Pondering the Outlook for the REIT Model: Where to From Here?

Without question, the global financial crisis exposed some weaknesses in the REIT model. The distribution requirements in most REIT regimes, which require the majority of earnings to be paid to shareholders each year, made it difficult for REITs to conserve cash to weather the storm.

It has been a challenging few years for publicly traded REITs. First, plunging capitalization rates in a booming real estate market forced REITs either to become more aggressive in pursuing and financing acquisitions or to sit on the sidelines. Then the availability of private equity capital and the perceived burdens of public markets saw a number of REITs taken private. Finally, the credit crunch arrived as the precursor to the global financial crisis. REIT stocks were pummelled globally as credit dried up and aggressive debt loads began to bite, and many suggested it was the death knell for the REIT model.

Without question, the global financial crisis exposed some weaknesses in the REIT model. The distribution requirements in most REIT regimes, which require the majority of earnings to be paid to shareholders each year, made it difficult for REITs to conserve cash to weather the storm. While there were options in some markets to provide some liquidity relief (such as the taxable stock dividend ruling in the US), many analysts were initially concerned that these options were problematic in a climate of plunging equity values. Other legislative restrictions (e.g., leverage ratios), while designed to temper REIT debt levels during growth phases, proved detrimental as asset values fell rapidly — and raised potential taxation implications for REITs already battling to survive.

And in many ways, the REITs themselves contributed to these issues. Distribution practices that decoupled payout ratios from underlying earnings in order to support equity prices resulted in “creeping leverage” and shareholder return expectations that were not sustainable. In addition, the face of REITs changed in some markets — a diversification into other income streams took them a long way from being “rent collectors” — with a commensurate change in their risk profiles.

But the recent financial turmoil also highlighted what has been one of the key advantages of the REIT model — a liquid real estate investment. Despite the volatility in equity prices, investors have been able to liquidate their positions in a short time frame if necessary — not such an easy proposition for other forms of real estate ownership. And the regulation and transparency required for REITs to participate in the public markets is suddenly not so burdensome. With investors rocked by high-profile frauds, many have welcomed the additional public scrutiny.

The attractiveness of these things appears to have been affirmed by investors. REITs worldwide raised tens of billions of dollars during 2009 while private equity and real estate funds struggled in some markets with redemption requests, potential investor defaults and a lack of access to new capital.

But where do we go from here? The substantial level of new capital that flowed into the sector in 2009 and continues into 2010 would suggest there is still strong support for REITs as an investment vehicle. And around the world, governments are still contemplating REIT legislation. As the world economy emerges from the upheaval of the last two years, we expect to see a number of trends materialize in the REIT space:

• With property yields increasing and investors resetting their return expectations, REITs should be able to offer acceptable returns with an emphasis on long-term, stable cash flows.

• Capital management will remain a focus. Lower gearing levels and proactive management of well-structured debt expiration profiles will be front of mind.

• Transparency will be a high priority, particularly the link of distributions to underlying earnings and cash flows. There is likely to be a continued push to develop consistent funds-from-operations-type measures, particularly in jurisdictions reporting under International Financial Reporting Standards (IFRS) that have struggled with the earnings volatility caused by fair value movements.

• IPOs will gain momentum in some jurisdictions as equity markets continue to strengthen, with IPOs seen as an attractive exit or re-leverage strategy for real estate owners facing restrictive credit markets.

Some mergers and acquisitions activity will occur, but perhaps not at the levels initially contemplated. The REITs that continue to struggle are likely to prove unattractive to the stronger REITs that wish to avoid their legacy issues. In real estate markets where property fundamentals continue to deteriorate, some REITs may face bankruptcy. Others may enter a gradual wind-down mode and seek to return capital to shareholders or to be privatized as real estate markets recover.

It will also be interesting to see whether governments around the world revisit their REIT legislation, looking for ways to simplify taxation requirements and provide greater flexibility for REITs in times of economic uncertainty. In all, it has been a rough ride for REITs over the last few years. Yet the period since March 2009 would suggest they are on the road to recovery. The mantra for many throughout the financial crisis has been to get back to basics. It would seem that the outlook for the REIT model is exactly that.