12/03/2009 | By Christopher M. Wright
The financial crisis and ensuing fall-out has left some institutional investors wondering whether it still makes sense to invest in REITs. The answer is a resounding yes, according to Michael Hudgins, global REIT strategist at J.P. Morgan Asset Management. In a new report, Hudgins lays out compelling arguments for why REIT volatility and diversification benefits will return to normal over the next few years. The report, "The Best of Both Worlds: Why the Strategic Case for REITs Endures," is available at www.jpmorgan.com/insight (select the Research and Publications Section and click on the Insights link). Recently, Real Estate Portfolio magazine asked Hudgins why he's so bullish about REIT investing.
Portfolio: What prompted you to explore the strategic case for REITs?
Hudgins: We recently saw every asset class falling dramatically when the financial crisis hit. It took awhile for shell-shocked investors to ask what will work moving forward. They're looking hard at their investments now and asking "What was the strategic case, and is it still intact?" It seemed a good time to review the strategic case for REITs.
Portfolio: What have your clients been saying about REITs this year?
Hudgins: We have a large corporate client managing its own pension fund who told us they didn't expect such volatility from their REIT holdings. By volatility I mean daily changes in REIT share prices. So the client is planning to move REITs from a standalone real estate basket into the "alternatives" investment bucket. The result could be a lower allocation to REITs in the overall portfolio. We're working to convince them otherwise.
Portfolio: Your study observes that REIT total returns have historically been less volatile than the total return on the S&P 500, but things have been different since 2004. Why?
Hudgins: When experts looked at the case for direct real estate in the early '90s, they saw an asset class that provides very stable income, high yields and competitive returns. They also found very low volatility because valuations are based on appraisals. Institutional investors liked the idea that real estate would act differently from stocks and bonds when added to a portfolio, and a substantial amount of investor capital went into the real estate world, driving valuations up and both yields and returns down.
As a matter of course, real estate investors and fund managers looked at ways to provide competitive returns, and one way was to use the cheap debt that was available in the early years of this decade to lift their equity returns. They began to lever up their buildings and portfolios, sometimes to 80 or 90 percent of investment value for single buildings. REITs also took on more leverage at that time. Leveraged equity is always more volatile. Any drop in value can wipe out that equity since bondholders have priority in bankruptcy. So volatility in REIT shares skyrocketed to reflect the added risk.
Portfolio: You conclude that REIT volatility will subside as time goes on. What is the basis for this conclusion?
Hudgins: This volatility will return to more normal levels in coming years as REITs reduce their leverage, something we're already seeing. Debt capital is not as available and certainly not as cheap as before. There is also evidence that highly leveraged REITs underperform their less leveraged counterparts over time. REIT debt levels have already come down, with new equity replacing debt in some instances. We expect that to continue. As any investment is deleveraged and equity becomes an increasingly larger portion of the investment value, the volatility of the equity should go down.
There's a second reason why we believe REIT share price volatility will decline further. In recent years, REITs started adding other sources of income to their cash flow. But some of this new revenue came from inherently riskier and more volatile types of businesses—for instance, funds management and development-for-sale (developing a building solely for sale to a REIT's own fund or to a third-party). These earnings are not sustainable in real estate bear markets. Some REITs created entire divisions to build buildings, lease them up, sell them to funds, and take the gains into earnings. That works great on the way up but, when the market slows down, you can't fill the buildings or count on the sales price to cover your costs.
The stocks of the REITs that engaged in such activities became more susceptible to exaggerated movements, either upwards or downwards. One of the traditional strengths of real estate, though—and therefore REITs—is the stable cash flow that comes from just collecting rents on wholly owned properties. We expect REITs as a group to return to business models more focused on stable income. The companies that do so will be less prone to downward (or upward) surprises in their earnings and their shares will be less volatile as a result.
Portfolio: Let's talk about correlations. REITs moved up when everything else moved down after the tech bubble burst, but REITs moved down with everything else in the current crisis. What do you expect to happen next?
Hudgins: It's very difficult to forecast correlations, but something we can do is to look for patterns in the historical data that tell us we may have been here before. We found a very interesting parallel to what's going on today in the data from the early '90s.
As property values fell in the early '90s, REITs had a spike in correlations with real estate, matching what were already elevated correlations with equity at the time. In other words, REITs fell when property values fell, just as we saw over the first four quarters of the current real estate correction. As property values subsequently bottomed and started to move up, REIT shares responded to the increase in real estate values, trading increasingly on the fundamentals of real estate. Both moved up together. That long rise for real estate values persisted, with only a small correction in 2001–2002, all the way to 2008. And during that period, rolling REIT correlations with equities came down significantly—from the 0.80 range to around 0.40.
The same thing appears to be happening now. REITs had an exceedingly high correlation with equities when both plummeted at the start of the crisis. Plus we had a spike in correlations between REITs and direct real estate the likes of which we haven't seen in 18 years. Real estate prices plummeted and REIT shares went down even more.
Portfolio: But what about arguments that suggest correlations between REITs and equities will remain high indefinitely?
Hudgins: It's human nature to believe that correlations will stay where they are. But our analysis provides evidence that REIT valuations climb when real estate prices have bottomed and start moving up. We are moving into that phase and you should see correlations between REITs and equities start to subside, as occurred in the '90s.
I'm not going to argue that correlations between equities and REITs will come down to 0.20 or even 0.40. But just assuming that they will stay at 0.80, as some investors are doing, is not borne out by the historical record. It's our view that REITs will start to act more like real estate long term and that correlations with equities will subside. REITs will be a good diversifier again, as they have been at most points in the past.
Portfolio: What does all this mean for REIT investing? Is it safe for investors who expressed concerns about REIT volatility and correlations to get back in the water?
Hudgins: REITs are a well-established investment both for institutions and retail investors. On the retail side, financial advisors liked the appreciation in REIT shares in the late '90s and early 2000s, and 401(k) investors liked the yield and the exposure to real estate that they could not otherwise easily get.
Institutions used REITs to add liquidity, which can facilitate tactical reallocations of real estate holdings in the short term. Institutions also appreciated the way REITs acted like their direct real estate portfolios over the long term, providing high current income, low volatility, and low correlations with equity over time. It can be argued that REITs should take on even more importance for this latter group of investors given the current experience with the illiquidity of direct real estate investments.
Portfolio: I'm hearing you say that things are normalizing and that traditional REIT investors ought to come back for all the reasons they have historically liked REITs.
Hudgins: Yes, but beyond that, I'm telling clients this is an opportunity that comes around only once every 18 years. We see evidence of a recurring 18-year long cycle in real estate. Commercial property values declined dramatically about 18 years ago and it's happening again today. Now is the time to get into this asset class, whether through direct real estate funds or REITs.
As for REITs, anything that is publicly traded is only super-cheap once in a cycle. Looking at prior cycles, what I find is that when real estate values come down, REITs initially come down much harder. Then, they bounce back up to correct the overreaction but tread water awaiting signs of a catalyst that will support price appreciation. Finally, when property values bottom and start to increase, REITs really begin to price in that recovery. We think REITs will start to move up again in a more sustainable fashion, as they have historically, when property values bottom in 2010.
Portfolio: How do you advise playing this—with ETFs, or individual companies with specific characteristics?
Hudgins: I tell my investors they need to be in what I call the "aggregators"—opportunity funds or REITs that have the capital to take advantage of attractively priced buying opportunities when real estate values bottom. Indexing is a well-accepted way to play markets early on in a sharp rally when investors have to react quickly.
However, with the initial rally past us, it's now a stockpicker's game. Active managers are typically very successful in these types of markets in identifying which companies will outperform.
Going forward, the outperformers in our space will be the REITs with relatively low leverage, a lower cost of capital than their peers, and continued access to capital—either unsecured bonds or equity. It's the companies that already have war chests or can put them together that will be able to take advantage of the buying opportunities I mentioned earlier. Others will not. Investors need to focus on the companies that can create the most value through acquisitions that are accretive compared to the cost of their equity and debt. F
Christopher M. Wright is a regular contributor to Portfolio.
This article originally appeared in the November/December issue of Real Estate Portfolio magazine.