With the equity markets having rebounded strongly over the past few months, the real estate sector has finally picked up, and the REIT (Real Estate Investment Trust) industry currently is undergoing a massive de-leveraging effort. Before delving further into this, it is vital to understand what REITs are. REITs are public investment vehicles aimed to promote ownership of real estate. Owning a share of a REIT is similar to owning a share in a typical publicly trade company. They are exempt from corporate level taxes if they meet certain tests. Due to their special tax status, REITs must distribute 90% of its net income to its shareholders.
Until about twenty years ago, the structural make-up of the real estate industry (i.e. small players, fragmented ownership, no outside equity sources, etc.) dictated that debt, not equity, serve as the primary source of external capital. So, in the good times when debt was cheaply and abundantly available, these REITs levered up to outrageous levels of 60%-80%. Two years down the line, the affinity towards leverage, which stemmed from fact that higher leverage would be accompanied by higher returns in order to compensate for its added risk, has reduced significantly. People have finally realized that this obscene amount of leverage hasn’t actually contributed to increased returns in the REIT sector. It only hits us now that more levered REITs failed to provide meaningfully better returns even in the ten-year period preceding the peak of the asset valuation bubble. Lower levered REITs have substantially outperformed over the last fifteen years.
In 2009 alone, U.S. REITs have raised a massive $16 billion equity capital to shore up balance sheets. The “re-equitization” trend has been well received as REITs have been bid up almost 60% in price since lows earlier this year. In the process of deleveraging a select number of REITs are emerging as potentially powerful acquirers of assets. However, there are some questions that need to be answered:
Some questions that will need to answered, going forward:
- What are the implications of the equity offerings for investors? Do the benefits of a stronger balance sheet outweigh the drawbacks of dilution?
- Why have some companies outperformed the market since their offerings and others have not? Are we starting to see the strong separate from the weak?
- How does raising equity affect a company’s ability to access other forms of capital? For example, is there a direct effect on the unsecured debt market of these offerings?
- What other routes are companies considering besides raising common equity? Are the debt markets becoming more a favorable option?
- Should we expect to see REITs raise their dividends this year as they shore up their balance sheets?
- Simon Properties (one of the biggest REITs) has now gone to the market twice. Are REITs amassing dry powder to make acquisitions when opportunities present themselves?
The good sign is that the REIT sector has finally commenced what is likely to be a multi-year de-leveraging process. It should unfold in three stages: 1) de-lever to ensure survival; 2) de-lever to return to prior leverage targets; and 3) acknowledge that prior leverage targets were too high and de-lever to achieve new, lower targets. Much progress has been made on the first phase, yet most companies are not yet entirely out of the woods. The subsequent stages will entail massive amounts of equity issuance, as leverage ratios need to decline by more than 1500 bps to return to prior norms, and a substantial reduction beyond prior targets is appropriate. At a time when other real estate market participants lack access to capital, REITs that aggressively de-lever as they articulate thoughtful strategic objectives with regard to their long-term capital structures will be well-rewarded.
