With Brian N. Hansen
[January/February 2007]
By Jada A. Graves
1. What is your outlook for the real estate investment marketplace in 2007?
Real estate fundamentals continue to be strong despite higher short-term interest rates, and the broader economy has thus far proven resilient. Assuming the Federal Reserve Board doesn't push too far, real estate fundamentals will continue to remain strong.
Sectors with positive leverage to the business cycle are likely to benefit from continued economic expansion. For example, I think apartment owners are well-positioned to grow rental rates in excess of inflation expectations due to lower housing affordability rates, delaying first-time homeownership for many. At the same time, benign interest rates at the longer end of the yield curve, lower volatility and lower real estate asset growth should continue to provide excellent returns on a risk-adjusted basis.
2. What challenges do you foresee for the REIT industry this year?
Continued multiple expansion. We are in a lower return environment globally. Investor preference has rotated from growth to value. The relative importance of dividends as a total return component has made a resurgence. Interest rates have remained low and inflation remains contained. Economic expansion has created favorable property level fundamentals, and we have not experienced a surge in other sectors that would drain interest in real estate.
I'm not implying that REIT multiples won't continue to expand, but with real estate trading on a yield basis that is tight relative to Treasuries by historical standards, future returns will be driven by a REITs' ability to grow dividends, either through internal growth or accretive acquisitions.
Now, the prevailing view has been that internal growth is offset by multiple contraction, resulting in flat total returns. Actually, REITs have delivered solid growth while benefiting from the multiple expansion that occurs with favorable fund flows.
3. In 2006, we saw an abundance of mergers and acquisitions within the REIT industry. What impact will this consolidation have on the market in the next 12 months? Will the M&A activity maintain its frenzy or subside?
Two of the primary factors driving consolidation have been private capital availability and increased regulatory costs related to operating a public company. Both are likely to impact the REIT market and the relative pace of M&A for some time. The private capital issue has impacted the REIT market well beyond large going-private transactions. A number of savvy REIT management teams have taken a portion of their portfolios "private" as joint ventures and reinvested the proceeds in higher return projects while adding a new fee income stream for shareholders.
As 2006 REIT valuations climbed, we saw takeout premiums decline on a relative basis and public and private market real estate assessments move back to equilibrium. There is still a considerable amount of private capital searching for attractive opportunities, and with the private markets' tolerance for considerably more public market leverage, it would not surprise me if we see additional large cap transactions. Also, as REIT valuations increase, public to public transactions will pick up.
Longer term, however, merger activity will migrate to the smaller cap names where value can be created simply by removing the regulatory costs of maintaining a public company. The current regulatory costs for public companies tend to be more dilutive to smaller cap companies' shareholders than to their large cap peers. As deal activity slows among the large cap names, and assuming continued sufficient private capital liquidity, one would expect M&A activity to pick up among the small cap names.
4. Given the industry's successful track record and broader acceptance, how has the typical real estate investor changed?
As a result of investors' desire for diversification as well as their preference for higher yielding asset classes, there has been an influx of new investors into the commercial real estate sector. Traditional retail investors who have entered the sector have done so through an array of investment vehicles. Recently, we have seen the proliferation of real estate dedicated unit investment trusts, closed-end funds, open-end funds and, more recently, exchange traded funds. This disciplined approach by retail investors to real estate investing has provided added diversification in either a passive or actively managed format.
Real estate oriented asset managers have benefited greatly from this trend in two primary ways. First is increased fee income. Second is a more powerful voice with regards to governance matters. Real estate companies on the other hand have benefited from multiple expansion caused by the weight of capital inflows into the sector.
Over time, a number of these companies have seen their investor bases become increasingly concentrated in institutional hands. However, the REIT sector also has notable exceptions that actively market their securities to traditional retail investors.
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