REIT assets up nicely a year after big meltdown

What a difference a year makes.

Managers of real estate investment trusts and other real estate securities saw assets under management climb 29% to $160 billion in the 12 months ended June 30, according to Pensions & Investments' survey of the largest real estate money managers.

In the year-earlier survey, assets invested in real estate securities had fallen 44% to $123.6 billion.

Assets invested in REIT securities for U.S. institutional tax-exempt clients rose 5% to $43.66 billion after a 36% fall in the survey for the year-earlier period.

Industry insiders say REITs are now at a crossroads. The question is whether REIT managers have learned their lesson after many flirted with bankruptcy because of leveraging up their balance sheets with short-term debt.

“The REIT sector has come a long way since the declines. Going forward, we will need to see fundamental improvement coming from tenant demand in order for REITs and private real estate to experience capital appreciation gains,” said David Brunette, senior research analyst, real estate, with Russell Investments in Tacoma, Wash. “We are at a critical juncture here with the economy. Hopefully, the industry will position itself to weather the storm should economic growth falter.”

“A lot (of the increase in REIT securities assets under management) could be attributed to the movement of the market,” Mr. Brunette said in an interview. “It's basically been an environment where investment managers were trying to keep existing client assets; that's been the major push, and not necessarily winning business from other investors that did not have exposure to REITs.”

The U.S. REIT market experienced a big rally on the heels of heavy declines in the fourth quarter of 2008 and the first quarter of 2009. The NAREIT Equity index return was 53.9% for the 12 months ended June 30.

“That (strong return) and dividend yield looks mighty attractive to investors” who can get these and cash flows from a liquid, tradable security, said Gary Koster, global leader, real estate fund services in Ernst & Young's New York headquarters.

When investors look at what else is in their alternative investment portfolios that produce yield or income, REIT stocks look “very, very attractive,” Mr. Koster said.

Managers of real estate securities agree, though, that much of the increase in assets was courtesy of the market.

Cohen & Steers Inc. was at the top of the ranking of managers of REIT securities, with $18.36 billion, an increase of 66.6% from a year earlier.

Stephen W. Dunn, New York-based executive vice president and director of institutional marketing, noted that the increase in the firm's assets under management was , in part, from the “dramatic rebound” of real estate securities across the world. In 2009 and so far this year as well, there were “strong flows” of investment dollars in separate account, commingled funds and subadvisory, he said.

Invesco (IVZ) Real Estate's real estate securities assets rose 61% to $8.8 billion, with tax-exempt assets growing 42% to $1.8 billion.

Max Swango, managing director who works in the firm's Dallas office, said much of the increase is due to the “simple math” of market appreciation.

In addition, he said, Invesco Real Estate gained more than $1 billion of new net capital in 2009.

“We have been managing REITs for 22 years and 2009 was the second-largest year in terms of net fund flows. In 2010 we still see significant positive fund flows but it's roughly half of what we saw in 2009 and flows are from all over the world,“ Mr. Swango said.

Market appreciation

Allen Smith, CEO of Prudential Real Estate Investors in Parsippany, N.J., agreed. “The majority of the increase is market appreciation,” he said. “There were some modest flows but the big driver is market appreciation.”

PREI's real estate securities assets grew 46% to $735 million.

Others on P&I's list of top managers of real estate securities that experienced rapid growth in assets were ING Clarion/ING Real Estate, which remained in second place with assets of $16.3 billion, up 43%, and third-ranked Morgan Stanley (MS), up 30% to $13.8 billion.

The REIT manager universe, at least in the U.S., has changed dramatically.

“Over the last several years, U.S. REITs had a lot of merger-and-acquisition activity highlighted by the sale of Equity Office Properties in February 2007,” said Russell's Mr. Brunette. “REITs were getting competing offers above their share prices and many sold their entire company.”

As a result, the number of U.S. equity REITs declined to 111 as of July 30, from 152 five years ago, he noted.

“While there's been some contraction in the number of U.S. REITs, existing REITs are getting larger. The average market capitalization was $2.4 billion as of July 30, up from $850 million as of December 2000,” he said.

The top five REIT stocks today represent almost 28% of the U.S. REIT industry, by market capitalization, Mr. Brunette said. “Historically it's been in the 20% range. Over 50% of the index is now concentrated in the top 15 REITs.”

In any case, this is a critical juncture for REITs and private real estate, Mr. Brunette said.

Overall, real estate managers' portfolio of securities have grown exponentially. According to P&I's real estate manager data, REIT assets under management grew 200% in the past decade. Investments from U.S. tax-exempt clients by and large trended up during the decade, but growth appears to have been slower.

Ric Campo, CEO of Houston-based Camden Property Trust, agrees that at least for REITs, the industry is at a crossroads.

“There definitely have been companies that weren't managed well, with short-term debt and too much of it,” Mr. Campo said.

Many were able to resurrect their overly leveraged balanced sheets and save themselves from bankruptcy by accessing equity and debt from the capital markets. REITs used the capital to turn short-term debt into long-term debt and reduce debt from their balance sheets, he said.

Camden is among those opting for a more conservative profile, given the economic climate. In March, it sold $272 million in equity.

“Over the last 12 months, we recharged our balance sheet to the tune of $480 million of equity and we restructured $1.5 billion of short-term debt into long-term debt,” he said. “With those transactions, we really created a very conservative balance sheet.”

“It's a critical juncture for REITs right now,” Mr. Campo said. “In the last five to six years before the Great Recession, REITs were lower leverage and paid dividends. When everyone was buying, we were selling.”

When private real estate managers were investing in construction projects and other types of opportunistic real estate in hopes of reaping higher returns, many REITs were heading for the sidelines, he said. For example, Camden shut down construction projects in 2007, including a $125 million project across from Nationals Park in Washington. “We shut it down and filled in the holes,” Mr. Campo said. “Today, it would be worth $60 (million) to $70 million.”

Not all so chaste

Not all REITs remained so chaste. The poster REIT representing leverage excesses is Chicago-based General Growth Properties, which filed Chapter 11 bankruptcy in April with close to $28 billion in liabilities.

But in 2008 and early 2009, the market priced REIT stocks as if they were all about to go bankrupt, Messrs Campo and Brunette both said in separate conversations. As a result, short-sellers went wild.

“There was more short selling in REITs than the broader equity markets,” Mr. Brunette said.

In March 2009, when REIT shares hit a low, short interest in all REIT shares outstanding was more than 11%, “significantly higher than the overall equity market of about 4%,” he said.

Short interest levels have scaled down gradually to less than 6% in mid-August, Mr. Brunette said.

“One key factor was REITs raising over $24 billion of capital in 2009 to lower their leverage levels,” he said.

Executives at the National Association of Real Estate Investment Trusts, a Washington-based trade association, say REIT asset growth is all about long-term superior returns.

According to a recent analysis by the Washington-based trade association, long-term REIT returns beat performance of opportunistic and value-added real estate funds that are typically in private equity-style real estate funds.

“There are advantages to having private equity real estate in the portfolio but it comes at a substantial cost,” said Brad Case, vice president, research and industry information at NAREIT.

The 10-year U.S. REIT return is an annualized 9.4% compared with 6% for the opportunity fund portion of the NCREIF/Townsend index and 3.6% for the value-added portion of the same index, Mr. Case said. n