The REITs resurgence

REITs were on the cusp of gaining strong momentum among European investors
until the financial crisis got in the way. Francesca Fabrizi asks what now
for the asset class

Real Estate Investment Trusts (REITs) were all the rage before the financial crisis. Performance was strong and awareness of the benefits of REITs as an asset class, while already fairly established in the US, was gaining ground among Europe's institutional investors.

Then came the financial crisis and, like most other asset classes, REITs suffered performance-wise. Of the numerous managers operating in that space at the time, not many lived to tell the tale. Neuberger Berman, however, which has been managing REITs since 2002, managed to make it through.

Elizabeth Reagan, managing director and product specialist at the firm, explains: "US REITs did go through a tumultuous time in the last three years. The single family housing crisis was precipitated by the sub-prime mortgage crisis which gave rise to the downturn in the US economy, and commercial real estate was not immune to that as jobs were lost and consumer confidence declined, so you saw a reduction in occupancy across essentially all types of property."

Neuberger Berman invests in a diversified portfolio - offices, apartments, industrial warehouse facilities, retail properties, hotels etc - none of which were immune to that downturn. In 2008, when we entered into the widespread global financial crisis, REITs were impacted dramatically and in 2008, they were down over 35%.

In the years that ensued, however, public companies went to the equity markets and issued secondary offerings of their stock at low rates, and they succeeded in raising material amounts of capital. In 2009, it is estimated that US REITs raised over $39bn in both equity and debt capital, the primary use of proceeds initially going towards addressing near-term debt maturities, and to reduce leverage in order to send a signal to the market that there were no on going concern risks - that these companies were solvent.

Capital raising continued and in 2010 another $50bn in debt and equity was raised. This time the capital was used to shore up balance sheets and to boost cash reserves. Suddenly REITs found themselves in a position to start making acquisitions again.

Reagan continues: "So REITs have gone through a major correction - they have come through a re-capitalisation phase and we think they are now at the early stage of a multi-year recovery which should provide competitive total returns."
Despite this correction, though, has enough been done to restore faith in this asset class among institutional investors? Apparently so, says Paul Osborne, head of European institutional marketing at Cohen and Steers, as the basic advantages of listed real estate are still there to be enjoyed: "While REITs, along with other financially-sensitive asset classes, displayed poor performance during the worst of the financial crisis, the basic characteristics that make REITs attractive are still very much intact, and this has drawn favorable attention, as have the strong total returns generated by REITs over the past two years."

These characteristics, says Osborne, include competitive total returns linked to economic growth; attractive current income due to REITs' minimum payout requirements; moderate volatility from generally predictable revenues; and low correlation to other asset classes.

"Although REITs fell significantly in the crisis (and ahead of direct real estate as one would expect of listed instruments), the recovery since early 2009 has been impressive. Real estate companies clearly demonstrated to the market one of the main strengths of listed companies - the ability to access capital through the public equity and debt markets at a much lower cost than direct property companies. Among other benefits, this has better positioned REITs to take advantage of distressed opportunities in the private market."

There are a number of other reasons why investing in commercial real estate through the stock market can be more effective than by going the direct property route.

Regan highlights three: "You get greater liquidity in the public market i.e. it is much easier to buy and sell a stock than it is a building; you get daily valuations, unlike an appraisal based process whereby you don't really know the value of your property until it comes time to sell; and you get ease of diversification - in a publicly traded security portfolio, one can put together a large number of different securities and give the client exposure to hundreds if not thousands of underlying properties."

And it's not just about getting exposure to more properties, but to the right ones. REITs offer investors an opportunity to get instant exposure to the prime parts of the recovering real estate markets, argues Paul Van de Vaart, global head of REITs at Aviva Investors: "REITs predominantly own prime assets, and this segment of the market is recovering earlier and faster than assets of secondary quality."

In addition, REITs provide an attractive, growing dividend yield which can provide investors with security in today's economic environment, and they are seen as a good hedge against inflation. Van de Vaart explains: "The majority of rental contracts have a yearly inflation adjustment, and as REITs need to pay out the majority of its received rents, this inflation adjustment is passed through to investors in REITs."

So, given all these positives, should pension fund investors be looking to replace their direct property allocations with REITs? Not necessarily, argues Regan: "Across the board, we enter into the discussion of private versus public and it is our contention that you really don't need to make a decision of one or the other. A significant number of large institutions are using equity REITs as the liquid portion of their allocation to commercial real estate. So it is our belief that publically traded REITs have a position in a mixed asset portfolio that can include direct property."

Also, despite the numerous positives, there are also inherent risks in REITs - such as falling property values due to increasing vacancies, declining rents resulting from economic, legal, tax or political developments, lack of liquidity, limited diversification and sensitivity to certain economic factors, such as interest rate changes and market recessions.

Chip McKinley, global portfolio manager, Cohen and Steers warns: "The risks of investing in REITs are similar to those associated with direct investments in real estate securities. Foreign securities involve special risks, including currency fluctuations, lower liquidity, political and economic uncertainties, and differences in accounting standards. Some international securities may represent small and medium-sized companies, which may be more susceptible to price volatility and less liquidity than larger companies."

But while risk cannot be eliminated, he concedes, it can be tempered by tools available to experienced active asset managers. Andrew Jackson, head of wholesale & listed real estate funds at Standard Life Investments, also says that much of the market risk can be diversified away through assembling a portfolio of different asset types: "For example office, retail, industrial and residential, geographic location and differing levels of debt."

The insolvency risk of the REIT sector has also improved considerably last two years, says Van de Vaart. The majority of the sector is able to look forward and is acting on the "front foot".

REITs have overcome their poor performance significantly over the last two years, while the ability to raise capital, both equity and debt in times when it was still very difficult for a lot of private real estate investors, has brought the sector back in focus.

On top of that, he says, REITs have recapitalised themselves and are positioned well to grow from acquisitions and development projects. "The low interest rate environment and the fear for higher inflation make the high yielding and inflation linked REIT sector an attractive alternative among other asset classes," he concludes.

Written by Francesca Fabrizi

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