Real estate investment trusts had both a good and bad year

February 14, 2014

Inside Business

By one measure, 2013 was a good year for real estate investment trusts: A record number of REITs filed initial public offerings and a record amount of capital was raised.

By another measure, 2013 was lackluster for REITs. While most stocks in other sectors rallied notably last year, gains in many real estate stocks were modest at best. By the end of last year, the S&P 500 posted an annual total return of 32.4 percent in 2013 while the FTSE NAREIT All REITs index, seen as the broadest measure of industry performance, returned 3.2 percent.

Created by Congress in 1960, REITs are real estate companies that pass 90 percent of their revenue to shareholders in the form of dividends and, in return, pay no taxes on that income. Known for their relatively high returns, investors tended to flock there in a post-recession period marked by low investment returns elsewhere. Non-traded REITs showed up for the cash as a record 19 REITs had IPOs last year raising a record $5.7 billion, according to the National Association of Real Estate Investment Trusts.

The Federal Reserve had been keeping interest rates low through a major bond-buying effort to help fuel the economic recovery, but last May former Chairman Ben Bernanke signaled the Fed would scale back. On fears that higher rates might pinch dividends, some REIT investors backed out.

“REITs are borrowing money to grow their business,” said Daryl Jones, a managing partner with Orlando-based Apex Wealth Management, LLC. “So when there’s an increase or potential increase in borrowing costs, obviously that could have an adverse effect on their business.”

Some industry observers have scratched their heads at the trend. An improving economy might trigger higher interest rates, but it also bodes well for REIT business.

“That means we’re going to have higher occupancy, higher rent growth, higher property values,” said Calvin Schnure, NAREIT’s vice president of research and industry information. “That’s all good for commercial real estate.”

Jones said he can think of at least one company that had an IPO last year and experienced a marked decline in share price “for reasons I don’t know that anybody can explain because this particular company has a good portfolio, a strong balance sheet, and strong earnings.”

Glenn Mueller, a professor at the University of Denver who specializes in REITs, said the inverse relationship between interest rates and REIT stocks is fairly new since REIT stocks in the past have done well during some periods of interest-rate hikes.

While he’s not sure of the exact cause, he suspects it has to do with investors being more short-sighted than in the past and the treatment of REIT stocks as financial stocks, “which I do not believe they are,” he said.

“They are not as subject to interest rates,” he said, comparing REITs to banks. “If interest rates go up tomorrow and a REIT just financed its properties with 10-year mortgages, then that interest rate isn’t going to change on them for 10 years.”

Interest rates do impact REITs, experts said, but the level depends on the type of REIT. Those that sign long-term leases with tenants, such as industrial or retail REITs, may be more vulnerable to rising interest rates squeezing profit margins, Jones said. Those that deal in shorter terms can respond by raising rents.

Some industry observers say they aren’t sure how close the correlation between interest rates and REIT stock prices will be going forward. The closer that is, some said, the more it could hamper some REITs’ efforts to raise capital. That money is often needed in an industry where businesses can only keep 10 percent of their pre-tax revenue.

“The REIT industry is unique in the fact that whenever it wants to buy more property,” Mueller said, “they have to go out and raise more equity capital by selling more shares of stock.”

Some said the recent REIT stock woes may be a bargain opportunity for some, especially if the economy continues to recover. Last year, according to NAREIT, 264 REITs raised a record $77 billion in capital.

“The REIT sector is providing the capital that commercial real estate needs to continue the recovery and grow with the rest of the economy,” Schnure said. “If you don’t have a healthy commercial real estate sector, you don’t have a place to work, you don’t have a place to shop and some don’t have a place to live. This money is absolutely necessary for communities and businesses to develop.”