REITs busy buying up Seattle apartments

By MIKE SCOTT
Dupre + Scott

Real Estate Investment Trusts, or REITs, have made quite a mark on the Puget Sound apartment market. They are the most active buyers and developers of apartments in the region today.

In the past four years, six apartment REITs pumped $500 million into this market, buying more than 8,000 units. To put that volume in perspective, our firm's research shows total market volume averaged $540 million annually over the past four years.

When they are not busy buying existing apartments, some buy other REITs and others build. Lately, developers have successfully negotiated presales with at least one REIT anxious to invest in high-end new properties.

All of these activities have brought the holdings of six apartment REITs to 20,000 units in the region. That represents about $1.2 billion in assets, or more, considering how quickly prices are rising these days.

REITs: Who's who

Six REITs are particularly active here. They are (in order of holdings): Equity Residential, Security Capital, Essex, Pacific Gulf Properties, BRE and Bay Apartment Communities.

Security Capital is not just a buyer. It is the busiest developer in our market, with 1,500 units scheduled to open over the next couple of years. To put that number in perspective, our Apartment Vacancy Report reported 3,200 apartment units opened in the region during 1997 and we forecast 5,900 new units for 1998.

Equity Residential has accumulated the largest portfolio in this area. It owns close to 11,000 units here. Security Capital, between its acquisitions and development efforts, controls more than 4,000 units.

Essex pushed its investment here over the 3,000 unit level this year. Pacific Gulf Properties and BRE control almost 4,000 units.

Bay Apartment Communities just discovered our market this year. It has already established a significant portfolio, picking up Trammell Crow's 264-unit Verandas at Bear Creek along with a few other large acquisitions.

Unfair competition?

Not everyone is happy about the impact REITs have on our market. Some investors complain they can't compete effectively because REITs enjoy such a low cost of capital. Most of the capital they use to buy apartments comes from selling stock.

Since REIT stock investors are content with dividends below 6 percent today, REITs enjoy cheap money. Even today's relatively low mortgage rates are a much more expensive source of capital for private investors.

Unfair competition is the name of the game in real estate. Most investors want it that way, usually thinking they know something nobody else knows. On top of that, there have regularly been imbalances in the market, with one type of investor enjoying benefits others can only envy.

Tax shelter syndication dominated our market in the early 1980s. Their tax-driven investing beat out other types of investors, particularly those who did not need, or could not use the tax benefits, such as pension funds.

Once the tax shelter days ended, pension funds, with a low cost of capital pegged to pension benefit needs, outbid most other investors who relied on a large amount of 9 or 10 percent financing to buy apartments. Next, Japanese investors beat out the pension funds, fueled by their even lower cost of overseas capital.

The seemingly age-old question about REITs -- are they stock or are they real estate -- has finally been put to rest, notes John Magnuson, a Counselor of Real Estate (CRE). He has a unique insight, as a former officer of two REITs and consultant to BRE Properties, a San-Francisco based REIT active in the Puget Sound region.

The large companies are definitely stock plays. Wall Street investors and analysts are looking for large portfolio deals. Tax structures get creative when a seller defers taxes using an up-REIT or down-REIT.

As a result, REITs can tolerate falling capitalization rates and still produce shareholder returns. That makes REITs tough competition for other investors today, as witnessed by the bidding wars taking place now for the few large, newer properties.

Tight supply

It will get even tougher, according to Magnuson. There has not been a lot of new apartment construction in the region. Most of it is in smaller properties, something REITs typically don't buy. They usually start at 150 units and look for even bigger deals. This year, developers will open fewer than a dozen of these large properties.

REITs spell opportunity for developers who build premium product. REITs plan a long-term hold, so they are picky about what they buy. So far they have not had a lot to choose from.

That has begun to change. The development market is gearing up to meet the needs of REITs. We are already tracking 54 developments, 150 units or larger, slated to open between 1998 and 2000.

Passing fad?

Today REITs provide significant capital for real estate, stimulating investment and development, as well as moving prices higher. Are they just another passing fad? Or worse, are REIT stock investors headed for a rude awakening in the not too distant future, the way tax shelter buyers were?

"The REIT market is all about capital," says Bill Ramseyer, CRE, chairman of Heitman/PRA Securities Advisors, based in Chicago. "Wall Street has always been interested in real estate investment, but what was lacking was a delivery system. After close to 30 years of effort since the first REITs were developed in the 1960s, the industry has found its mechanism." What an effective mechanism it is! REITs raised about $20 billion in 1997 through October.

The REIT industry now has a total market capitalization in the neighborhood of $100 billion. Apartment REITs are the largest part of the market, with over $20 billion in assets.

Many happy returns

Citing the Wilshire Real Estate Securities Index, Ramseyer says REIT investors have done well. The index shows real estate securities produced annual returns of 14.8 percent over the past 20 years. He notes the returns were almost evenly divided between dividends and growth.

He goes on to dissect the growth portion of REIT returns. That 7 percent growth rate also needs to be viewed in two parts. The first is internal growth, or increases in revenue. That has probably been 4 percent per year. Over the long term, internal growth should come close to matching the rate of inflation. The rest of the growth comes from enterprise value: creating more efficient management, primarily through growth.

Arnie Tesh, CRE, who heads a Washington D.C. real estate advisory firm, calls the REIT market, "a bubble looking for a pin." In the long run, REITs can not expect enterprise value to add to growth year after year. Sooner or later all of the efficiencies have been implemented. Eventually you can't get any larger.

He wonders how investors can expect REIT prices to continue climbing 10 percent or more annually once REITs maximize enterprise value. Eventually, you would expect earnings and prices of a well-managed REIT to move up or down with overall real estate market trends.

On a long-term basis, that should translate into an average annual change of 3 percent to 5 percent.

Rich Hanson, CRE, senior managing director of Mesirow Stein Real Estate, Inc. based in Chicago, defends price trend expectations. He agrees that about one-quarter of REIT yields are being generated by enterprise, or franchise value. He thinks the most important question investors need to ask about any particular REIT is whether or not the franchise value actually exists and will continue.

For Hanson, the answer lies in the consolidation that is taking place in the industry today, being led by the strongest REITs with the most efficient management. The result will be fewer companies, controlling much more real estate.

In spite of the rapid growth of REITs in the past few years, they still control a small share of the commercial real estate market. That leaves a lot of room to grow, which will take a long time. Add to that the consolidation trend, which is much more recent, and the potential for REIT enterprise value gains appears to have a long life.

If enterprise value cannot sustain its 3 to 4 percent annual contribution to growth over the long term, then, all other factors remaining constant, yields would dip from 14 percent to 10 or 11 percent. That's still not a bad return.

Cheap money

Overall, REITs today are priced to produce dividends near 6 percent annually. On the local front, the most active apartment REITs produce even lower dividend returns for investors today. We took a recent look at The Wall Street Journal on the internet to find out what dividend yields investors accepted from the six active apartment REITs in our region.

The Journal showed dividends ranging from a low of 4.23 percent for Bay Apartment Communities, to a high of 7.54 percent for Security Capital Pacific Trust. The average unweighted dividend yield is 5.39 percent.

REIT stock investors are clearly impressed by the strong national real estate market. Real Estate Capital Markets Report shows that just 18 months ago these same six REITs had to produce an average dividend yield of 7.29 percent. Three years ago they had to generate dividends of 7.72 percent to attract investors.

How about retirees, widows and other stock market dabblers? Don't they get attracted to REITs because the dividends beat money markets and everyone knows real estate goes up in value on top of that?

Since REITs distribute 90 percent of earnings, dividend yields close to 6 percent don't sound as attractive to real estate investors as they might to the T-bill crowd. Everything comes down to sustainability.

Leverage

REITs have redefined real estate's relationship with debt. Real estate investors have long used leverage as a wealth-building tool. Taking on 70 percent or more debt pays off in a rising market. But it doesn't leave any breathing room in a recessionary climate, leading to foreclosures for some whenever income falls 10 percent or 20 percent.

By comparison, REITs take on only about 30 percent debt. That provides a large security cushion in the event of market downturns. Tesh warns that the low debt levels of REITs are illusory. "Their 30 percent debt load is based on the stock price, its market capitalization, not on the underlying value of the real estate. Since REITs are trading at a premium to their real estate values, the actual amount of debt, measured against the underlying real estate values, may be higher."

The long-term liabilities for the six REITs we looked at represented 38 percent of total assets. Their definition of assets may not translate directly into property market value, but even so, as a starting point, that's conservative leverage. At least it is for those six REITs. At least for now.

"It remains to be seen if we have finally found the right way to do it," says A.C. Schwethelm, CRE, a real estate counselor from Texas. He is skeptical about the way REITs are traded, pointing out, "REITs go against the way things have always been done in real estate."

It has long been recognized that investors normally discount a minority undivided interest in real estate. If an apartment complex is worth $10 million, investors would value an undivided 10 percent interest at less than $1 million.

These days, we take a minority undivided interest in real estate, and cleverly package it as a REIT. Then we sell that interest to investors at a premium instead of a discount.

The six apartment REITs active in the Puget Sound region have a total market value, based on stock prices, of $8.4 billion. Their net assets, after deducting long-term liabilities, total $6.4 billion. Here again, if assets come close to reflecting market value, these REITs are selling at a premium of 30 percent over the value of the real estate.

"British Property Companies compare to REITs," notes Web Collins, CRE, executive vice president of CB/Whittier Partners in Boston. "Those companies trade at about a 20 percent discount to their underlying real estate values. Shouldn't that be true for REITs as well?"

Price volatility

Real estate has traditionally been less volatile than the stock market. REITs own real estate, but they operate in the stock market. The six REITs active here have experienced stock price fluctuations ranging from 25 percent to more than 40 percent this year. Wall Street is demanding. When revenues do not meet or exceed expectations, REIT shares suffer.

The risk is that as REITs become a larger component of the real estate market, their volatility will rub off to some degree on real estate generally. That's not all bad.

REITs bring a new level of information to the real estate market. Just as Wall Street punishes poorly performing REITs, all real estate participants gain a window to market behavior.

In the future, we will probably not have to spend a year or more in a declining market before it becomes obvious. Quarterly reporting will give us access to current trends as we've never seen them.

So even if you have no interest in REITs as an investment, they will likely start playing a increasingly valuable role in your ongoing market research.

What's next

There are over two-hundred publicly traded REITs. "You can readily zero in on those likely to be interested in expansion, and that may include the Puget Sound region," Magnuson said, "by looking for those that are trading a significant volume of shares on a daily basis."

He does not expect Equity Residential to look for more properties here right now, but he believes other REITs plan to double their presence in the Northwest. Those include BRE, Essex, Security Capital and Bay Apartment Communities. Post Properties out of Atlanta has targeted this region, as has Oasis, a Las Vegas-based REIT.

These, and probably others, will likely account for at least another $100 million in apartment acquisition and development volume in the next year or two.

Copyright © 1998 Seattle Daily Journal of Commerce.