Created by the Congress in the 1960s to facilitate public ownership of real estate, Real Estate Investment Trusts took off in the 1990s, allowing small investors to secure advantages normally available only to those with large resources. As a consequence of the increasing popularity resulting from the key financial benefits this way of owning real estate offers to investors in terms of dividend-based income, strong market performance, liquidity, transparency, inflation protection and diversification, REITs experienced enormous growth, becoming a trillion dollar market and owning approximately $2.0 trillion of commercial real estate assets.
However, to obtain the REIT status and to benefit from the resulting tax exemption at the corporate level, REITs must satisfy several requirements stated by the Internal Revenue Code, among which the distribution of at least 90% of their taxable income in dividends to shareholders and at least 75% of their assets invested in real estate. IRC requirements’ violation has severe consequences, including the loss of the REIT status and the payment of the previous tax benefits. Though a source of competitive advantage from a fiscal perspective, REITs’ required dividend policy is one of the main critical factors of this ownership structure, since the limited availability of cash for self-financing purposes renders REITs’ growth dependent on external sources of financing and, therefore, vulnerable to the health of the debt and equity markets. For example, in the context of the stock market crash of 1998, REITs’ share values declined significantly, consequently increasing their cost of equity, to the extent that in some cases the cost of capital exceeded their internal rate of return, making potential acquisitions inconvenient.
These structural characteristics raise concerns about the potential exacerbated impact that recessionary periods, such as the unprecedented crisis we are experiencing nowadays, may have on REITs. A disruption in their cash-flow, resulting from the tenants’ inability to pay rent or interest on loans and from the lack of optimization in space of commercial properties, could prevent REITs from complying with the mandated dividend distributions and/or servicing their debt obligations. In the wake of the pandemic, as many REITs had to reduce their dividends due to the expectation of a dramatic decline in rent payments, the National Association of REITs (NAREIT) submitted a letter to Treasury, requesting the temporary possibility to satisfy 90% of the mandated distributions in stock dividends, with only 10% to be necessarily paid in cash.
The second main concern regards the increasing difficulty in meeting their quarterly asset test, since the value of real estate holdings may decline relative to the value of other assets, such as stock investments in taxable REIT subsidiaries.
REITs’ stock market performance reflected investors’ concerns, as total returns year-to-date are around -10.4% (Figure 1). However, there is significant variation across the sectors: lodging/resorts, office, retail and residential reported the largest declines, as opposed to the double-digit gains of the industrial, self-storage, data centers and infrastructure sectors.
However, to obtain the REIT status and to benefit from the resulting tax exemption at the corporate level, REITs must satisfy several requirements stated by the Internal Revenue Code, among which the distribution of at least 90% of their taxable income in dividends to shareholders and at least 75% of their assets invested in real estate. IRC requirements’ violation has severe consequences, including the loss of the REIT status and the payment of the previous tax benefits. Though a source of competitive advantage from a fiscal perspective, REITs’ required dividend policy is one of the main critical factors of this ownership structure, since the limited availability of cash for self-financing purposes renders REITs’ growth dependent on external sources of financing and, therefore, vulnerable to the health of the debt and equity markets. For example, in the context of the stock market crash of 1998, REITs’ share values declined significantly, consequently increasing their cost of equity, to the extent that in some cases the cost of capital exceeded their internal rate of return, making potential acquisitions inconvenient.
These structural characteristics raise concerns about the potential exacerbated impact that recessionary periods, such as the unprecedented crisis we are experiencing nowadays, may have on REITs. A disruption in their cash-flow, resulting from the tenants’ inability to pay rent or interest on loans and from the lack of optimization in space of commercial properties, could prevent REITs from complying with the mandated dividend distributions and/or servicing their debt obligations. In the wake of the pandemic, as many REITs had to reduce their dividends due to the expectation of a dramatic decline in rent payments, the National Association of REITs (NAREIT) submitted a letter to Treasury, requesting the temporary possibility to satisfy 90% of the mandated distributions in stock dividends, with only 10% to be necessarily paid in cash.
The second main concern regards the increasing difficulty in meeting their quarterly asset test, since the value of real estate holdings may decline relative to the value of other assets, such as stock investments in taxable REIT subsidiaries.
REITs’ stock market performance reflected investors’ concerns, as total returns year-to-date are around -10.4% (Figure 1). However, there is significant variation across the sectors: lodging/resorts, office, retail and residential reported the largest declines, as opposed to the double-digit gains of the industrial, self-storage, data centers and infrastructure sectors.
Figure 1
From the comparison between REITs’ performance in the current crisis and in the Global Financial Crisis, significant differences emerge, providing us with an insightful window on their evolution towards greater resiliency over the last decade. In the first months following the outbreak of the pandemic, REITs’ stock returns fell faster and more dramatically compared to what happened at the beginning of the GFC, and faster has been the recovery as well, with an upward trend observed as early as April (Figure 2).
Figure 2
“In the 2008 financial crisis, we had a credit crisis that crossed over to the real economy and, particularly with REITs, we had concern about their ability to access credit and capital,” said John Worth, executive vice president for research and investor outreach at Nareit. “This time, polices quickly put in place by the Federal Reserve and Congress have limited the spillover into the real economy.”
Providing an overview of their position in the current environment, Worth analyzed the key evolution patterns that made REITs much more prepared to face the current crisis than they were in 2008.
REITs entered this crisis with stronger balance sheets and greater financial flexibility for several reasons. As of the end of 2019, the REIT sector had over $28 billion in cash and approximately $120 billion in untapped lines of credit resulting in a liquidity cushion, which proves to be crucial especially for those sectors experiencing a significant reduction in rent payments (Figure 3).
Providing an overview of their position in the current environment, Worth analyzed the key evolution patterns that made REITs much more prepared to face the current crisis than they were in 2008.
REITs entered this crisis with stronger balance sheets and greater financial flexibility for several reasons. As of the end of 2019, the REIT sector had over $28 billion in cash and approximately $120 billion in untapped lines of credit resulting in a liquidity cushion, which proves to be crucial especially for those sectors experiencing a significant reduction in rent payments (Figure 3).
Figure 3
The focus on recalibrating levels of leverage through greater reliance on equity financing to support growth resulted in a reduction in REITs’ leverage ratios, which are below pre-financial crisis levels. Looking at another key risk metric, we can observe a dramatic reduction in the percentage of REITs with low interest coverage ratios since 2007, with around 80% of REITs showing an ICR greater than 3x as of 2019 (Figure 9). These aspects resulted in greater ability to take advantage of refinancing opportunities and extend their debt’s average term to maturity from 60 months or shorter in 2009 to more than 70 months in 2019.
Figure 4
Another relevant aspect limiting REIT sector’s exposure to the adverse effect of the current crisis relates to the high-quality of the tenants, as evidenced by the recent Nareit’s survey about monthly rent collections, which suggests that among most sectors rent collection remained strong and has stabilized at high levels (Figure 5).
Figure 5
Last but not least, talking about allocations, Worth highlighted the increasing diversification pursued by the REIT industry over the last decade, allowing investors to get exposure to the fastest-growing sectors of the real estate markets, especially the e-commerce related sectors, which accounted for 32% of the industry market cap as of 2019 ( only 9% in 2010).
The COVID-19 caused a sudden and unprecedented disruption on people’s lives and on most types of economic activities and, compared to past economic challenges, the commercial real estate industry has been impacted much sooner, with some structural changes in how people interact with physical spaces that are likely to be longer-lasting if not permanent. Though the level of uncertainty is still high, and the longer-term consequences are difficult to predict, the CRE industry entered this crisis in a stronger position compared to the GFC. Within the REIT subsector, the impact has been significantly varied across property types with the most impacted segments experiencing heightened pressure on rent collections. However, the stronger balance sheets, the ample sources of liquidity and the greater diversification with which REITs entered this recession, may provide greater confidence in their ability to navigate this crisis.
Francesca Romana Curato
The COVID-19 caused a sudden and unprecedented disruption on people’s lives and on most types of economic activities and, compared to past economic challenges, the commercial real estate industry has been impacted much sooner, with some structural changes in how people interact with physical spaces that are likely to be longer-lasting if not permanent. Though the level of uncertainty is still high, and the longer-term consequences are difficult to predict, the CRE industry entered this crisis in a stronger position compared to the GFC. Within the REIT subsector, the impact has been significantly varied across property types with the most impacted segments experiencing heightened pressure on rent collections. However, the stronger balance sheets, the ample sources of liquidity and the greater diversification with which REITs entered this recession, may provide greater confidence in their ability to navigate this crisis.
Francesca Romana Curato