Since the fall of 1991, real estate investment trusts have received an incredible amount of attention. In this relatively short time, the market capitalization of publicly traded real estate companies has risen more than 200%.
This growth was kick-started by the combination of investors seeking higher yields and the evaporation of private sources of real estate equity. Future growth will be propelled by the sensibility of the REIT vehicle and a better understanding of REIT return characteristics.
In spite of the growth of real estate securitization, real estate continues in many ways to be viewed as a capital asset, rather than a financial asset. Until real estate is readily expressed in financial terms, rather than in terms of "office," "warehouse," "apartment," "retail" or "health care," investors will be kept in the dark about expected return characteristics.
The emergence of publicly traded real estate companies, most commonly structured as REITs, represents the beginning of the integration of real estate and financial assets. Previously, institutional real estate managers rarely focused on appropriate methods for measuring financial asset performance. They have had their own language.
To this day, the Russell-NCREIF Index, the most widely disseminated index for institutional real estate performance, reports returns that defy conventional performance measurement. The index is composed of three components: income, appreciation and total return. Income is not cash flow or even what an investor receives; it is based upon accrual accounting and ignores capital reinvested in the properties. Appreciation does not equate to changes in value; it includes capital reinvestment that would otherwise be deducted from cash flow. Total return does not include vehicle or management costs.
In a 1990 Pensions & Investments article, Christopher Volk and Thomas Crawford illustrated the problems with conventional real estate performance measurement (P&I, May 28, 1990). The lack of cash flow disclosure conceals investment attributes and the extent to which investors rely on property appreciation to meet return objectives.
Publicly traded real estate securities, along with the new performance reporting standards of the Association of Investment Management Research, are slowly reshaping the way real estate is viewed. Industrial companies are valued using dividend discount models whereby Price = Dividends*/*(Expected Return - Growth). Real estate companies using a REIT structure are no different. They support the assertions that real estate is an operating business and can be analyzed as a financial instrument. In this environment, the National Council of Real Estate Investment Fiduciaries is considering changing the index's calculation methodology to be more comparable to real estate securities. The worlds of finance and private real estate will integrate.
Not far behind will be the use of the real estate securities market as a point of reference for real estate appraisals. Appraisers should have a greater sensitivity to asset net operating income after capital costs and management expenses (i.e., cash available for distribution, and its growth prospects). In the traditions of capitalism, the values in the public and private real estate markets should more closely move in tandem to limit the potential arbitrage.
What drives returns
It is noteworthy that the Russell-NCREIF Index reports returns at the property level. At the property level, the principal means of increasing returns is through increases in tenant rents. On the other hand, the Wilshire Real Estate Securities Index measures returns at the security or company level.
There are four principal ways for a company to raise its cash flow per share. The first is to raise tenant rents. The second is to reduce expenses as a percentage of revenue. The third is to reinvest free cash flow not used for dividends to increase growth prospects. The last is to acquire new properties so long as there exists a positive spread between net rents and the current debt service and dividend requirements. This method, referred to as "spread investing" has been a primary source of cash flow growth for many REITs since 1991.
Analysts often refer to this as "external" growth. By contrast, growth from tenant rent increases, expense reductions, or the reinvestment of surplus cash flow is termed "internal" growth.
A REIT cannot subsist forever on external growth. This is because REITs require more shareholder equity than debt and therefore are in greater need of rent increases to meet long-term dividend growth objectives. REITs that cannot structure property investments with the strong potential for tenant rent increases are certain to eventually disappoint their equity holders.
Increase property-level attention
Because property rent increases are a key source of internal growth for companies (and the only source of cash flow growth for the Russell-NCREIF Index), it makes sense more attention be given to property acquisitions and their lease structures. There are several reasons for this needed focus:
Expected total returns. The expected total return of a property acquisition should be at least equal to a REIT's total cost of capital. The notion of "positive spread" investing and "external growth" generally refers to the present available spreads. The spreads may narrow or even disappear if a property does not contribute rent increases that keep pace with anticipated dividend growth.
Lease structure. Lease structure risk can be analyzed using the financial concept of duration. Duration is the weighted average time period of the anticipated lease payments. Portfolios having longer term durations have less exposure to short-term real estate market volatility. On the other hand, longer term portfolio durations tend to imply increased volatility with respect to interest rate changes.
Lease characteristics. Expected total return is a function of initial lease pricing and anticipated lease escalations; these are lease characteristics and provide insight into anticipated interest rate and inflation sensitivity. Lease characteristics also can explain much of the volatility of expected total return.
Why is property-level attention so important? In the wake of seven Federal Reserve interest rate increases during the past 14 months, a number of analysts have sought to examine the sensitivity of REIT share prices to interest rate movements. The ability of REITs to make acquisitions with expected returns that are at least equal to their cost of capital has been discussed in light of interest rate increases and asset value corrections.
With a payout requirement of 95% of taxable income, it is clear REIT share prices should be sensitive to interest rate movements. One question is: How much? With a better understanding of lease structures, lease characteristics and anticipated sources of internal and external growth, the answer becomes more clear.
Real estate as a financial asset
If company shares are a financial asset, then tenant leases should likewise be priced as a financial asset. In this regard, the value of any property can essentially be broken down into two components: The present value of existing leases and the present value of future leases (the residual value).
This view has been put forth by Real Asset Management Inc. and has been explored in a number of articles by Wiley Greig and Michael Young of The RREEF Funds, San Francisco. In the view of Messrs. Greig and Young, specific property lease and expense characteristics appear to be a key determinant of property performance. An important related finding is that the virtues of diversification by property type appears unfounded. These thoughts pose serious questions to the historic practice of reporting Russell-NCREIF or REIT performance by property type.
As the world of real estate and financial assets integrate, dominant financial themes will prevail. In the world of equity investment, such themes include "growth," "income," "value," and "cyclical" - not "office," "warehouse," "apartment," "retail" or "health care." In the world of financial assets, a health care REIT is simply a long-term net lease REIT. Its prospects for increases in cash flow per share are tied to its lease pricing, its dividend payout ratio, its cost structure and its ability to execute "positive spread" investing. An outlet mall REIT might represent an intermediate-term lease "growth" REIT because of superior tenant rent levels and the comparative lack of competition within the property type. When the day arrives that real estate securities and properties are discussed in terms of their return styles, then integration of real estate with financial assets will be nearly complete.
The light of day
For shareholders, knowledge and understanding of expected return characteristics and meaningful financial risks are the light of day that will lead to better financial decisions. With expanded knowledge, it becomes possible to talk of companies in terms of their return characteristics, rather than their asset composition.
Real estate securities have a long growth period ahead. As a vehicle, the REIT is too sensible; public trading encourages disclosure, provides a price mechanism and offers regulatory protection and enhanced corporate governance not otherwise available in private real estate investments. The marketplace will only advance with a better understanding of return attributes. Only through enhanced disclosure and analyst attention will insights into the factors of anticipated growth be understood. Greater understanding should contribute to broader investor participation and more efficient pricing.
Michael Torres is executive vice president with AMB Rosen Real
Estate Securities, San Francisco, and Christopher Volk is senior vice president and corporate secretary with Franchise Finance Corp. of America, Scottsdale, Ariz.