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Real Estate Inv. Trusts: REITs
Re: Just got offered VNO preferred at 7%

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By RDonohue
August 19, 2004

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"As far as REITs business improving in a higher inflation market, I doubt it. The people in the country are highly leveraged to interest rates, I do not really know of any company that relies on consumers that would benefit from higher interest rates, certainly not any REITs that own shopping centers or office buildings."

There have been numerous studies that looked at whether or not real estate can be used as a hedge against inflation. This has been a key question that people here have been asking. Undoubtedly others have answered it, and probably done a better job, but I post in the hopes it will be useful to some.

These comments are meant to provide some thoughts on real estate and inflation, rather than underplay the price level risk associated with preferred shares, which is significant and should not be overlooked.

This is a bit long, so those who find long posts irritating should move on with my apologies.

One of the reasons that real estate is viewed as offering diversification is that real estate may not be highly correlated with other asset classes like stocks and bonds is because real estate responds differently to changes in the rate of inflation. The major research question in this area has been whether the correlation between real estate and unexpected inflation is different from that of other asset classes. Obviously, the stronger and asset's correlation to unanticipated inflation, the greater its ability to provide an effective hedge against unexpected inflation and continue to offer a steady real rate of return.

There is a fairly lengthy history of academic work in this area. One of the first studies of this type was by Hallengren (The Commercial and Financial Chronicle, Vol 219, No 7415, 1974) in which he looked at how various investment vehicles performed during inflationary cycles. Real estate was found to perform very well during highly inflationary period over some fairly long periods. Will Goetzman and Roger Ibbotson (Journal of Applied Corporate Finance, Vol 3, Iss 1, Spring 1990) looked at real estate as an asset class over a sixteen year period. They analyzed real estate and compared it to other investment vehicles to demonstrate its place in the portfolio. They looked at commerical real estate (both commingled fund and REITs) to get a picture of commerical real estate returns and risks, and the home purchase index to get at residential real estate. Real estate provided a hedge against inflation over the entire period, which was not the case with any other asset class.

There have been subsequent studies, which showed that real estate's effectiveness as a hedge against inflation varies substantially depending on period analyzed. Particularly, these studies showed that real estate's effectiveness as a hedge depends on the balance of supply and demand (excess supply reduces the hedging ability) and the lease structure.

Stepping away from the academic literature (well summarized in 'Sirmans and Fisher, Real Estate in Pension Fund Portfolios: A Review of the Literature and Annotated Bibligraphy , Pension Real Estate Association) we get to the question of why real estate may act as a hedge against inflation. There are several factors which may be considered in this analysis, some of which are positive and some of which are negative.

The first factor is the nature of the asset. Real estate is a real asset, unlike stocks or bonds which a financial assets. REITs are financial assets, but underpinned by real assets. Real estate is a durable good, so its replacement cost rises with the rate of inflation. As the cost of new supply rises, the competitive position of existing supply (assuming proper maintenance) strengthens, and so does price. Also, this durable good is sold or marketed through a specific form of legal agreement, a lease. In many cases, the lease is structured to pass through inflationary expenses (through common area maintenance) and often provides for adjustments in base rent through CPI adjustments. Proper lease structure can help to insulate Real Estate from inflationary pressures.

Also, on the debt side, there is an opportunity to effectively lock in cost of capital (or at least the ceiling) through fixed rate mortgages, or floating rate mortgages subject to caps, locks or swaps. This allows for the use of significant leverage, which magnifies gains and losses on invested capital. As we all know, leverage is a two edged sword, so capital structure is a critical issue for real estate owners. Since real estate is so capital intensive, differential decisions as to debt type, term and amount can dramatically impact returns. So, rising interest rates can be a real opportunity, or a real problem for real estate owners.

The above quote from your post has its merits, particularly if interest rates increase in the absence of growth in the economy. There can also be growth that does not increase demand for space (productivity increases as an example), which is a more troubling case for real estate. However, if there is growth in the economy, there can be increased employment, and increased demand for space. Demand for space starts with basic employment in the industrial sector (and increasingly the FIRE sector) and then carries through to the residential sector (both single and multifamily sectors) and the retail sector. As demand for space increases, occupancy increases and eventually rents increase. Rents increase to the point where additional construction is justified, then new construction occurs. Typically, construction goes substantially beyond what is justified by demand, rents decrease and the cycle starts over again when (if) demand catches up with supply.

REITs tend to own assets that benefit from growth in employment. In the industrial sector, they tend to own trans-shipment facilities, warehouses, and R&D space. As economic activity picks up, so does activity at these types of uses. In the office sector, companies tend to keep their space for some period of time despite growth in employment (decreasing sq.ft. per employee) then lease new space as they reach a tipping point. REITs tend to own multifamily residential, which often fares better in inflationary periods when mortgage rate increase and home ownership is more expensive (higher entry hurdle rates). Other real estate sectors can also see upticks in demand for space. Again, the structure that allows real estate to pass through inflationary expenses is very important in this equation.

There are risks to some sectors. You are correct in pointing out that there may be risks to the retail sector. I would argue that the risk of inflation varies substantially by type of center. High-end luxury "lifestyle" centers are certainly more likely to experience a pinch than neighborhood centers focusing on providing basic goods (groceries and the like) Malls can have issues because they are heavily dependent on Women's apparel, which is quite sensitive to inflation. So, the risks can and do go up for some parts of the sector, while others are more stable. Barring bankruptcy or kick-out clauses, reduced sales at retail stores seldom result in reduced rents (with the exception of percentage rents which are usually not a major portion of total rents)

There are certainly other opinions on the relationship between real estate and inflation. I have read dozens of academic and industry articles on this issue, and I am uncertain as to whether they come to a clear consensus. I do not think they do so.

Your point about Preferred shares and their exposure to price level risk is a good one. It is one I was trying to make (albeit unsuccessfully) in my earlier post. The example shows a realized rate of return, based on the assumption of a sale. You may recall that the point I was making was not to buy unless you could afford to hold through the exact type of conditions you were describing, or unless you are prepared to accept the kind of diminution in value you described in your excellent example. If you hold through the down period and continue to get the dividend, your long term realized return will be 7%. Annual variations in total return do not impact the long-term realized return. I recognize that not everyone shares my perspective on this issue, but I can only play with the hand I am dealt.

I think that we are in agreement as to the very real risks attendant upon investing in Preferred shares, whether they be real estate or any other type of industry.

Thanks,

Ron


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