CHAPTER 5

REAL ESTATE INDUSTRY GROUP

When people think about real estate, most may think first of residential real estate—whether a single-family home in the suburbs or a condo by the beach. This category includes one- to four-unit properties, and while the sheer size and breadth of the market make pinpointing the true value difficult, it’s safe to say it’s one of the largest markets in the world.

When it comes to equity investing, real estate typically refers to commercial property designed for retail, wholesale, office, hotel or service use, which globally accounts for more than $21 trillion in assets.1 It also refers to residential real estate in excess of four units, such as apartment buildings or senior living facilities. Companies focused on commercial properties are in the Real Estate Industry group.

The Real Estate Industry group is the smallest in the Financials sector in most major indexes, with one exception—US small-cap benchmarks. The group consists of Real Estate Investment Trusts (REITs) and Real Estate Management & Development (REMD) companies, both of which concern owning, managing, financing and/or developing mostly commercial real estate assets. It represents 2.6% of the MSCI World index, with most REIT exposure in the US, while most Management & Development companies are outside the US (Table 5.1).2

Table 5.1 Real Estate Industry Group Weight in Major Benchmarks

Source: Thomson Reuters; S&P 500 and Russell 2000 Indexes; MSCI, Inc.3 As of 12/31/2011.

Since REITs dominate the Real Estate Industry and are similar globally, this chapter primarily focuses on the US REIT industry. We discuss:

• What is a REIT?
• Equity, mortgage or hybrid?
• REIT characteristics
• REITs in detail
• Common REIT terms

WHAT IS A REIT?

A REIT is an investment fund focused on real estate assets that comingles investor funds to purchase primarily commercial properties and mortgages. REITs were created to allow broad access to investment opportunities in diversified, professionally managed real estate enterprises. While REITs vary globally, each type’s core rules are typically the same—to qualify as a REIT (regardless of type or nationality), a company typically must have most of its assets and income tied directly to commercial real estate assets and distribute most of its earnings to shareholders. These rules were established to make REITs as similar as possible to owning real estate assets directly and are a precondition for favorable tax treatment.

Investable REITs

REITs can be categorized as publicly traded, public non-listed or private entities (Table 5.2). Whereas publicly traded REITs trade like stocks (typically on an exchange) and are available to the masses, public non-listed and private REITs cater to longer-term investors and typically have higher minimum investments and a potentially opaque liquidation process. Since we are examining REITs as they relate to equity investing, we will focus on publicly traded REITs.

Table 5.2 Types and Characteristics of REITs

Source: “Which Type of REIT Is Right for You?” NAREIT (2009).

Taxes

REITs receive beneficial tax treatment at the corporate level—meaning provided certain rules are met, REITs don’t pay income tax. This makes REIT ownership pretty similar to direct property ownership. Without this tax treatment, REIT dividends would typically be taxed at the corporate and investor levels, compared to owning property directly, which is typically taxed only at the investor level.

There are different types of REIT dividends, the most common being an ordinary dividend, based on normal operations (E&P, or earnings and profits) from rental, lease, dividend or interest income. These dividends are generally taxed as ordinary income to individual REIT investors and typically account for the majority of dividends. REITs can also distribute dividends in the form of capital gains, return of capital or deprecation recoveries, which would likely be taxed differently. Interested investors should consult a tax expert for further clarification of these differences.

Equity, Mortgage or Hybrid?

REITs are broken down into three categories: equity REIT, mortgage REIT or hybrid REIT. Equity REITs typically invest directly in commercial properties, whereas mortgage REITs typically invest in mortgages or other debt instruments related to commercial properties. Hybrid REITs invest in both—since they’re less common, they’re often categorized as either equity or mortgage REITs, depending on their primary focus. Globally, 92% of REITs are equity and 8% are mortgage.6

There are seven sub-industries in the REIT Industry, each focusing on a different area of real estate: Diversified, Industrial, Mortgage, Office, Residential, Retail and Specialized (Table 5.3).

Table 5.3 REIT Sub-Industries as a % of the REIT Industry

Source: Thomson Reuters; S&P 500 and Russell 2000 Indexes; MSCI, Inc.7 As of 12/31/2011.

The Retail sub-industry is the largest in global benchmarks, while Specialized is the largest in domestic benchmarks—driven primarily by storage and hotels.

REIT CHARACTERISTICS

There are numerous ways to describe REITs, but a few core characteristics stand out: REITs are value and small, pay dividends and are defensive-ish and impacted by interest rates. Furthermore, as with all securities, REITs and the underlying properties are driven by supply and demand.

REITs Are Value

Growth investors tend to favor companies with above-average earnings growth rates, while value investors tend to prefer companies with below-average valuations. There are many benchmarks for each style, including the well-known Russell Value and Growth Indexes. REITs, with normally low growth rates, higher dividend yields and below-average valuations, are typically preferred by value investors.

REITs Are Small

Historically, big companies fare better during recessions because they’re seen as relative safe havens, while small companies bounce big early in recoveries because they’ve usually suffered more during the preceding recession and bounce bigger off the bottom. And since REITs are usually small, it’s no surprise they typically perform better when small cap is beating large cap.

Dividends

Since REITs are required to distribute at least 90% of income to shareholders, REIT dividend yields are generally higher than the market, making dividends a core component of REIT investing. Since REITs’ inception, dividends have generally accounted for all cumulative total return—price swings up and down have mostly offset each other.

Supply and Demand

Commercial property demand can be volatile, ebbing and flowing with the economic cycle, but supply is more stable and easier to quantify. Property supply can be measured a few ways: absorption rates, vacancies, new construction, permits and construction spending, all of which are well reported and commonly updated monthly (Figure 5.1). Considering REITs typically have a limited geographic presence and in real estate it is mostly about “LOCATION, LOCATION, LOCATION,” understanding supply and demand trends for the underlying property market is critical when investing in REITs.

Figure 5.1 US Vacancy Rates 2004–2011

Source: Thomson Reuters, Reis 12/31/2004–12/31/2011.

Property Prices

Physical property prices are a core component of REIT valuations, though REITs tend to lead property prices (see Table 5.4 and Figure 5.2). This relationship exists because of the liquid nature of exchange-traded REITs and the illiquid nature of physical properties. Markets react to new information quickly, and since you can buy or sell many REITs with the click of a button, they tend to react quicker. While this drives the leading nature of REITs, it also adds to the volatility relative to physical property prices.

Table 5.4 Correlation of NCREIF TBI National Property Index and the NAREIT All REIT Index

Source: National Council of Real Estate Investment Fiduciaries; Thomson Reuters from 12/31/1977 to 12/31/2011.

Figure 5.2 Growth of a Dollar (Moody’s TBI Property Index Versus NAREIT REIT Index)

Source: National Council of Real Estate Investment Fiduciaries, Moody’s, Thomson Reuters. From 12/31/1977 to 12/31/2011.

REITs Are Defensive-ish

Since the NAREIT US REIT Index’s 1971 inception, REITs have tended to be defensive. When the S&P 500 is negative on a total-return basis over a 12-month period, it averages −15%—during the same periods, REITs average −6%. However, when the S&P 500 is positive in 12 months, it averages 19%, while REITs average 17%.8 Simply, REITs tend to underperform when the market rises and outperform when the market falls. By no means does this ensure REITs will underperform during every bull market or outperform during every bear—but it has been the case on average.

REITs Are Interest-Rate Sensitive

REITs are interest-rate sensitive in two very important ways: If interest rates fall, it could make financing a property cheaper, which could increase REITs’ profitability. Additionally, since REITs distribute dividends, rising interest rates could make other cash-flowing investments more attractive if a given REIT doesn’t increase its dividend.

REITs in Detail—Mortgage and Equity REITs

Mortgage and equity REITs are impacted by different drivers and act differently over time. Whereas equity REITs are impacted by commercial property trends, mortgage REITs are impacted by residential housing credit markets.

Mortgage REITs

A mortgage REIT, or mREIT, specializes in mortgages and mortgage-backed securities (MBS), both residential and commercial. These mortgages can be purchased from third parties, or the mREIT can underwrite the loans directly—either way, it functions primarily as a pool of mortgage-backed securities. Whereas an equity REIT can be viewed as a mutual funds of real estate assets, mREITs can be viewed as mutual funds of mutual funds of mortgages. While the focus of mREITs is mortgages, domestically, they own a very small slice of the overall mortgage and MBS pie.

A REPRESENTATIVE EXAMPLE: ANNALY CAPITAL MANAGEMENT

As of December 2011, Annaly Capital (NLY) is the largest US mortgage REIT—its $15.5 billion market capitalization nearly doubles its nearest peer and accounts for about 35% of total mortgage REIT market capitalization.9 Moreover, it accounts for 36% of total mortgage REIT assets.10 Since NLY is such a dominant presence, let’s take a look at what makes it tick.

At the heart of a mortgage REIT is its portfolio of mortgages. NLY’s $104 billion MBS portfolio accounts for 95% of its total assets.11 Of this, 100% is considered agency—underwritten per Freddie, Fannie or Ginnie guidelines. This puts its portfolio at little risk of a credit event—unless the agencies themselves were to default.

Since NLY is essentially a leveraged pool of agency MBS, it’s important to note the direct link between NLY and agency MBS. Figure 5.3 clearly illustrates Mortgage REITs’ relationship to a benchmark agency MBS index.

Figure 5.3 Annaly Capital Versus Agency MBS

Source: Bank of America Merrill Lynch, Thomson Reuters from 12/31/2000 to 12/31/2011.

Looking at the NAREIT mREIT index shows a similar pattern (Figure 5.4), with some noticeable differences. Note the relationship between mREITs and agency bonds fell apart around 2003 and then again in the 2007–2008 period. In the early part of the decade, private-label MBS outperformed agency MBS, and mREITs benefited from exposure to the riskier mortgages. Then, later in the decade, agency MBS vastly outperformed as mortgages started to sour. During this time, many mREITs went bankrupt or were dissolved. However, the relationship between Annaly Capital and agency bonds stayed pretty tight during this time, primarily due to its focus on agency MBS.

Figure 5.4 Agency MBS and Mortgage REITs

Source: Bank of America Merrill Lynch, Thomson Reuters from December 2000 to December 2011.

As you can tell, the type of MBS within the portfolio makes all the difference—credit risk is a big concern for private label, less so for agencies.

If mREITs Act Like MBS, Then What Drives MBS’ Total Return?

Interest rates’ direction, interest-rate spreads, the number of prepayments and the potential for credit events (defaults) impact MBS returns. Simply put, rising interest rates, wider spreads, increased prepayments or increased default expectations could all pressure MBS values. A firm understanding of these drivers is imperative when investing in mREITs—allowing investors to over- or underweight appropriately and providing guidance on which characteristics likely play a role moving forward.

EQUITY REIT SUB-INDUSTRIES

Each equity REIT sub-industry focuses on a particular real estate sector and has unique characteristics over and above the aforementioned shared traits.

Retail REITs

Retail REITs focus primarily on leasing properties to retail-oriented companies, such as grocery or electronics stores or even regional malls or outlet centers—meaning they tend to be more tied to consumer spending patterns than the others.

Rent is a core revenue source and is typically broken into minimum rent and overage rent—the minimum rent typically tied to inflation and overage rent tied to tenants’ sales. As tenants’ sales improve, so does the rent, and vice versa.

Office REITs

Office REITs own and operate office properties and earn revenue primarily from office rents. Leases are among the longest, with 7- to 10-year leases not unheard of, making office REITs less cyclical than others. If market rents move lower, it takes longer for that decrease to impact office REITs since most leases are “locked in.” Similarly, in robust economic times, office REITs are at a disadvantage to those able to quickly increase rents. This is why office REITs typically offer information on “above-market” and ”below-market” rents and lease expiration schedules. If a REIT is heavy on “above-market” rents and has many leases expiring soon, this may lead to reduced upcoming rental income as those rents are either adjusted down or lost completely if tenants move. Of course, the reverse could also happen.

Building quality is an important consideration in analyzing office REITs’ portfolios. Buildings are generally classified into three grades referring to property quality: Classes A, B and C. Class A properties are the highest quality, Class B are mid-quality and Class C are the lowest quality.

Beyond portfolio quality, tenancy is of utmost importance. Major office space users are legal services, other financial companies such as banks and insurance companies, professional services, the government and affiliated agencies and health care companies. Office REITs often focus on a particular niche, which can make the REIT act differently from more diversified REITs, so understanding tenant industry trends is crucial. For example, in adverse economic times, a focus on government contracts may be prudent because occupancy trends here are typically more stable.

Residential REITs

Residential REITs focus on residential properties, including multifamily homes, apartments, manufactured homes and student housing properties. An important distinction is the residential properties owned by residential REITs are commercial interests—i.e., the properties are cash flow-generating properties, typically not single-family residences.

Home ownership is Residential REITs’ main competition. Residential REITs prefer an environment where mortgage affordability and interest rates are low. This way, the REIT can access cheap funding while consumers cannot afford to buy, so they rent—driving up aggregate demand for space in their properties and making the REIT quite profitable. If affordability improves, more renters can afford to purchase and vacancies could increase as rental demand falls. Additionally, rising interest rates could pinch profitability—but they would also likely pressure home affordability through increased mortgage rates. Understanding the cost of owning versus the cost of renting is useful in considering residential REITs.

Likewise, residential REITs will be impacted by renters’ and owners’ considerations, such as job growth, government program changes, etc.

Industrial REITs

Industrial REITs focus on properties that are used primarily for logistics, operations such as transport, distribution, packing or storage. Industrial properties can be simple warehouses or complex distribution facilities, but regardless, they are typically found close to major arterial road, air and/or sea networks. Since many industrial buildings are relatively inexpensive to build, supply is more fluid than many other types of properties. Think of a simple warehouse—there’s not much to it.

As the name implies, industrial activity drives demand for these types of properties, as does global trade.

Diversified REITs

A diversified REIT is generally focused on a combination of office, retail and/or residential properties. Aspects of each sub-industry impact diversifieds, but the diversified REIT may benefit from synergies among the groups. An office REIT could develop a project where its core is office buildings, but it supplements these offices with a smattering of retail shops and apartments to capture as much demand as possible.

Specialized REITs

Specialized REITs are typically those without sufficient company representation to warrant a specific sub-industry classification. Core areas in specialized REITs include health care, hotel and storage. Whereas hotel and storage REITs tend to be more economically sensitive due to very short lease duration, health care’s generally longer lease structure makes it a bit less so.

UNIQUE MEASUREMENTS FOR REITs

Because traditional GAAP accounting rules don’t really work for REITs, the industry focuses on funds from operations (FFO) instead of earnings and on net asset value (NAV) instead of book value. The industry also uses cap rate for property valuations and net operating income (NOI) for core profitability measurements.

Funds From Operations (FFO)

FFO, the most common measure of a REIT’s operation performance, is generally defined as net income excluding gains (or losses) from property sales plus depreciation and amortization and after adjustments for unconsolidated partnerships and joint ventures. The aim is producing a measure of consolidated operating performance that’s repeatable and avoids the drawbacks of using historical cost depreciation. Since real estate assets don’t typically rise or fall predictably over time like other assets such as machinery, computer software or inventory, historical cost depreciation is considered inappropriate for REITs, and FFO is a way to measure performance excluding depreciation and amortization.

Because FFO is usually considered to portray REIT growth, strength and valuations, the price-to-FFO ratio (P/FFO) could be considered the industry’s equivalent of the price-to-earnings (P/E) ratio. Inverting the P/FFO gives you an FFO yield, which can be considered equivalent to a company’s earnings yield. It’s important to keep in mind, though, an FFO yield cannot effectively be compared to a company in another industry’s earnings yield. In fact, FFO yields are generally best restricted to individual sub-industries within REITs.

Net Asset Value (NAV)

NAV measures a REIT’s value, typically in terms of assets minus liabilities—with some adjustments. This is similar (but not equivalent) to book value since, as with FFO, REITs are skewed by considerable depreciation of their real estate assets. NAV uses the fair value of these assets rather than cost minus depreciation.

Because REITs are much more liquid than most real estate assets, REITs’ market capitalizations typically move before the value of the underlying assets. If investors believe the REIT’s portfolio is more valuable than recent NAV valuations, investors may drive the market capitalization above the REIT’s NAV.

Net Operating Income (NOI)

NOI is the company’s (continuing) operating income minus (continuing) operating expenses—it excludes one-time or extraordinary events. Because depreciation and amortization skew net income and since FFO is an adjusted number, net operating income (NOI) is a measurement often used to report the status of a REIT’s operations. Moreover, NOI is used in determining cap rates and NAV, so it is useful in many ways.

Cap Rates

A cap rate, or capitalization rate, is simply net operating income divided by property value. Said another way, a cap rate can be considered the profitability level of a property or portfolio of properties. One problem with cap rates is they rely on property values, which can be rather arbitrarily determined and based on myriad assumptions and variables, like expected rents, cost of funds, risk premiums and other projections. However, cap rates can be useful for comparison purposes, provided the same methodology’s used over time.

As with any ratio, rising cap rates can signal rising NOI, or they can equally mean falling property prices—the driver behind the trend is important.

Forward implied cap rates can be used as a proxy for cap rates, which can fluctuate widely. The forward implied rate uses NOI divided by enterprise value and attempts to discern a cap rate based on current market expectations. Enterprise value is essentially market capitalization plus net debt and is often referred to as a theoretical takeover value, since this would be the total cost of acquiring the property at current market pricing. Since enterprise value and NOI are given items, this takes some of the guesswork out of REIT analysis.

Notes

1. “The Future Size of the Global Real Estate Market,” RREEF Research (July 2007), www.rreef.com/content/_media/Research_The_Future_Size_of_The_Global_Real_Estate_Market_July_2007.pdf (accessed 03/27/2012).

2. Thomson Reuters; MSCI World Index, as of 12/31/2011.

3. MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages.

4. Bloomberg Finance L.P., as of 03/20/2012.

5. Thomson Reuters, Russell 2000 Value Index, as of 12/31/2011.

6. Bloomberg Finance L.P., as of 03/20/2012.

7. See note 3.

8. Thomson Reuters, S&P 500 and FTSE NAREIT All REIT Indexes, total return in USD, as of 12/31/2011.

9. Thomson Reuters, as of 12/31/2010.

10. Annaly Capital Management 2011 10-K; Bloomberg Finance L.P., as of 12/31/2011.

11. Annaly Capital Management 2011 10-K.