Most real estate investment trusts (REITs) buy real estate (obviously), and just like when you or I buy a home, they do it with a mix of equity and debt. But that four-letter word d-e-b-t can be dangerous, and when General Growth (NYSE: GGP ) entered what Reuters deemed a "historic real estate bankruptcy" in 2009, leverage took down a major industry player.
But good news: Ralph Block, a leading REIT expert, thinks it'll be a long time before troubling debt ratios come back to the space. While using zero leverage would be a competitive disadvantage, investors in REITs with high leverage ratios -- including Apartment Investment (NYSE: AIV ) , Pennsylvania REIT (NYSE: PEI ) , and Sun Communities (NYSE: SUI ) , which each have high debt-to-capital ratios -- nonetheless need to keep close watch on debt-level trends.
Block is a qualified commentator on the subject of commercial real estate -- a fourth edition of his book, Investing in REITs, is in the works right now, and he's a former co-manager of the Undiscovered Managers REIT fund. He's been personally investing in REITs for more than 40 years. What follows is an edited portion of our conversation.
Brian Richards: Do you think the industry learned a lesson in 2008 that will be applied forever more, or is it your sense that they survived and they're going to go back to pre-'08 crash days when they were more levered than maybe they should have been?
Ralph Block: I don't have a firm conviction on the answer to that. I'll tell you based on listening to the REIT management teams and watching what they're doing, I think there's clearly a conviction that they want to run their REITs with lower leverage ratios and measure them more conservatively. But there is kind of a cross current where I think some management teams are saying "Well, yeah, but you know, that was a 100-year flood, it's not going to happen again. And look how cheaply we can borrow money."
So I think probably the majority of REITs have learned a lesson and want to manage their business with less debt, but there's probably a minority who may still be anxious to borrow. I mean, borrowing is in the DNA of real estate people. It's like I'm saying in my book: People have borrowed money to buy real estate probably since the Renaissance. And yet the argument for it is that "Well, real estate's a stable asset, the value doesn't go up or down very much. Cycles are long; we have long-term leases. And if we can borrow a couple of hundred basis points below what our returns are we can goose our returns with very little risk."
The problem with that argument today is that we seem to have had recessions come with more frequency. These fat tails come a lot more frequently than people think, and if you get yourself in the position where you're forced to do stuff to pay off your debts it's usually going to be at a time when prices are down. It's like buying stocks on margin -- you get a margin call, you've got to sell probably at market bottoms.
And then of course, Green Street Advisors -- I don't know if you know those guys but they're the best buy-side research firm in the industry -- they have done a study and they have concluded that even during the up part of the cycle before 2007, the REITs with the most leverage did not perform the best. So if you can't perform with leverage in the upside of the cycle …
Richards: Then what's the point?
Block: Yeah. And you know, the other problem -- I'm not saying REITs should have no debt. There are some people who say that REITs should have no debt; I'm not in that camp. But I do think that debt levels should be very low and maybe ramping up during unusual periods at the beginning of space market cycles or capital market cycles where you can find properties at unusually attractive prices.
And I just don't think we're there now. There's just a lot of capital coming into commercial real estate. Everybody thought we were going to see a lot of grave dancing because of the problems in commercial real estate, we were going to be able to get 10% returns on good quality commercial stuff -- it's just not happening. There's too much capital.
And so I would advocate for a pretty low debt leverage. The problem that a lot of REIT management teams have is that when you reduce your debt leverage, especially when you're paying off debt, it's only costing you 4% or 5% -- it negatively affects your earnings. So a lot of these guys don't want to take that kind of earnings hit. But I think we'll see more equity raises. I think it's going to be a long time before we see some real troubling debt ratios across the industry spectrum.
For more of Block's thoughts on REITs: