Among REITs, is bigger almost always better?

One result of the recent rise of public real estate investment trusts (REITs) is a race among them to grow larger and at faster rates. Some leading REIT pundits proclaim unabashedly that "bigger is clearly better" - especially if they happen to manage one or more of the biggest REITs. Do large size and rapid growth almost always produce major advantages over smaller, slower-growing REITs? Does the market reward bigger REITs as though they were inherently better? This article seeks to answer these questions.

Advantages of large size Undoubtedly, there are several "advantages of large scale" in the REIT business. Investors typically trade more shares of a REIT each day if it is larger, because there are more such investors and more shares outstanding. This bigger daily stock float permits large financial institutions to buy or sell more shares at a time without affecting the price. Such large-scale trading is administratively more efficient for big pension funds. Also, the resulting liquidity provides them with a feeling of security, since they believe they could "get out" without suffering big losses in value. Since big institutions prefer investing in larger REITs, and since those institutions control huge amounts of capital, a large REIT can attract more funds than a small one. This fact motivates all REIT managers to expand their portfolios as much as possible. Ironically, the minimum size required in theory to attract funds from large institutions is an ever-receding target. It once was $100 million, then $200 million, then $500 million, and is now in the billions.

Large size also exposes REITs to opportunities to buy sizable portfolios of assets that smaller REITs cannot raise enough funds to purchase. This permits faster growth than buying properties one at a time. Also, large size creates economies from volume purchasing of goods and services in property management. And it permits some economies of scale in other property operations. For example, a REIT operating dozens of regional malls across the nation can more effectively negotiate with national tenants than a REIT running only a few centers. Large size also reduces overall risk by diversifying a property portfolio over many markets, and permitting operators to sell off their least-promising assets more readily.

Advantages of rapid growth Rapid growth - as distinct from large size - also provides important advantages to all organizations, not just REITs. Fast-growing organizations can offer more opportunities for promotion to their personnel; hence, they can attract more talented and ambitious associates. Among all publicly traded corporations, rapid growth in earnings generates faster stock-price increases and higher price-earnings ratios, since investors can expect more future value appreciation. Higher price-earning ratios make it easier to merge with other firms by trading stock for them. The latter advantage is especially important for REITs that want to grow by consolidating with other, smaller REITs.

Disadvantages of size and growth Both large size and rapid growth also have disadvantages. The larger a REIT becomes, the harder it is to achieve the same percentage growth each year, because the absolute size of what must be acquired or developed grows too. The great pressure on REITs to grow also generates less prudence about what is bought - or developed - and what prices are paid. Since big REITs can nowadays raise a lot of capital at relatively low cost, they are tempted to pay higher prices for properties than can support competitively profitable operation over time. And as competition among well-financed REITs drives prices of existing properties upward - and yields downward - REITs will be tempted to undertake more and more new development to obtain what appear to be higher going-in yields. But new development is riskier than buying established properties; hence, the apparent yield on development is much lower when risk-adjusted.

Large size also requires managing bigger organizations that inherently develop tendencies toward more rigid bureaucratic decision-making. And big REITs must operate in more market areas, requiring a greater variety of local expertise. Smaller, more regionally specialized firms can often act faster, detect opportunities earlier, and focus more intensively on them.

What do market results show? Proponents of both large size with its greater financial resources and small size with its greater flexibility can argue endlessly about which is better, but the acid test is how the stock market rewards these attributes. To measure this, I conducted a multiple regression analysis of data concerning 97 major REITs provided by Merrill Lynch in its Comparative Evaluation REIT Weekly for one week in December 1997 (the final test involved 58 of these REITs for which complete data were available).

I used the 1997 price-FFO multiplier as the dependent variable, against the following independent variables: total return for the preceding 12 months, net asset value per share, the per-share percentage premium of market capitalization over net asset value, dividend yield, total market capitalization, debt as percentage of total capitalization, dummy variables for eight specific types of properties, and the estimated percentage increase in FFO from 1997 to 1998. The overall adjusted R-squared measures the percentage of variation in the price-FFO multiplier explained by all these variables; it is 79.86%, a relatively high figure. However, only three variables are statistically significant - that is, they have a confirmed relationship to the price-FFO multiplier. These are the estimated percentage increase in FFO from 1997 to 1998 (a very strong positive relationship to the dependent variable), the dividend yield (a moderately strong negative relationship), and whether the property type consists of hotels (also a moderately strong negative relationship). By far the most important influence upon the price-FFO multiplier is the estimated percentage increase in FFO from 1997 to 1998. This variable has a 98% correlation with the price-FFO multiplier, and its explanatory coefficient is about double those of the other two significant variables.

Rather striking and surprising is the finding that the size of a REIT, as measured by its total market capitalization, has almost no impact upon its price-FFO multiplier (the beta value of size is -0.006865), and is not statistically significant. In fact, the correlation between total market capitalization and the price-FFO multiplier is only 44.84%. This conclusion is not obvious from a direct inspection of price-FFO multipliers and REIT sizes. Among the 97 REITs included in the Merrill Lynch database, 17 had total market capitalizations of over $2.75 billion each as of December 1997. These 17 largest REITs together accounted for $83 billion of the $184 billion in total market capitalization (45%) of all 97 REITs, though they comprised only 17.5% of those REITs. These 17 big REITs had an average adjusted pr ice-FFO multiplier of 16.8 (or 16.9 if weighted by their market capitalization), compared to the overall average of 13.09 for all 97 REITs.

These data seem to suggest that large REIT size is indeed rewarded by the stock market. But analysis with the multiple regression technique reveals that this conclusion is erroneous. Expected FFO increases are what drive the price-FFO multiplier, and those increases are only partially correlated with total REIT size. And REIT size itself has no real impact upon the price-FFO multiplier.

Other notable variables with very low influence (small beta values and low t-scores) are net asset value per share, the premium of price over net asset value, the percentage of debt in total market capitalization, and the specific property types of apartments, neighborhood shopping centers, factory outlet malls, office and industrial buildings and regional malls.

So the answer is: Among the public REITs, bigger is not necessarily better, even though it might seem to be from casual inspection of the data. o

* The stock market treats REITs more as income stocks than growth stocks.

* The average ratio of share price divided by adjusted funds-from-operations per share for REITs in December 1997 was 11.7.

* A REIT can attain growth-stock status in the long run only by achieving acquisition gains per share of around 9% or more per year.

* The ability of individual REITs to achieve growth-stock status will depend upon their maintaining a capital-raising advantage in financial markets.

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