Lynn Strongin-Dodds explores what the future holds for real estate investment trusts (REITs) in light of the current economic crisis
There is no doubt that 2008 was a dismal year for real estate investment trusts. Plunging property prices coupled with the global financial meltdown in the autumn took a savage toll. Not surprisingly institutional investors are reluctant to step back in even at bargain basement prices. They would rather bide their time and wait.
This is a dramatic turnaround for one of the darlings of the stock market which had typically outshone equity and bond counterparts, even in the bad times. For example, in the middle of the dot com crash in 2001, US REITs turned in positive returns. The US and Australia are two of the most established REIT markets while Asia enjoyed a flurry of activity with Japan, Korea, Singapore and Hong Kong joining the fray in the past eight years. Real estate had always been fashionable among sophisticated investors with deep pockets, but the listed market enabled a wider range of investors to access the income, capital growth and portfolio diversification story. The UK was the latest entrant in January 2007 but the timing was off as they were launched at the height of the commercial real estate boom. Within months of making their debut, the subprime crisis exploded onto the scene triggering the beginning of the property slide.
Alka Banerjee, vice president, Standard & Poor’s (S&P) Index Services, says, “REITs had a huge bull run for seven years and then they were caught in the centre of the subprime crisis which first hit the US home market. It has spread to every sector and has not spared any region. REITs have fallen disproportionately to the larger equity index and across all regions. It is difficult to see conditions reversing until investor sentiment changes. Eventually when equity markets improve and the credit crunch eases then it will filter through to the REIT sector.”
According to figures from S&P, returns from global REITS were down 45% in 2008 compared to 48.85% for global property and 42.4% for the S&P global equity indices. Breaking it down further, the developed REIT market plunged 45.2%, with Europe turning in a negative 47.3% performance followed by North America’s 38.8% slide. Emerging REITs fared better with only a 29.6% drop with the Asia Pacific region registering a significant 55.3% decline.
Patrick Sumner, head of property equities at Henderson Global Investors, notes, “Property has become a global phenomenon and prices have fallen despite the fundamentals being different from country to country and sector to sector. The worst affected have been markets in the US, UK and Europe, but overall, there is a lack of confidence in the market and a risk aversion that we expect to dominate the capital side for a year.”
A contracting market
One of the biggest issues, of course, is the refinancing of debt and the dearth of liquidity. A recent report by Fitch, the ratings agency, points out that the US market is shrivelling due to weakening property fundamentals, gridlocked credit markets and falling stock prices. The firm voiced its concerns about the financing and funding risks and the potential of downgrades should the debt markets not open. At the moment, REITs are mostly reliant on banks revolving lines of credit to fund near term maturities because of the tight lending conditions and limited ability to sell assets.
Fitch also noted that while most REITs maintained liquidity surpluses, the number with shortfalls has risen. Every sector except healthcare and self-storage REITs – which had improved their liquidity positions in recent months – has weakened. For example, office REITs are being weighed down by a shrinking labour pool, higher vacancies and lower rental growth while industrial are suffering from the same fate. Retail is also on the watch list due to consumers having firmly tightened their belts.
The scenario is being played out across the geographical spectrum in varying degrees although even those companies with loans backed by relatively strong properties are experiencing problems. This has forced some REITs to offload properties at rock bottom prices to bolster cash reserves and pay dividends. British Land, for example, a large UK REIT, sold £721m worth of properties in the six months ended 30 September at a 5.7% discount while more recently the group is looking to sell a large stake in its flagship £1.4bn Meadowhall shopping centre in the north of England. Meanwhile, US based General Growth Properties, one of the sector’s largest players, which has loans near maturity, is being forced to seek extensions from creditors or sell assets to avert bankruptcy.
David Kivell head of real estate securities at Macquarie Asset Services, notes, “This is a completely different cycle. In the past, the financial sector helped get the economy back on the right footing. Today, the financial sector is the problem. The other issue is that investors are also using their listed REITs as an exit strategy to provide liquidity.”
Light at the end of the tunnel
While market participants acknowledge that 2009 will be a difficult year for property, they are advising institutional investors to take a long term view. One issue that could affect timing is the so called denominator effect which has left many institutions with overweight positions in property. Typically pension funds have allocated 6% to 10% of their portfolio to property while the figure is larger for other players such as endowments and insurance companies. In the past decade, all participants raised their game to take advantage of soaring prices. The problem is that unlike equities, real estate is only valued once a year. The dramatic drop in equity prices has meant that the relative size of property portfolios has grown and institutions are now overexposed to the sector.
Mark Meiklejon, investment director at Standard Life Investments says: “The denominator effect will be a factor this year but from an institutional standpoint, all the benefits remain and they are still good long term investments. REITs are a cost effective and transparent way to access illiquid markets and a wide range of underlying properties. The big question is when the most opportune time to invest is. They have mostly priced in all the negative news and will recover faster than direct property. However, investors must have a long term view and by that I mean minimum five years. I think the more sophisticated investors will put off going back into the market in the immediate short term because there is still a high correlation between equity markets and REITs.”
Todd Briddell, managing director and chief investment officer of Urdang Securities Management, a subsidiary of BNY Mellon Asset Management, says, “This coming year will be difficult. The income levels are falling because we are in a global recession but the yields are moving up. The fundamental business model of REITs is not broken nor is the asset class facing obsolescence. The reasons for investing in REITs remain sound but investors need to be careful. They should look at companies that have low leverage and strong management teams who have a focused business strategy.”
Robin Priest, real estate partner at Deloitte, adds, “It is important to look at why REITs took off in the first place. There was a need for a new source of capital and from the retail investor standpoint REITs were seen as middle of the road investments that sat between equities and bonds. They were viewed as dividend plays with capital appreciation upside. My advice for now is that if institutions are already invested in REITs and they believe that the listed market reacts ahead of the direct market, then they should stay in. I think we will see some confidence return to markets such as the UK and US, which are further along in the cycle. The year to look forward to, though, is 2010 because prices should have stabilised and debt funding is expected to have returned to the markets.”
Sumner agrees, adding, “Investing now requires a long-term view, and at some point there will be a sustained recovery. I do not think we will see the same dramatic falls as in 2008 but the recovery is unlikely to happen until 2010 and 2011. For now, we are avoiding Southern and Eastern Europe, including Austria and are underweight in UK. We are overweight in Asia, which has done better than other markets relatively speaking. In all regions, though, our focus is on companies with quality portfolios, strong management teams as well as strong interest and dividend coverage.”
Asian markets may also receive a boost if the Chinese government gives the green light to its version of REITs. At the end of last year, The State Council, China’s cabinet, said it would begin a pilot REIT programme, but so far, there is no concrete timetable. Depending on their structure, they could attract local retail or institutional investors, as well as potential foreign investors. The aim would be to reinvigorate the country’s slumping property market as part of a bigger push to bolster the domestic economy.
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