Real Estate Awards 2015: A profitable time in US real estate

by Ben Edwards

Having enjoyed double-digit returns for years, the gloss has swiftly come off US real estate investment trusts this year: at the end of July, the FTSE NAReit ALL Reit index was returning an anaemic -0.64%. That has prompted some Reit fund investors to start cashing out. 

In the first half of the year, around $4 billion net had been returned to investors, according to data provider Morningstar, the first time investors have withdrawn more money than they’ve put into Reit funds since 2007. In fact, Reit fund flows have been negative on only three occasions since 1993 – twice in the late 1990s and then again at the start of the financial crisis eight years ago. This year could mark the fourth.

“There is a component of the investor base in Reits that are concerned about the potential for rising interest rates, and that has dampened some enthusiasm for Reit shares,” says Brian Jones, a fund manager at Neuberger Berman in New York.

Reits were introduced by US Congress in the 1960s as a way for ordinary investors to profit from bets on commercial real estate instead of it being solely a playground for the rich and their sprawling property empires. Reits work by pooling money from shareholders to buy real-estate assets such as office buildings, apartments and even mobile phone towers, which are then leased to tenants. Rental income is passed on to investors through dividend payments. By law, US Reits have to pay out at least 90% of their taxable profits in dividends.

We’ve essentially lost more than 20 years in terms of the pace of new supply Brad Case, NAReit

That has made them popular with investors. Net flows into US Reit funds – including both mutual funds and exchange-traded funds – hit $12.2 billion in 2014, the highest level since Morningstar started tracking Reit funds in 1993, and around $1.5 billion more than the previous record in 2012. That surge in popularity has seen assets owned by US Reits swell to $1.7 trillion, according to the National Association of Real Estate Investment Trusts, or NAReit, up from $500 billion in 2010.

That growth has also given rise to a different type of Reit – one that can’t be bought or sold on an exchange. These non-traded Reits have been snapped up mainly by retail investors as they have sought to boost returns amid record low interest rates. Non-traded Reits have appealed to these investors because they tend to offer chunky fixed dividends and, unlike publicly traded Reits, are not subjected to the vagaries of the stock market.

And while they only make up a small proportion of the overall market, fund raising for non-traded Reits jumped from $6 billion in 2009 to a record-high $20 billion in 2013, according to data from investment bank Robert A. Stanger & Co.

But as interest-rate concerns now shake the wider Reit market, the vulnerability of non-traded Reits is becoming all too apparent.

When CNL Lifestyle Properties – a non-traded Reit – started selling shares in 2004 that were linked to assets ranging from ski resorts to theme parks, they were sold to investors at $10 a share.

But as the US real-estate market nosedived amid the financial crisis, the value of CNL’s shares tumbled.

In March this year, the company said the shares were worth just $5.20. Today they could be worth even less – and shareholders can only look on and hope for the best.

That is because when investors buy non-traded Reits, they are usually stuck with them until the company returns their cash through a so-called liquidity event, typically an asset sale or by listing on a public stock exchange. And that can sometimes take years.

Zombie Reit

Some people have dubbed this type of investment a zombie Reit – non-traded Reits that have plunged in value but are staggering on instead of accepting their fate and returning cash to shareholders.

“A zombie Reit goes around eating shareholder value from the living and, unlike a publicly traded Reit, can’t be stopped,” says Allan Roth, a financial advisor at Wealth Logic LLC in Colorado Springs.

This has been exacerbated in many cases by the type of investor they have been sold to, says Brian Mahany, founder of law firm Mahany & Ertl LLC in Milwaukee.

“The problem we see over and over again are folks that are nearing retirement being put into these investments, and when they need to access their money, they can’t,” he says. “These investments are fine if you are an institutional investor and you understand the risks, but these people are not.”

CNL says it intends to return cash to its shareholders by the end of December at the latest – as it had always planned. But having seen the value of its shares topple by almost 30% in the last three years, investors may wonder why CNL didn’t try and liquidate sooner. The trust has sold some assets already, but proceeds from those sales have been used to pay down debt, according to a letter to shareholders in July. The letter adds there is no guarantee that the efforts CNL is undertaking to find buyers for its assets will result in liquidity, or if it does, what the share value might be.

Another zombie Reit is one formerly known as Inland American Real Estate Trust.

Launched in 2004, Inland American sold shares to investors at the industry standard price of $10 and bought assets such as student housing and shopping malls. After being roiled by the country’s property meltdown, by the end of 2013 the trust was valuing the shares at just $6.94, according to a filing with the US Securities and Exchange Commission.

Brian Mahany, founder of law firm Mahany & Ertl LLC in Milwaukee

Instead of calling it a day, Inland American earlier this year split into two companies by spinning off its hotel assets into a publicly listed Reit called Xenia Hotels & Resorts. Investors received one Xenia share for every eight Inland American shares they owned; the result was to cut dividends by more than half. While the split gave investors something they could sell, the total value declined. Soon after, Inland American changed its name to InvenTrust Properties and started buying up new assets, frustrating some shareholders.

“When management has destroyed shareholder value, their obligation is to give capital back to the shareholder,” says Wealth Logic’s Roth. “Instead they are doubling down and trying to do more.”

Roth, who owns rebranded InvenTrust shares, adds that part of the problem is that non-traded Reits often have no motivation to satisfy shareholders. If a publicly traded Reit cuts dividends or runs into other financial difficulties, it gets punished in the market place, he says. For a non-traded Reit, there is no such penalty.

InvenTrust declined to comment for this article.

Neil Petkovic, an investor rights attorney at Chapman LLC in Cleveland, says that some of these problems stem from the financial crisis. If Reits bought assets at the top of the market before prices crashed, then they will struggle to pay investors back in full, he says.

“That’s why some of these Reits aren’t having liquidity events, because they’re trying to hold on and collect rents and wait for property values to recover,” Petkovic says. “It might not be an awful strategy in every instance either. The problem is that some people were told the specific Reit they were buying would have a liquidity event in three to five years, but it might actually take as much as 10 years. That doesn’t necessarily mean it’s a bad investment, but if you were expecting one thing and are getting another, you wouldn’t be too happy.”

Valuations can also be tricky. Because non-traded Reits aren’t bought or sold on an exchange, it is difficult to work out before that liquidity event how much the shares are worth, says Mahany of Mahany & Ertl.

“Traditionally the industry has always valued these investments at $10 a share, so even if you can’t sell it, you’ve got a statement that says your investment is worth, say, $500,000,” he says. “But then there’s a liquidity event and you find out that it’s only worth $250,000. The problem with these investments is that investors often think they have more money than they do.”

Part of the problem is the size of the fees and commissions that investors have to cough up, which in some cases can total as much as 15%, says Jason Moore, an analyst at Green Street Advisors in Newport Beach. That means for every dollar spent, only 85 cents will get invested, giving these Reits an instant deficit to plug.

Dividends can often be in excess of what a Reits property assets have earned too, forcing some trusts to dip into shareholder capital to maintain payments, Moore says. That means when non-traded Reits come to return cash to investors, the shares are sometimes worth much less than what investors initially paid for them, even if the value of the underlying assets have appreciated.

Chapman’s Petkovic says that another recurring theme he sees is the vast number of non-traded Reits many individual retail investors have been sold.

“It’s one thing to diversify your portfolio with a Reit or an alternative investment, but I’ve seen folks that have portfolios that are full of [non-traded Reits],” he says. “If somebody’s only investing 5% or 10% of their portfolio in this it’s less of a problem, but if somebody is loading up 50% or 60% because the broker can collect big commissions, then that’s a huge issue.”

Hurt in long run

The nub of the problem, Petkovic says, is that broker-dealers – incentivised by far bulkier commissions than publicly traded Reits – promise investors hefty dividends of 6% or more and their money back after a couple of years or so. And that doesn’t always happen.

“The pitch is good, and clients are sometimes misled,” he says.

Yet while being spared the gyrations of the stock market might mean non-traded Reits avoid any volatility around the potential rate hike, they could still be hurt in the long run if the value of their underlying assets fall.

“Just because you can’t see the price go up or down every second like a public Reit doesn’t mean it doesn’t have market risk,” says Wealth Logic’s Roth.

The extent to which Reits in general will be impacted by rate rises is still up for debate. According to conventional wisdom, Reits suffer as interest rates rise because in such an environment asset values typically fall. But for Reits, that thinking is flawed and needs revising, reckons Brad Case, an economist at NAReit in Washington DC.

“When interest rates go up, usually it’s because the economy is strengthening, and that’s certainly the situation we’re in right now,” he says. “And when the economy is strengthening, that means occupancy rates are going up, that means rent growth is going up, that means net operating income generated by commercial properties is going up, and that means the properties are worth more. So the people who were saying that Reits wouldn’t do well in an environment of rising interest rates have their analysis wrong.”

Neil Petkovic, an investor rights attorney at Chapman LLC, says: ‘These Reits aren’t having liquidity events because they’re trying to hold on and collect rents and wait for property values to recover. It might not be an awful strategy.’

Some Reit investors agree. “It’s not as simple as when rates go up, Reit share prices suffer,” says Neuberger Berman’s Jones. “More often the case is when there’s a spike in interest rates, Reits in the short term are negatively impacted, but as long as the rate increase doesn’t disrupt the fundamentals of the real-estate market, Reits can recover from that interest-rate shock.”

Furthermore, NAReit’s Case says a study of historical data going back to 1995 shows that in 12 out of 16 instances when interest rates were rising, Reit returns were positive. Those periods also came against an improving economic backdrop, he says.

“It’s good to be a real-estate investor when the economy is strengthening,” Case says.

Even so, some analysts still maintain that the direction of interest rates in the coming months will likely set the tone for the US Reits market.

“When Reit fundamentals are very strong or very weak, fundamentals will dictate how Reits do instead of interest rates,” says John Guinee III, a managing director for equity and Reit research at brokerage Stifel Nicolaus in Baltimore. “However if fundamentals are moderate – as they are now – interest-rate moves are more important than fundamentals.”

Guinee also says that not all Reits will be impacted equally. Reits backed by assets including apartments, office buildings in main US business districts such as New York, west Los Angeles and San Francisco, and self-storage facilities, have all held up pretty well amid the wider drop in Reit share prices this year, he says.

“Investors are being very selective about what they own, and they tend to be favouring companies and sectors with good underlying fundamentals and staying away from those that have lower quality earnings growth,” Guinee says.

Allan Roth, Wealth Logic LLC

Shopping-mall Reits have struggled this year, partly because Americans are shifting their shopping habits away from bricks-and-mortar shops and onto the internet, which is squeezing traditional retailers’ margins and putting pressure on rents, Guinee says.

Despite the shadow of uncertainty cast by the potential for rising rates and the problems crushing some corners of the non-traded Reit market, the long-term outlook for the asset class in general remains positive.

For starters, publicly traded Reits have been able to raise cash even while fund flows have floundered. By the end of July, listed Reits had raised almost $22 billion from convertible bond issues, follow-on share sales or initial public offerings – up 24% on the same period a year earlier, according to data provider Dealogic. Almost $19 billion of that cash came from follow-ons, the data show. American Tower Corp., for instance, was able to raise around $3.9 billion in February from selling additional shares and convertible bonds.

“It’s still pretty easy for Reits to raise cash either through share sales or debt offerings – capital markets are pretty wide open,” says Green Street’s Moore.

Transparency rules

Meantime, proposed regulatory changes may soon help ease some of the issues impacting the non-traded Reit market.

Kevin Hogan, chief executive at the Investment Program Association, an industry trade body, says rules due to be introduced next year will enhance the transparency of non-traded Reits, particularly around the topic of fees, which will have to be disclosed in full and upfront.

IPA has itself also taken steps to introduce guidelines on how valuations for non-traded Reits are conducted in an effort to encourage more standardization across the industry, Hogan says.

And Mahany of Mahany & Ertl hopes that clearer information on fees and measures like those taken in states such as Massachusetts – where the amount of illiquid assets retail investors can be offered by brokers is restricted – will become more widely adopted and prevent ordinary investors from being lumbered with unsuitable shares.

The construction backdrop in the US is also favourable for Reits. Even though the commercial real-estate market is recovering from the downturn, demand for new builds has continued to outstrip supply, boosting the value of existing properties. Average commercial property prices have risen almost 90% since their lows in 2010 and are around 12% higher than their pre-crisis peak in 2007, according to data from Real Capital Analytics.

“There hasn’t been enough new construction to disrupt the recovery that we’re seeing in the existing assets, so the fundamental outlook for US commercial real estate continues to be strong and the asset values in the real-estate market continue to improve,” says Neuberger Berman’s Jones.

Jones says that historically, real estate recovery cycles have typically been between eight and 10 years in length, suggesting that the market is probably about halfway through its recovery phase.

“The two primary things that can put an end to real-estate recoveries are overbuilding and economic recession, and we do not see either of those two scenarios playing out for the foreseeable future,” Jones says. “We think the recovery has a number of years to continue before we are worried about reaching or going beyond the peak.”

Further reading

Real Estate Awards 2015: New era, or another accident waiting to happen?

Fitch Ratings reckons because employment growth was weak early on in the US economic recovery and because new construction has been hamstrung by banks’ reticence to underwrite new loans, the recent upturn in the commercial real-estate market might last longer than previous cycles.

Supply could start to pick up though as latent demand in the rental-apartment sector starts to seep through. NAReit’s Case estimates that there are about 4.5 million fewer households than there should be in the US because young would-be-renters are still living at home with their parents or sharing rooms with college buddies because they can’t afford to move out and get a place of their own.

“Right now the apartment vacancy rate is extraordinarily low, so when those people start hitting the market, that will generate increased construction,” Case says.

But that largely depends on the trajectory of the US economy, and whether or not growth – which has been consistently sluggish since the crisis – improves enough to give potential tenants the confidence to start renting. Revisions to gross domestic product data published in July show the US economy expanded at an annual rate of 2% between 2011 and 2014, worse than previously thought.

And while the pace of construction has increased over the last five years, because it had dropped so low, the amount of new building is back only to levels last seen in the early 1990s, Case says. That hints at a longer recovery than normal, which could ultimately help prop up Reit share prices.

“We’ve essentially lost more than 20 years in terms of the pace of new supply, and that imbalance of improving demand conditions and continued lagging in supply has made it a really profitable time to be a real-estate investor,” he says.