A column from the National Multi Housing Council
Everyone involved in real estate has heard the debate about whether Real Estate Investment Trusts (REITs) are good or bad, whether to stay private or go public. On the one side are the pro-REIT, pro-change forces laying out their vision of why rolling up into a REIT is the greatest strategic move since diversification. Lining up in predictable formation on the other side are privately-held companies owners who tout their unilateral control and their freedom from unyielding market pressures for growth no matter what the market.
The success of REITs will ultimately be determined by their ability to weather the "down" sides of cycles. Until then, however, "To be - or not to be?" shouldn't be the real estate industry's sole concern.
A Summary of Positions REITs enjoy the fundamental advantages of low-cost capital, and observers such as Dr. Peter Linneman of the Wharton Real Estate Center have eloquently enumerated these advantages: lower-cost and less restricted debt capital; equity capital with a lower risk premium due to regular disclosure; lower transactions costs per dollar raised; larger margins on revenue; a higher valuation of acquisition assets relative to competitors with higher capital costs; and greater operating efficiencies.
REIT critics say that the constant dividend, and quarterly growth requirements of the equity marketplace, do not accurately model real estate's cyclicality. They say that the market's demand for continual growth is not consistent with historical performance and is an attempt to graft a low-volatility financing model onto assets that do not perform in that manner.
In periods of market distress, the inability to meet the expectation of dividend payout could cause a flight of capital from REITs. Further, the requirements of regular, sustained growth could pressure REITs to make sub-par acquisitions based on timing, not value. Some also claim that the inexorable demands of the equity market for revenue growth may force public real estate companies to consider business opportunities outside of their core expertise. Private operators with going concerns are already meeting the expectations of their investors, and are free to "time" markets for the best return opportunities in new investments.
Synthesis Each camp has valid arguments. Rather than rest in the comfort of the existing market, however, the private real estate market, and the apartment sector in particular should consider adopting some of the best features of the public market. This would help mediate the distinctions in the cost of capital and gradually put in place the financial infrastructure to support the continuing vitality and competitiveness of the private market going forward.
Risk Perception and Compensation Consider three major risks for which investors and lenders must be compensated - credit quality, liquidity and available data. The basic Capital Asset Pricing Model (CAPM) theory tells us that in aggregate, the greater the risk, the greater the compensation to the holders of risk, i.e. the greater the expected returns in the form of interest and dividends. CAPM's cousin, the Arbitrage Pricing Theory (APT), goes further and allows financiers to evaluate the component risks, and price them according to comparable risks in other investments. Each disaggregated risk can be weighted by the market, and the bundle of risks reassembled and priced with a single risk premium reflecting the combined uncertainty.
Regular investor disclosure can drive down the cost of what Princeton University's Professor Uwe Reinhardt calls the "premium for sleepless nights." Clearly, providing quarterly information to investors decreases their uncertainties and limits the number of sleepless nights in between fresh reports of financial performance and significant happenings. In return for sleeping better, investors ask for less in return. Beyond that, however, full and timely disclosure has created whole new classes of investors who can responsibly invest in financial instruments.
Disclosure creates liquidity, as more diverse investors have the ability to justify their investments, based on available information. While it is possible to quibble with the uniformity of the quality of disclosure, it's tough to argue with the accountability that it brings.
Liquidity Accountability and transparency do not necessarily mean conformity. Every industry has its standards and foibles, to which investors and lenders adapt or work around. High-volatility industries such as mining and entertainment enjoy the benefits of liquidity not because they have changed their nature, but rather because there is a large pool of investors who are comfortable with the risks. Their expectations are shaped by the information infrastructure that readily transmits industry- and firm-level performance expectations and investment horizons.
Credit Risk Analysis Liquidity is not the only market-level benefit of disclosure. Widening the ability to evaluate the cost of credit risk is another. The more information that is available to the marketplace, the lower the cost of analyzing the investment decision. The creation of the Multifamily Housing Institute (MHI) as the central source of financial and property performance data for the multifamily industry is a major step by the lending industry attempting to harness this benefit. The second step is the benchmarking of individual properties against the data available from MHI, or some other source. Several analytical firms are developing credit risk models that will allow users to determine estimations of the price of risk. These models will analyze property portfolio pools for cumulative risk and the effects of diversification, as well as provide estimations of the price of an individual property's credit risk to an investor or creditor.
Data Already Flowing - But on Whose Terms? The flow of information via MHI from the private apartment market is going to begin in the next year, however it won't be property specific. There will be industry-level, regional, and market level disclosure, but there won't be infrastructure to provide property or portfolio level information. Individual owners wishing to participate in credit or investment transactions may individually have to present their properties for underwriting against a backdrop of market-wide data which is very transparent. This piecemeal approach to disclosing property-level information means that the private transactors in the apartment market will not receive the benefits of disclosure, as they might if the industry had an organized, unified approach to disclosure and investor education.In the past, the role of creating disclosure infrastructure has fallen to industry only when forced by governmental regulation. Now that the lending industry is taking the lead in creating data infrastructure, the private multifamily sector must take the lead in promulgating the architecture and methodology of disclosure. Creating the pre-conditions for disclosure doesn't mandate public disclosure, but having standardized data available for private evaluation creates the discipline and long-term record that will lower the private investor's or creditor's premium for sleepless nights. Thus it makes private investment financing more competitive with the public market.If and how the industry chooses to create a disclosure infrastructure shouldn't be left to chance. A well-thought out program, properly supported by the apartment industry's central groups, could be relatively painless. By taking the initiative, the industry can put in place its own architecture with all deliberate speed. At least one model already exists for doing so - the municipal bond industry - which is a recent example of industry responding to regulation to create its own central data repository, complete with protocols.
A Role for HUD in the Private Market? Interestingly, the U.S. Department of Housing and Urban Development (HUD) is creating its own reporting infrastructure to assess the condition of FHA-insured and financially assisted properties. HUD's to-be created Assessment Center will be the repository and analyst of its data. Rather than create two different disclosure architectures, the industry has an opportunity now to adopt HUD's disclosure protocol, or perhaps even to suggest modifications that would improve it for general market use. This would fulfill HUD's mission to provide support for the liquidity of the market, and the industry wouldn't have to start from scratchWe're still a few cycles away from the public markets overwhelming the private ownership market, but the cost of capital distinction can only grow and segregate future business opportunities over time. Even ignoring the threat of competition, there is money for the private market in learning from the experience of the public market in mitigating financial risks.
Doing well on a status quo basis is not enough. The continued ability to grow as an operating firm requires facing new challenges. Maintaining continued viability in the face of a deep-pocketed sub-sector is, in fact, the collective responsibility of the diffuse members of the private ownership community. Doubt it? Just ask the remnants of what was also once a private, family real estate business - American farming.
Stephen Lefkovits is vice president of housing and finance for the National Multi Housing Council and its Joint Legislative Program with the National Apartment Association.