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Some of the industry's leading REIT leaders gathered recently at the Ritz-Carlton in Orlando for the 2014 edition of the EY REIT CFO and Tax Directors' Roundtable. With recovery in full bloom, it's still a question as to what will happen with interest rates in the foreseeable future. A panel of experts talked about the REIT outlook in the face of a recovery that still holds many questions. The panel consisted of: James Collins, managing director, Morgan Stanley; James Sullivan, managing director, Green Street Advisors; and Adam Markman, in his new position as EVP and CFO, Equity Commonwealth. The session was moderated by Michael Straneva, partner, Ernst & Young LLP.

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MICHAEL STRANEVA: While economists tell me the world's recovery is still uneven, the REIT regime is spreading around the world. The search for yield explains the popularity of the REIT sector. Jim Sullivan, what are you seeing?

JAMES SULLIVAN: REITs have outperformed the S&P so far this year. That has a lot to do with what interest rates have done relative to people's perspectives. A year ago, there was almost a consensus view that interest rates had to go higher in 2014, and that hasn't happened. Interest rates and cap rates are very much correlated. So, we have this dynamic where operating fundamentals range from good in some property types to fantastic in others, capital is abundant and cheap and real estate values continue to rise. We're in a position today where prices for almost all property types are above the peak in 2007. The average is about 10% over peak pricing in 2007.

 

STRANEVA: What's happening to REITs compared to the S&P 500 fixed and income prices?

SULLIVAN: We're often asked whether REITs are cheap, and that's a tough question unless you have some context, and the context we use is relative to the S&P 500 and the fixed-income market. The total return that you get from real estate is higher and the spread is wider than it has ever been. That means one of two things: real estate is cheap or the fixed income market is overpriced. Time will show us which of those is correct, but there's a real mismatch now between real estate and the bond market in terms of overall valuation.

JAMES COLLINS: I'll just add that it's hard to generalize real estate as one buying type, because you have long-leased assets, such as triple-net healthcare, that seem to react very strongly to predictions in the bond market and interest rates. Then you have shorter lease types, apartments or hotels, that are less sensitive.

 

STRANEVA: Let's discuss the abundant sources of capital that are available today.

COLLINS: For the past several years, there's been a very strong bid for yield product as investors gravitate toward equity and still face allocations. I don't see that abating anytime soon.

ADAM MARKMAN: Given my role as the CFO of a newly reorganized office REIT, all of a sudden I'm the prettiest girl at the dance. That's a testament to the abundance of capital. Meeting with bankers both on the equity side and the debt side could be all I do all day. There's an inordinate amount of opportunity and capital.

SULLIVAN: It's important to realize that we're still well below the 2007 peak in terms of transaction volume. And activity is disproportionately weighed to the gateway markets, the big markets. A lot of this capital we're talking about is very picky, and it wants to go only to certain places. For us, when everybody is over here crowding this auction tent, we get really interested in that tent over there. So, when you think about relative pricing between, say, gateway markets and secondary markets, do the cap rates reflect that?  

 

STRANEVA: What's occurring with REIT NAV premiums and discounts?

SULLIVAN: We've had a bit of a downdraft over the past few weeks in REITs and the average discount to NAV is now negative 4%, negative 5%. The public market has been a terrific predictor of subsequent moves in CRE values. There's a strong correlation between premiums to NAV and future appreciation. There's also a strong correlation to when REITs trade at discounts to NAV with subsequent decreases in values. The public market seems to do a really good job of predicting the future when it comes to values, so the signals you get from them, you ignore at your own peril. In the major property types, we're at NAV or below, and it's these niche property types where we're seeing big premiums—hotels, self-storage, net lease and healthcare—and when companies trade at big premiums, they have a real opportunity to raise capital and buy things. It also gives opportunities to companies in those sectors that want to be public to effectuate an IPO in a way that's beneficial for the sponsors. So, premiums and discounts to NAV can tell you a lot about future prices. They can tell you a lot about optionality with respect to raising capital.

MARKMAN: There's a new perspective I'm starting to gain now that I've switched from advising the industry to my new role managing and operating from within a REIT. Remember, these are levered NAV premiums. The real estate underlying these companies isn't trading at these discounts. To make the math easy, if the REIT is 50% leveraged, the asset value premium or discount is half of what you're seeing at the share level. So the arbitrage opportunity isn't as great as it appears based on NAV discounts, especially after you layer on the costs of going public, or from the other side of this spectrum, what we're more interested in is the cost of M&A. If you're interested in looking at a company that's trading at a discount, that discount can go away quickly when these market factors come into play.

I agree with Jim that you must pay attention to NAV premiums and discounts, and that's the barometer we think about most in terms of whether our foot should be on the accelerator or the brake. 

STRANEVA: We were discussing that REIT performance is outpacing the S&P. What are the implications for M&As?

COLLINS: If you look back over any reasonable period of time, REITs have outperformed the S&P. That's partially attributed to strong corporate governance. On the strategic front, there's a heightened level of dialogue. It's incredibly difficult to buy assets in the open market, particularly in gateway cities. You have the C-suite and directors thinking about different ways to grow shareholder value. It's probably standard practice for each of these blue-chip REITs to be looking at their comp group every day and see who is mispriced. When you apply the filter of reasonable control premium to find deals that are actionable, that funnel gets very narrow very quickly. Nevertheless, we expect to see a pickup in M&A activity at the end of this year or next year.

 

STRANEVA: What about IPOs and the efficiencies and effectiveness found there?

COLLINS: One benchmark we look at to determine the cost of an IPO discount or the ease with which a company can go public is the volatility index, the VIX, and there's a general correlation between volatility and the expense of the requisite IPO discounts. Presently, we're in a lower volatility environment, which we've enjoyed for the past couple of years, and it bodes well for REIT IPO entrants.

SULLIVAN: People who shouldn't go public are the folks who view it as a sale of their company to the public market. That's a narrow way of thinking about an IPO. What it really does is create an opportunity to partner with the public capital markets and to avail themselves of a broader menu of capital alternatives that they don't have as a private compa People who are hypersensitive to where the REIT index is or where premiums are to NAV probably are not the right candidates to go public. Also, keep in mind that it's easy to focus on IPOs and private companies going public, but we're seeing non-traded REITs list their shares. We're also seeing spinoffs from existing public companies, some of which are existing REITs. We're seeing REIT conversions bringing new companies public.

 

STRANEVA: Is there a trend toward externally managed public REITs? Will we be seeing more externally managed REITs outside of the mortgage REIT space?

MARKMAN: We just fixed one of these problems, and so, I can tell you there are real inefficiencies. Coming up with a structure that works for an externally managed REIT is going to be a challenge for the bankers out there, because the alignment of interests just doesn't work as well as internal management. It's the subtle things, which assets are owned and which are sold, reactiveness on the leasing front, small decisions that amount to a real difference.

SULLIVAN: I'm more optimistic that we'll see an equity REIT that's externally advised and accepted by the marketplace, because, if you look at the mortgage REIT market, the externally advised structure is the norm, not the exception. The private equity model is in essence the definition of an externally advised structure. So it works in private equity. It works in the mortgage industry. It doesn't work in equity REITs, at least not yet.

 

STRANEVA: What are you seeing in terms of the supply pipeline of new development?

SULLIVAN: One of the supports of strong operating fundamentals is what's happening on the supply side. Those of us with gray hair know that it's excess supply that kills the market, not the absence of demand. Supply is well below historic norms and that's the forecast for many years to come. Also, information is much more detailed, accessible and transparent today, which helps construction lenders, in particular, make better choices than in the past.

At the same time, real estate guys like to build and if they have capital, they'll build. It's fascinating to look at the ramp-up since 2010 and the 2014 estimate for REIT development pipelines, which is $37 billion, larger than the peak in '07. Granted, the REIT industry is bigger so, as a percentage, 2014 is smaller, but you get the point. REITs have actually been the leaders in development, and because they had access to capital, they were able to develop when their competitors, the private guys, couldn't get construction loans. So, I'm optimistic that this round of development is actually going to turn out pretty well for the REITs that are active.

COLLINS: Our clients, by and large, are measured in the amount of development they do, making only smart bets and only to a limited extent. The public investor universe for large-cap REITs doesn't want to see more than, call it 10% of your assets in construction, and our executives have heard that message.

MARKMAN: On one hand, development overall is near historic lows; on the other, REIT development is at an all-time high. So, it tells you who is doing the building, right? It's disproportionately REITs and disproportionately in primary markets where the REITs are strongest. And it's being done by guys that probably have a better handle on things than some of the smaller players.

 

STRANEVA: Now, it's time for everybody to get their crystal balls out. Where generally is the REIT Index going to be 12 months from now?

SULLIVAN: Tell me where interest rates are going to be 12 months from now, and I'll tell you whether the REIT Index is going to be up or not. The consensus view right now is that interest rates are going up. Don't forget, that was the consensus 12 months ago as well. But, more importantly, tell me why they're up. If rates go up because there's an acceleration in economic growth, that's good for real estate. But if rates go up because QE unwinds and there's no economic growth, that's a really bad scenario for any capital-intensive industry, real estate included.

COLLINS: Several of my clients are expecting an 8%, 9% or 10% total return over the next 12 months from their business plans. So, when you back off of a 3%, 4% or 5% dividend, it points toward an expectation that we're going to be up modestly in the RMZ, and it's not an unreasonable expectation. In the very short term, we're in a rate-sensitive sector. So it's something we need to watch carefully.

MARKMAN: The other panelists have said it really well. Tell me where interest rates are going to be and I'd have a good guess at where real estate value will land. Without a treasury or bond-market shock, IRRs in the high-single digits are what people would expect to achieve. Jim's right. We've been feeling that interest rates have to go up for a long time now. I wish we had longer duration on the debt we have on our balance sheet, because I don't know when interest rates are going up, but it's hard to imagine them going down. We're just bouncing along the bottom. Without a move in rates, a modestly levered 8% seems reasonable. With a change in the debt markets, all bets are off. 

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John Salustri

John Salustri has covered the commercial real estate industry for nearly 25 years. He was the founding editor of GlobeSt.com, and is a four-time recipient of the Excellence in Journalism award from the National Association of Real Estate Editors.