With REITs, less owners in it for the long haul

Investors who own a lot of commercial real estate in the form of real estate investment trust (REIT) shares now have much shorter time horizons than did most traditional real estate investors when the latter dominated property ownership. This change is profoundly affecting how commercial property markets operate.

The rise of REITs and commercial mortgage backed securities (CMBS) has shifted the ultimate ownership of billions of dollars of commercial real estate from traditional developers and financial institutions to both individual and institutional investors in real estate stocks. Most traditional developers created or bought property, using heavy leveraging with debt, as part of a strategy of building up their wealth over long periods. They held their properties for many years, while accumulating equity through minimizing income taxes via interest and depreciation deductions, and using their cash flows to reduce debt.

Inflation often aided this accumulation process by raising market values faster than expected, thereby reducing the real cost of debt. The illiquid nature of real properties also encouraged long-term holding rather than rapid in-and-out movements by owners. These owners often refinanced their properties at higher mortgage levels rather than selling them, thereby permitting them to take out tax-free capital for other purposes or for more real estate investment. Many of the nation's largest fortunes were built up in this manner - before the age of Internet stocks and explosive high-tech IPOs.

By contrast, the owners of real estate held by REITs - aside from the managers of the REITs who own stock in them - consist of two groups: individual investors and major financial institutions such as mutual funds. Because REIT shares are much more liquid than directly-owned properties, share owners can quickly shift from one REIT to another, or out of REIT holdings altogether. The institutions that own REIT shares are under pressure to achieve high-yield, short-term performance ratings so they can keep attracting more funds from individuals. Both these groups have no proprietary feelings about the properties they own comparable to the feelings of traditional developers who built and owned properties they created through their own efforts. On the contrary, both these groups regard real estate assets as just another form of commodity.

These conditions encourage REIT shareholders to have very short-term views concerning their property holdings. Moreover, both individual and institutional REIT shareholders have many more alternative uses of their capital easily available to them than traditional investors did. The latter focused their efforts almost entirely upon real estate, but REIT shareholders can quickly move their capital into one or more of dozens of different industries and thousands of firms and mutual funds.

The temptation to use this mobility to avoid commercial real estate is intensified by the relatively poor performance over the past 15 years of commercial property values vs. the values of stocks in almost all other fields. Whereas property price indexes show that most real estate - other than single-family homes - has increased in value relatively little in the 1990s, the stock market has soared more than 200 percent. Specific high-tech firms and Internet stars have risen much more than that. By contrast, commercial real estate values collapsed in the early 1990s after massive overbuilding in the 1980s. The Internet phenomenon of "day-traders" has aggravated the shortening of horizons to a ludicrous degree: According to Business Week, the average share of Amazon.com on the market is held for only seven days.

Is real estate's nature compatible with stock market values? Wall Street investors place high value on each firm reporting steady and sizable percentage increases in net income over time, without any lapses. Yet, in two key respects, commercial real estate assets are inherently unsuited to this concept of steady increases in after-tax income. First, market conditions (which affect rents) and development spending and property maintenance (which affect expenses) occur in either cyclical or irregular and unpredictable patterns. Second, one of real estate's main advantages is the ability, over time, to build up capital while paying relatively low taxes, as noted earlier. But this involves reducing reportable income as low as possible, rather than maximizing it.

This irregular timing pattern can be offset to some degree by combining many properties in a single portfolio and manipulating overall flows of capital to produce steady increases in total earnings, even though individual properties have irregular earnings flows. But even large property portfolios are still susceptible to cyclical movements in rents and expenses.

Moreover, the need to tailor reported income to meet the exact pennies of analysts' predictions can cause deferment of needed repairs and capital expenditures, which come in lump amounts and at irregular periods. Yet the stock market punishes REITs and other firms that miss the stock market analysts' predictions of income by even tiny amounts per quarter. But these analysts themselves are enmeshed in egregious conflicts of interest because they are used for marketing purposes by investment banking firms, rather than acting as "pure" researchers. Most investment banking firms will not permit their analysts to report regularly on any REIT unless the REIT first does business with it. Hence the analysts' predictions are tainted by the pressure to supplement the investment banking deals of their parent firms.

Another pressure for shorter horizons arises during periods of prosperity, when investor competition drives cap rates lower. This can cause internal rates of return (IRRs) to decline as a property is held because sale prices are higher in relation to annual rental income flows.

The shortening of investor time horizons described above also increases the volatility of prices in commercial property markets. And it causes greater absorption of resources in "churning" properties - a major source of inefficiency in stock markets with high turnover rates.

Less focus on basic worth Is the shortening of time horizons among owners of commercial properties good or bad for the economy as a whole? Pressure to increase yields at every specific moment causes more efficient use of capital - at least in theory. But this is paid for by less focus by many owners on the basic value of the properties they own, since they view those properties solely as short-term vehicles for appreciation and gain. Thus, strong pressures arise to pay more attention to how the stock market values properties than how well they are doing "down on the ground," where they are performing their basic social functions. For all the aforementioned reasons, it is by no means clear that this basic shortening of horizons will be good for the nation's real property over the long run.

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