How securitization changed investors' time horizons

The rising share of commercial real property ownership in public markets has markedly changed the people and institutions considering commercial real estate investment. These new investors differ from traditional suppliers of capital, particularly in that the new investors have much shorter time-horizons concerning property ownership than did traditional developers and equity investors. This has potentially important consequences for commercial property markets.

The new actual and potential investors in commercial real estate include many individuals and institutions who formerly avoided this type of investment. They had little real estate expertise and no convenient vehicles for investing in it. These investors include individuals, mutual funds, small pension funds, small insurance companies and larger insurance companies that seek more diversified and liquid approaches to owning real estate.

Now, REITs and CMBS provide them with such vehicles, and many stock analysts have sprung up to supply information about this exotic field. This new group of investors normally considers a much broader set of alternative investments than did the traditional commercial property investors. Therefore, commercial real estate must compete with many more alternatives.

When real estate was financed mainly by institutions specializing in that function and not directly linked to Wall Street, no matter what stock market-oriented investors thought about the desirability of owning commercial property, financing was still available from institutions like banks, insurance companies, savings and loans, and mortgage bankers. Pension funds also became involved, but they focused more on stock and bond markets.

But the advent of REIT ownership of commercial property - and REIT dominance of capital flows into private property markets - brought commercial real estate's desirability as an investment into competition with the desirability of all other securities in the minds of the investment officers weighing whether to buy REIT shares.

Moreover, the change in ownership of properties formerly held by private developers and now held by public REITs altered the outlook and incentives typical of real property investors. Developers who borrowed heavily to build properties used tax-sheltered cash flows to build equity over the long run by paying off debts. Their cash flows were sheltered by high interest and depreciation deductions. This resulted in low reportable earnings but rapid equity build-ups - especially during inflationary periods. Another trait of their holdings was irregularity of net earnings because of long initial construction and rent-up periods, plus intermittent heavy capital expenditures for modernization and rehabilitation. A key factor in this strategy is a long-term ownership perspective with little emphasis on reportable earnings.

Many investors in public REIT shares - especially institutional investors rated by quarterly performance - have much shorter time horizons. Also, they want steady increases in reportable earnings. In addition, REIT investors constantly survey myriad alternative stock and bond investments, for which they can use money from the same allocation pool as REIT shares. Therefore, the relative attraction of REIT shares compared with other types of stocks has become much more important in determining the valuation of real properties.

This is the converse of the advantage that REITs have of exposing real estate to large pools of investable capital that formerly ignored commercial properties. The expansion of the capital pool allocable to real property is supposed to reduce capital's cost, and it did so under favorable stock-market conditions. But REIT shares must compete in this expanded capital pool with far more types of investments.

Many investors in stocks also have much shorter time horizons than those in real properties. This is particularly true of mutual and pension fund managers, who are judged on quarterly performance. This sets the stage for greater volatility of REIT share prices than direct property prices. Thus, REIT shares' liquidity encourages short-term thinking in contrast to direct ownership's illiquidity. Traditional developers adopted long-term horizons because they could not exit quickly from equity positions.

This change in time perspectives means that many of today's owners of real estate are not willing to hold REIT shares over long periods in hope of large eventual value increases. They are more likely to bail out because of some short-term adverse factor influencing their REITs' properties. This causes much more volatility in REIT share prices than if shareholders had a true long-term perspective. Moreover, the pressure on REITs to produce steady quarterly increases in funds from operations (FFO) is not consistent with the irregular revenue and cost flows inherent in commercial properties. In periods of adverse market conditions, this pressure will eventually tempt some REIT operators to skimp on needed capital improvements in order to maintain rising FFO.

Thus, the shortening of investor time horizons caused by increased securitization of real properties is not really beneficial to the stable and efficient long-run operation of real property markets. Yet it is undoubtedly here to stay, so those conditions will stay with it.

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