Last November, board members of the National Association of Real Estate Investment Trusts’ (NAREIT) rang the opening bell at the New York Stock exchange to celebrate an anniversary: 50 years ago President Eisenhower signed into law an act creating REITs. Many on the trading floor were surprised that REITs had been in existence since 1960, believing them to be creations of the 1990s. That’s when Sam Zell demonstrated how the REIT structure could successfully securitize the vast overhang of property, either in foreclosure or in financially-troubled developer/investor hands after the severe commercial property bust of the early 1990s. But the origins of REITs in North America can actually be traced back to the business trusts formed in Boston, Massachusetts in the mid-19th century, when the wealth created by the industrial revolution led to increasing demand for real estate investments. State laws at the time prevented a corporation from owning real estate beyond that required for a business. The so-called Massachusetts trust was the first legal entity created to specifically permit investment in real estate and allowed the transfer of shares, established limited liability, eliminated federal taxation at the trust level and permitted the retention of specialized management.

A substantial portion of REITs’ assets in the 1960s were in construction and development loans as banks, thrifts and insurance companies could not directly engage in such high-yield lending.

Instead they did so indirectly by sponsoring publicly funded REITs which bore their names. However a number of factors, including lax lending practices, high financial leverage, conflicts of interest and an economic recession, led to a 40 percent decline in REIT assets and a 68 percent drop in market capitalization for REITs between 1973 and 1975.

After a slow recovery, REITs regained some of their former popularity in the 1980s as investments in property ownership rather than levered lending, but the loss passthrough benefits of competing real estate limited partnerships (RELPs) tended to eclipse them. It was not until the aftermath of the severe property bust of the early 1990s that the new, more conservative debt and operating structures of REITs allowed them to become the securitization vehicle of choice in moving property from distressed vendors into the hands of long-term, income-oriented investors.

Canadian Beginnings

From 1990 to 1995 the equity market capitalization of REITs rose from U.S.$8.5 billion to U.S.$56 billion and the number of REITs almost doubled to 223. It was during this period that Canada saw its first major boom in equity REITs, having only modestly participated in the mortgage REIT phenomenon of the 1970s. RioCan REIT and Canadian REIT were formed from small real estate mutual funds that had closed their redemption windows in the real estate industry’s dark days in the early 1990s.

REITs maximized their income payout ratios to entice investors with yields of over 12 percent when the real estate industry still bore the stigma of past losses and financial failures. The favourable business experiences of REITs in the both Canada and the U.S. and stable, growing distributions attracted an increasing following among conservative, income-oriented investors. Today the U.S. REIT industry consists of 150 REITs with an equity capitalization of $349 billion while in Canada there are 30 REITs with an equity capitalization of C$36 billion. The popularity of REITs has stemmed from their:

• freedom from taxation
• high income distributions
• lower variability in returns than other equities
• low correlations of returns with the overall stock market

These features make them solid savings and retirement income vehicles. Despite the constraint of low-income retention/reinvestment rates, capable REIT managements have added value by:

• careful, disciplined specialization by property type and region,
• focusing on internal growth through rental rate increases,
• property enhancements,
• property sales and reinvestment,
• limited development and property management activities and
• carefully selected and financed acquisitions.

Experience in the Recent Financial Crisis

The recent financial crisis and economic recession created major stock market concerns about the ability of REITs to refinance their maturing debt during a severe credit crunch. However, with very few exceptions the relatively stable profitability and modest leverage of REITs enabled them to refinance their maturing debt and in most cases to benefit from lower interest rates as well. At the NYSE the president of NAREIT was pleased to point out that U.S. equity REITS had delivered an annual average return of over 11 percent over the past 10 years compared to a marginally negative return for the S&P 500. Currently the S&P/TSX REIT Index shows an annual average rate of return since its creation in 2003 of 11.9 percent versus 11.5 percent for the S&P/TSX Composite Index.

The Future of REITS

But what does the future hold for the REIT investment asset class? Despite all the new financing activity over the past two decades, the percentage of eligible real estate that has been securitized in North America is estimated to be under 10 percent. In other countries the percentages are much smaller. Yet by some estimates 40 percent—50 percent of the world’s capital is held in real estate and of that amount an estimated 30 percent is commercial, income producing property. Clearly the potential for the REIT investment asset class to grow remains very large.

History has shown that the extent to which REITs account for a growing share of investors savings will depend to a large extent on preservation of their freedom from taxation at the trust level. Both the U.S. and Canadian governments have demonstrated their willingness to maintain this tax-exempt status for REITs that derive their income predominantly from property rental income. Many countries in Europe and Asia have passed legislation creating REITs in recent years.

Meeting a Demographic Need

The future of REITs will also depend on demographics and economics. Demographics are important because REITs are designed to be relatively conservative and at times passive recipients of rental income – which is largely passed on to shareholders in the form of distributions. The potential for capital gains is generally less than with income re-investing, growth-oriented companies. This kind of investment appeals more to older, income-oriented investors—a growing demographic group in most developed Western countries. Economics play a role because in high growth economies the conservative, modest growth prospects of REITs tend to attract less investor interest. On this basis many of the western developed economies may prove fertile areas for new REIT issues. However, real estate ownership is an appealing prospect in most of Asia particularly China and India. In many cases this appeal arises from:

• histories of restrictions on real estate ownership
• a high regard for property ownership in local societies
• lack of experience with and/or trust in securities markets
• concerns about high rates of local inflation

In this context REITs are proving enticing to investors who are seeking investments they can readily understand and derive recurring income from. Overall most industry participants believe that Asia could account for the majority of REIT asset growth in the next 10 years.

“…history provides important lessons on REIT management and financing, at least three of which are still being assimilated…”

Lessons for Management

History also provides some important lessons about the management and financing of REITs that need to be learned if future set-backs are to be avoided. Some of these have already been widely absorbed: notably the need to have internal rather than external managers as well as strong independent boards of directors. But at least three others are still being assimilated.

Firstly, REITs should not try too hard to be high-growth investments.

Attempts to grow too rapidly have led a number of REITs into the mistakes of:

• buying lower quality properties than their original portfolios
• trying to develop too much new property in search of higher yields
• raising distribution payouts beyond sustainable levels

At the same time managements have been over-promoting their growth prospects to investors in efforts to reduce the cost and increase the amount of their equity and debt financing. Investors should always examine so-called “accretive” acquisitions that lead to higher income per share to ensure that they are not merely exercises in financial engineering or quality dilution that raise risks more than they augment potential returns.

Secondly REITs should be skeptical of untested innovative forms of debt financing from banks and investment dealers. When in doubt they should emphasize tried and true conventional forms of debt, particularly long-term mortgages. In the recent financial meltdown it was those REITs that had relied on short-term unsecured debt (with loan-to-value tests) and commercial mortgage-backed securities that had the most difficulty refinancing their debt maturities. General Growth Properties, the second-largest shopping centre REIT in the U.S., was forced to seek temporary Chapter 11 protection from its creditors in 2009 despite remaining highly profitable during the recent credit crisis for this very reason. However, REITs with conventional long-term mortgage debt issued to lenders who kept the loans on their balance sheets generally experienced relatively little trouble.

And thirdly REITs should adhere to the rules of prudent development: refraining from starting construction until projects have been both substantially pre-leased and pre-financed with construction financing and a permanent take-out financing commitment as a backstop.

Potential for Long-term Rewards

These policies may bring criticism from some aggressive investors and even periods of underperformance for REITs during boom times in the economy and stock markets. The technology stock boom of the 1990s was such a period: despite strong fundamentals, REITs tended to decline in price as investors forsook them for internet and other technology stocks. Many of these generated spectacular initial returns that were soon reversed. But maintaining these policies will reap long-term rewards for managers and investors. In today’s aggressively- traded stock markets, that may be the most difficult rule for REIT managements to remember and adhere to.