While the Bear devours complacent investors, the Bull climbs a wall of worry. If the significant improvement we've seen in REIT stock prices beginning late last year is, indeed, the beginning of a new bull market, one major worry for investors will be whether higher REIT prices will be greeted with a wave of new equity offerings. Today, of course, this is a non-issue. According to the National Association of Real Estate Investment Trusts, the capital raised from secondary equity offerings in the last quarter of 1999 and the first quarter of 2000 was a mere shadow of what was raised in recent prior quarters. With the prices of most REITs trading below estimated net asset value (NAV), and the near-contempt with which investors have, until recently, viewed REIT shares, selling new stock to raise capital just hasn't been an option. But if REIT shares continue to climb, and begin to trade at NAV premiums, there's little doubt that the prospect of raising fresh equity will be a hot topic at many upcoming board meetings.

A WACCy World
Whether a REIT's decision to sell more stock will be greeted warmly or be met with the ol' Bronx Cheer will depend, of course, on whether such financing is likely to create or destroy value for shareholders. The argument that the new shares will be issued at a price that will be "accretive" to NAV or to funds from operations (FFO) won't fly with today's sadder but wiser REIT investors. We have learned (if we didn't already know) that selling new shares at "accretive" prices creates no value if the offering proceeds are invested at returns which fail to meet the REIT's weighted average cost of capital (WACC).

Unfortunately, WACC has been rising. Debt capital has obviously become more expensive, and the true cost of equity capital has risen because higher debt levels, equilibrious real estate markets, occasional balance sheet mismanagement and competition from faster-growing equity investments have combined to increase REIT investors' required returns.

Let's assume that a typical REIT is capitalized at 40 percent debt, 10 percent preferred stock and 50 percent common stock, that the cost of debt and preferred is eight percent and nine percent, respectively, and that the cost of common is 14 percent. Such a REIT's WACC would be 11 percent. Earning a return of that magnitude was achievable several years ago when REITs could (and did) buy assets at prices well below replacement cost and with significant upside potential from occupancy and rental growth. But this is much more problematic today. Indeed, according to several recent research reports, returns on invested capital haven't exceeded nine percent for most REITs (though asset appreciation may boost that return).

Keeping Credible
There's also a credibility issue here. It would be a tough sell for the typical REIT to convince the investment community that "things have changed." Of course there will be exceptions, but the vast majority of the REIT universe would not likely be able to do so, and their executives should spend as much time thinking about selling new stock as they spend worrying about who's going to win the 2006 World Series.