REIT Capital Inflows Show Paradigm Shift

When analysts contemplate the recent immense flows of financial capital into real estate, they usually think of the worldwide boom in housing prices. But an equally impressive flood of capital has been funneled into real estate investment trusts.

The total market cap of all publicly traded REITs was only $1.5 billion in 1971, according to the National Association of Real Estate Trusts (NAREIT). In 1991, that total hit $13 billion — 8.7 times as much as in 1971. By 2001, that value reached $155 billion — 12 times as much as in 1991.

Over the next four years, the total market cap of REITs more than doubled to $331 billion. That's an average gain per year of $44 billion, or 113% over four years. During that same period, the S&P 500 Index rose by 8.1%; the Dow-Jones Industrial Average increased only 6.3%; and the Nasdaq Composite Average gained 11.4% — but it was still less than half its peak value in March 2000.

In short, there has been a paradigm shift in investor thinking since the 2000 stock market crash. Real estate, which includes REIT stocks, has now been definitively recognized as a distinct asset class separate from stocks and bonds. Moreover, investors worldwide have decided to maintain a bigger share of their total assets in real estate, including REITs, than in the past.

This strategy helps investors diversify their portfolios because prices of real estate and stocks move in different time patterns from the prices of bonds and non-real estate stocks. REIT investments also increase the cash flows from equities because of their relatively high and stable dividends vs. most other stocks.

Will the pendulum swing?

Now that the worldwide housing price and construction boom is cooling off, some observers believe both institutional and private investors will return to their previous skepticism about commercial real estate as an enduring investment.

If so, capital should begin to flow out of real properties and back into general stock and bond markets. That would cause the recently escalating prices of commercial real estate properties to stop rising, and perhaps fall sharply, and stock and bond prices to resume their dominance.

As of this fall, there are no signs of investor fatigue in commercial properties, at least insofar as those held by REITs are concerned. There are two overall indices of REIT price performance: the NAREIT Equity Index and the Morgan Stanley Composite REIT Index. At the end of August 2006, both were hitting all-time highs.

They have both increased in percentage terms during 2006, far more than any of the major stock indices. The total amount of capital raised in REIT security markets exceeded $38 billion in 2004 and 2005, and was running at a similar rate in 2006. Most of that capital raised was debt capital, a majority of which was unsecured.

Although interest rates have risen somewhat in the past two years, there seems to be no shortage of financial capital available for investment in real properties by REITs and private equity funds.

Furthermore, the aging of the developed world's population indicates that more people will be entering retirement ages when they need current income from investments. And pension funds will also need cash-paying investments — such as REITs — to pay off their retiring customers. So, the underlying demand to own REITs is likely to remain high.

Nothing lasts forever

Of course, there can be no ironclad guarantee that REITs will continue to outperform most other forms of investments, as they have since 2000. After the credit crunch caused by Russia's financial default in 1998, REIT capitalized values actually slumped for two years, losing 11.5% of their 1998 value.

But from the end of 2000 through Aug. 30, 2006, the NAREIT index for equity REITs gained 189%; whereas the S&P 500 index gained 1.4%, the Dow-Jones Industrials index gained 5.2%, and the Nasdaq composite lost 0.5%.

REITs can't continue to greatly outperform alternative investments indefinitely. But until the world's investment community loses more faith in commercial property than it has up to now, and gains a lot more confidence in other stocks in this uncertain world, REITs remain a sound investment, especially for people and institutions who need current income.

Anthony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at [email protected].

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