FRBSF Economic Letter
2000-02 | January 28, 2000
Western Banking Quarterly is a review of banking developments in the Twelfth Federal Reserve District, and includes FRBSF’s Regional Banking Tables. It is published in the Economic Letter on the fourth Friday of January, April, July, and October.
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.
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).
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.
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.
Nelling, et al. 1995. “Real Estate Investment Trusts, Small Stocks, and Bid-Ask Spreads.” Real Estate Economics 23, pp. 45-63.
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