While 2008 was not one of the best years for securitized real estate in the form of Real Estate Investment Trusts (REITs), 2009 was another story. The FTSE/NAREIT Equity REIT index returned, in total, an abysmal -37.73 percent in 2008; for 2009, however, it was great.
The REITs started off with quite a hammering, probably due to the continued momentum of the last year. In the second half of the year, however, the market climbed back. The NAREIT index ultimately had a total return of 27.99 percent, beating the return on the S&P 500 index, which had a total return of 26.46 percent. While the performance of the REIT sector has always been under scrutiny by skeptics, it has consistently delivered returns across years. With uncertainty over the equity markets in years of financial turmoil, the importance of dividend-paying stocks is even more recognizable. That is what provides the cushion for REITs.
Having completed 2009 on a high note, the question is what's in store for REITs in 2010? What are the concerns going forward for these income-producing companies?
The first big question for any investor following this sector is the level of debt obligations maturing in 2010. For overall commercial real estate debt, for example, the figure is approximately $1.4 trillion. Although not highly leveraged, REITs still maintain debt levels around 40 percent to 50 percent on average, depending on property type. Any REIT higher than that is not favorably looked at. With the expectation of higher interest rates going forward, stringent and tightened credit measures by banks and lending institutions, REITS with maturing debt this year will find it difficult to get debt sources to refinance. It is a dual question of getting debt and getting it at favorable rates to refinance. The debt maturing in 2010 for REITs was at a very low interest rate, which may not be available when they plan to refinance. This is as big as a problem as an opportunity. An opportunity exists within the REIT sector for mortgage REITs to fill the void left by banks and lending institutions. So either existing REITs will step forward to address this concern/opportunity or new ones will spring up.
Looking at other variables affecting this sector -- namely employment growth, GDP growth and consumer spending -- the picture looks very hazy going forward. This means there will be tremendous pressure on the earnings for these REITs. This kind of pressure may lead to M&A activity, with larger and stable REITs scouting for opportunities/inorganic growth. This will give them a chance to get into markets that they are not currently present in and diversify their portfolio from a risk perspective. In addition, private equity and hedge funds will be waiting to acquire some of the distressed REITs in part (only some of their assets) or as a whole when the opportunities arrive going forward.
On the development side, with the direct real estate markets offering attractive opportunities through distressed properties, REITs will prefer to acquire rather than develop properties. This may continue for some time, until demand for real estate gets built up over the next few years and supply is curtailed through less development/more acquisition with improving employment numbers, GDP growth and consumer spending. Once economic growth fuels demand for real estate products, we should see more development activity by REITs.
2009 saw the highest number of capital offerings -- 130 total including initial public offerings (IPOs), secondary and debt -- since 2006. If only IPOs are considered, it was the best year since 2005 and the third best year since 2001. However, with apprehension in the commercial real estate markets and concerns of rising interest rates, economic growth, employment and consumer spending, REITs that could not go public earlier may reconsider their decision now, due to market uncertainty. Some of them, however, might still want to time the equity market momentum in the early half of 2010.
Ultimately, we can expect REITs to be more cautious this year and focus on their core competencies/markets. At the same time, there will be opportunities for inorganic growth through acquisitions to diversify their portfolios both at the property-type level and market level.
The objective in a market of uncertainty is to retain the trust of your investor base by doing what REITs are supposed to do: provide a consistent income stream by maintaining dividend levels consistent with historical investor expectations.
Sah, Ph.D., is an assistant professor at the University of San Diego's Burnham-Moores Center for Real Estate.