They’re Back: REITs Once Again Find Favor
- Nov 18, 2010
When the commercial real estate markets flame out, REITs act as the fire engine that comes to the rescue of capital structures consumed by debt.
Coming up on their 50-year anniversary, real estate investment trusts have been a key component of the commercial real estate investment scene since their approval by Congress. Because of the restrictions under which they operate, they tend to come in and out of favor depending on where the capital markets are at any given point in the business cycle. When the market crashed, so did their values as excessive debt brought on by production-driven models for some of the large REITs almost buried them. What is remarkable is the way that they have bounced back and been able to raise cash – both new debt and equity to restructure their balance sheets and position themselves for future growth. When the commercial real estate markets flame out, REITs act as the fire engine that comes to the rescue of capital structures consumed by debt.
While the publicly traded REITs are carefully scrutinized by the market, the unlisted and private REITs, which are raising millions daily, are not so burdened and their investment models are more aggressive. Their risk return profile is driven by core demand, that is, personal pension fund money and individual investors seeking something better than 1.0 percent to 2.5 percent from treasuries. But with all in loads in excess of 20 percent, the only way for this model to work is with cheap debt. For every $100 dollars taken in, they promise a return of $6.50+/-. With only $80 to invest after the load, they need a cash-on-cash (COC) return of 8.125 percent from day one to deliver this return. If they can buy at a 6.1 percent cap and borrow 50 percent loan-to-value at 4 percent, their COC will be 8.2 percent. This formula works as long as they invest quickly, borrow cheaply, keep the debt structure in line with the income profile and don’t chase risky deals.
What remains to be seen is how these private and unlisted REIT transactions unwind and how successful they are at pricing risk. For now, they have one of the most aggressive investment models in the market and are pushing their competitors to drive cap rates below 6 percent to compete. How long this will last depends largely on how long interest rates stay low. Once the 10-year T-bill moves above 3 percent, the private REIT model will come under pressure and could lose its competitiveness altogether if it hits 4 percent. As with all cycles, it is not a question of if – it’s when. Timing is everything.