITs or private managers (private equity, etc) is that REITs tend to be the most active acquirer toward the bottom of the market, only to ramp up sales at the top of the market. At that point, he says, the institutional money, which has a much longer view, pours in.
Dick thinks there's still a lot of time left in the real estate game. For one, we have not yet seen significant institutional capital coming out of China, though he warns that it's coming. That money is going to be a major competitor to many of the institutional buyers and blue chip, core-owning REITs. Most of that capital will be directed to core office and other core products in gateway cities, such as DC, New York, Los Angeles, San Francisco, Boston and Chicago.
Are REITs overvalued?
But some believe the time to privatize may already be approaching and that REITs are getting overvalued in the market.
Brad says REIT valuation has most to do with where we are in the cycle. And where we are in the cycle is really controlled by construction, which he says is still way below normal despite a strong increase. While pricing may have recovered and vacancy is headed in the right direction, construction has a long way to go.
As an investment for the everyman, REITs may be a good spot to look. Morningstar senior research analyst Todd Lukasik says rising interest rates may be an immediate valuation risk to REIT share prices, but in-place debt maturity schedules dampen the near-term impact on REIT cash flows. He says US REITs with development capabilities are setting aside more capital for ground-up developments and redevelopment of existing, productive assets.
REITs are off about 15% in the S&P this year, and insiders have been selling stock. Dick says the market fluctuation has created at a discount relative to net asset value on many public companies in the marketplace. And since REITs by definition have to pay out at least 90% of taxable income as dividend, they can be a very good income-producing stock. If you're looking for the quick pop, REITs are likely not the best place to be, as rising interest rates will surely cause some concern with the Wall Street crowd. But you're supposed to buy low, right?