Executive Summary
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Commercial real estate has historically been a low-volatility, low-correlation
asset to add to a diversified portfolio.
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It has been a tumultuous few years for commercial real estate, with both
volatility and correlation spiking up.
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There is an exceptionally large overhang of debt issued by investors in real
estate as well as a lot of speculation regarding what will happen if and
when borrowers cannot refinance.
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The public real estate companies may be in a position to benefit if there
is substantial forced selling of real estate by overleveraged private owners.
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Allocation to real estate should be treated as opportunistic equity exposure.
The risk is too high to treat it otherwise.
The Basics
A Real Estate Investment Trust (REIT) is a company formed for the purpose
of investment in Real Estate. As with many companies, the primary method
of investment in REITs is to buy stock. Thinking of REITs as just another
sector of the broad market, Real Estate Investment Trusts are only a
small slice of the larger stock universe. Less than 2% of the Russell
3000 is composed of REITs and less than 1% of the S&P 500.
However, there are two important reasons why these stocks deserve consideration
as their own asset class. First, these companies typically generate income
from tenant leases. This means that unlike the stocks of companies who
must sell their products each day, REIT cash flows are typically much steadier
and more predictable. The second reason is legal - the law requires that
companies structured as REITs pay out at least 90% of their income to shareholders.
Given these two differences, there is logic to treating them as a hybrid
asset class, which should theoretically have some of the capital appreciation
potential of stocks with the income component of bonds.
A potential third distinction to be made between real estate stocks and
non-real estate stocks is the presence of the private market. Roughly 10%
of commercial real estate is owned by publicly traded companies with the
remainder being owned by private companies. Unlike the market for non-real
estate companies, the primary asset of real estate companies is property.
With a private market in which real estate can change hands regularly,
there is a ready benchmark for how much a company’s assets - and
the company itself - are really worth.
The Past
Theoretically, the returns of Real Estate Investment Trusts should fall
in between that of stocks and bonds. In actual practice, however, this
occurs only in the very-long-term and even then, with occasional aberrations.
[The graphs below use the S&P 500 Index as a measure of stock performance,
the NAREIT Composite index as a measure of REIT stocks and the Barclay’s
Capital Aggregate Bond Index as a measure of bond performance. Note that
all three are domestic indices.]
Over shorter time frames, REIT stocks rarely behave so nicely.
Similarly, it seems fair to assume that the risk of these securities would
be less than that of stocks but greater than that of bonds. While this
has often been the case, the chart below shows that the volatility of REIT
stocks can ary greatly and is currently at unprecedented levels.
In deciding whether or not REITs deserve to be treated as a separate asset
class, another issue is whether or not their addition diversifies a portfolio.
Historically, the case could be made that Real Estate was uncorrelated
enough to the broader universe that it could be a diversifier. Right now,
that argument is thin for any sector without predicting a return to normalcy – and
this includes real estate.
The Present
Given the historical statistics above, it just does not make sense to treat
real estate as an uncorrelated conservative alternative to stocks. But
they do still require special consideration in the broader space of stock
investments and have unique attributes that must be taken into account.
Commercial real estate by nature is linked to the broader economy. Bankrupt
companies don’t pay rent and struggling companies don’t increase
their demand for space. In this way, commercial real estate acts as a leveraged
investment in the economy during times of stress. Incidentally, this is
part of the explanation for why the correlation has risen between REITs
and the broad market.
The credit-oriented nature of the crisis weighs heavily on commercial
real estate. In recent years, the steady cash flows of these companies
combined with easily available credit created an opportunity for companies
like these to greatly enhance their returns. Rather than pay cash for a
property paying a small percentage of the purchase price, a company could
easily pay half and finance the rest at very low rates, nearly doubling
their return. The strategy made perfect sense as long as the economy remained
strong but with a clearly weaker economy, the players of this game may
be in dire straits.
To illustrate the potential problems, the chart below (courtesy of Advisor
Perspectives) shows the loans of these companies maturing by year. The
average commercial real estate loan matures in 5-7 years, so we are just
entering the peak period of loan maturity. The question of what will happen
when these loans mature is significant and as yet unanswerable.
On average, vacancy rates are higher, lease income is lower, property
values have fallen and credit is more expensive and difficult to obtain.
Presumably, some portion of these loans will not be able to be refinanced.
Assuming government intervention is nonexistent or not substantial enough
to refinance all of these loans, the properties underlying these loans
will have to be sold at discounts to recover some portion of the lenders’ capital.
Most market participants seemed to understand that the highly-leveraged
real estate strategy would be unsustainable when the economy slowed. As
a result, as the current crisis developed, the market compensated, or perhaps
overcompensated, for the issue. In the two years from February 2007 to
February 2009, real estate stocks lost more than two-thirds of their value.
There has since been a fairly strong recovery but certainly not enough
to recover what was lost. Is this just the beginning of an amazing opportunity
or simply a return to fundamental value? The answer is likely somewhere
in between; the private market all but closed and is currently useless
in providing guidance as to the real value of these companies.
The Future
In short, the future is murky for REITs. In the near term, it is impossible
to say whether they will be able to ride out the storm that is the mountain
of debt maturities that are coming. For that matter, the possibility
of another downturn in the economy creating an even larger storm cannot
be entirely ruled out. The only thing that seems to be certain is that
the volatility and correlations of commercial real estate rule them out
as an income-producing hybrid asset.
One potential bright spot for investors is that most of the public companies
did not borrow as heavily as their private counterparts. In addition, they
have the option of raising new cash through the equity markets. The mid-year
rally in real estate shares created a perfect opportunity for public companies
to raise capital in the equity markets. Public companies raised almost
$16 Billion in the second quarter – more than double what was raised
the prior year on larger initial capitalizations – which was primarily
used to pay down debt. More heavily leveraged private companies did not
have such an opportunity and will likely be doing the majority of the forced
selling.
In the near term, this forced selling will likely lower all asset prices,
as well as the value of both public and private companies. In the intermediate
and longer terms, those companies with the strongest balance sheets and
best access to cash and credit should be in the best position to profit
by buying distressed properties. The public companies clearly have an edge
in this regard.
On balance, real estate right now is clearly not the diversifier or reliable
income-producer that it once was and should be treated as an opportunistic
sector allocation. But even then, the potential short-term downside is
large. For all but the most aggressive (and optimistic) investors, the
most prudent answer is to avoid the sector altogether or invest in a diversified
alternative fund that has an allocation to REITs.
-- Benjamin King, Senior Research Analyst
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