FRBSF Economic Letter
2000-02; January 28, 2000
 Economic
Letter Index
REITs and the Integration between Capital Markets
and Real Estate Markets
Traditionally, commercial real estate financing has not been well integrated
with capital markets. Ownership has been concentrated, with wealthy individuals
and large institutions such as insurance companies and pension funds as
the primary investors in commercial real estate. These investors typically
have held the real estate in portfolio rather than repackaging the ownership
claims into shares that could be actively traded on an exchange. Banks
have been among the primary financiers of commercial real estate, funding
investment both in existing structures as well as new development. This
lack of integration stands in contrast to other sectors of the economy.
The assets of industrial corporations primarily are funded in the stock
and bond markets. Ownership of these claims is broadbased and trading
is frequent. Residential real estate is funded through mortgages that
are pooled and then resold in the capital markets.
Why have the links between capital markets and commercial real estate
been slow to evolve? Prior to 1986, the tax treatment of losses on real
estate gave wealthy individuals a comparative advantage in holding these
assets. Other impediments such as the large number of parties to a transaction,
the high degree of asset heterogeneity, and regulatory controls (such
as zoning laws and environmental restrictions) all have contributed to
commercial real estate's relatively slow pace of integration.
Despite these impediments, the past decade has seen much more integration
of commercial real estate markets with the capital markets. Two developments
in particular stand out: the growth of the real estate investment trusts
(REITs) and the increased securitization of commercial mortgages. This
Economic Letter focuses on REITs and the possible implications
of their growth for commercial real estate.
Characteristics of REITs
REITs provide a way for ordinary investors to take positions in real
estate. Much like mutual funds, REITs are pass-through entities that distribute
income and capital gains from investments to their shareholders untaxed.
Also like mutual funds, REITs are specialized to offer investors ways
to target specific asset classes and geographic regions. REITs, however,
have significant restrictions on the types of investments they can make.
At least 75% of portfolio assets must be in the form of real property
or mortgages, and at least 75% of REIT income must be generated from these
types of investments. The most interesting constraint on REITs is the
requirement that they pay out at least 95% of their income as dividends
to their shareholders. If the REIT management wishes to buy new assets,
more than likely it must raise the necessary finance through new equity
or a debt issue, or by tapping a line of credit at a bank. Either way,
the absence of a retained earnings buffer forces REITs to submit their
plans to investor review every time they buy or build.
The REIT is actually an old organizational form, dating back to 1960. Early
REITs were allowed to own real estate, but they could not manage it, forcing
them to contract out the operations to third parties. The potential for
conflict of interest with these arrangements and the cyclical nature of
real estate itself did much to hamper REIT growth in these early years.
The REIT structure enjoyed a surge in popularity after 1986 when management
restrictions were removed and changes in the tax code reduced the appeal
of the limited partnership ownership form. Investors, eager to capitalize
on the recovery of the real estate market, poured money into REITs and fueled
much of their growth. Today, REITs control approximately $300 billion in
assets. While this is just a small percentage of the estimated $4 trillion
value of the U.S. real estate stock, the REIT share of the total stock has
been growing quickly (see Figure
1).
Potential benefits of REITs
REITs have provided real estate investors with a host of benefits. First
and foremost, REITs are exchange traded and, hence, provide investors
with liquidity. Absent an active market for real estate claims, investors
cannot easily hedge their exposures, so, all other things equal, investing
becomes more risky and required rates of return must adjust accordingly.
There is no doubt that the growth of REITs has coincided with improved
liquidity for investors. Bid-ask spreads on REIT shares have narrowed
significantly over the past ten years (see Nelling, et al. 1995). The
fact that REIT returns are not highly correlated with stock market returns
implies that investors can buy REIT shares in order to diversify.
A second benefit of REITs is that capital markets can send valuable signals
to real estate operators about the wisdom of their projects. Figure
2 reveals that the market has mainly disapproved of the REITs' prospects
over the past few years. Note that REIT share prices started declining
at approximately the same time that dividend payments fell. During this
period, the national vacancy rate also increased slightly. Many commentators
have hailed this episode as a triumph of market discipline over a sector
perceived to have dwindling growth opportunities. Of course, we can never
know for sure whether this forecast was prescient or not. But warranted
or unwarranted, the financing problems currently plaguing REITs have caused
them to curtail their investment strategies.
A third benefit that has been proposed is that improved integration between
capital markets and real estate markets reduces the importance of bank finance,
and thus partially insulates the end users of capital from shocks that might
impede the flow of capital. Allegedly, real estate developers faced just
this sort of problem in the early 1990s when banks drastically cut their
real estate lending. REITs, of course, borrow from banks, so the growth
of the REITs hardly signifies perfect insulation from bank shocks. What
is interesting to note, however, is that by expanding their sources of finance,
real estate markets now face an expanded array of shocks. Indeed, during
the fall of 1998, spreads on virtually all classes of risky debt widened
after the Russian default. This event caused a disruption in the real estate
markets quite unrelated to real estate fundamentals or to bank health.
Conclusion
The advent of REITs represents an increase in the integration between
real estate markets and capital markets. Liquidity has improved, and recent
events suggest that if capital market participants view the real estate
industry unfavorably, then they will enforce discipline through market
prices. This is surely a positive development and will force greater scrutiny
on real estate deals. Of course, it is premature to proclaim an end to
the real estate cycle, or even an end to a real estate cycle driven by
funding considerations. Capital markets are vulnerable to shocks in the
same way that banks are.
John Krainer
Economist
Reference
Nelling, et al. 1995. "Real Estate Investment Trusts, Small Stocks, and
Bid-Ask Spreads." Real Estate Economics 23, pp. 45-63.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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Research Department
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