Real Estate Investment

Direct Real Estate Investments
Is This "Old-Fashioned" Alternative Actually the Wave of the Future?

T he growing attention to real estate investment trusts (REITs) is causing investors to question traditional methods of real estate investment. Should they bury the "old-fashioned" direct investment practices and only purchase investment real estate interests through publicly traded shares on Wall Street? Has the "new world order" of real estate securities overtaken the old practices of fee-simple purchases, mortgages, and notes that successfully created value in the past?

A REIT Primer
Simply defined, REITs are tax-advantaged shares of publicly traded companies that are in the business of owning and operating real estate projects. By federal mandate, as long as a REIT pays out 95 percent of its annual profits, it avoids paying taxes on a corporate level, deferring the tax hit until it reaches the individual level. This tax treatment makes the REIT form of ownership competitive with partnership tax treatment.
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The REIT structure was legislated into existence in the late 1960s, but has become particularly active more recently as a result of the real estate depression in the early 1990s. With so few lenders, Wall Street found real estate attractive because the depressed values allowed tremendous profit potential, and the lack of financing alternatives made Wall Street's fee structure affordable. Added to the cost of real estate and its operation (such as improvements, management, utilities, local real estate taxes, and insurance) is the cost of going public and complying with the numerous regulations imposed by federal and state governments to protect investors. Compliance with these rules diverts time, money, and effort from direct investment and the management of real estate assets.

While many believe that REITs are the future of real estate investment, it may be too soon to discount the "old-fashioned" approach of direct investment. Given its history, direct investment deserves a second look; it may provide today's real estate investors with an alternative financial strategy they have consistently overlooked.

A Measure of Security
The real estate recovery has been portrayed as relatively noncontroversial, measuring its success in part by real estate security price activity. However, given the nature of securities and security market indices, it can be reasonably argued that these indices understate the extent of the real estate securities rebound, which, in turn, may underestimate the strength of the real estate recovery. To the careful observer, then, it appears that not only have the securities performed quite well, but also that real estate is performing even better.
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What implications for future investment may be drawn from this performance? REITs saw an extraordinary rise in share values because of the severely depressed nature of the underlying assets. It is widely accepted that the real estate depression was preceded by extensive overbuilding of most product types in most markets, spurred by tax laws and the pressures of newly deregulated institutional lending practices. There was virtually no new construction for approximately four or five years, while demand continued to grow. Though demand weakened during the 1990-91 recession, the subsequent economic recovery saw the gradual but continual absorption of property ease the burden of oversupply.

A REIT Repeat?
Ironically, the improving nature of the real estate market is exactly the factor that weighs against repeating the recent securities performance. REIT prices have been tied to the perceived future cash flows of the underlying real estate. Because Wall Street is in the business of discounting or forecasting the future, the dramatic rise in REIT prices was predicated, in part, on the occurrence of the current real estate recovery. While there may be still more price recovery to come, especially on a property-by-property basis, this price recovery is fully anticipated and already priced into the REITs. In other words, there is little opportunity for the "spread buy," in which a REIT could purchase a property based on a lower valuation of the net cash flow than the market pays the REIT. Real estate spread buying today is analogous to the conglomerate spread buys of ITT and other companies in the 1960s. For Wall Street, REITs are simply companies that produce predictable earnings that can be forecasted, priced, bought, and sold.
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According to some analysts, the rush to REIT securities is over, with the occurrence of a more mature, sustainable level of investment. REIT market capitalization has doubled during the last two years, surpassing the key $40 billion benchmark at which institutional players feel "comfortable," allowing them to trade in REIT securities at a meaningful level without disrupting the market by their presence. Industry experts expect that annual growth in REIT investments will fall to a mere 5 percent ($2 billion yearly at current rates). At this juncture, the slowdown in new investment and the recovery in real estate pricing will make it difficult to continue achieving the entrepreneurial returns from REITs that have been seen over the past few years.

Direct Investment Benefits
For the more accomplished investor or pension fund, direct (nonintermediated) investment in real estate can offer additional benefits and opportunities not available to the intermediated or REIT investor, whether through mutual fund or stock ownership. The "old-fashioned" approach to real estate has the advantage of flexibility and efficiency: eliminating Wall Street's cost and investing more directly into property improvements result in a stronger negotiating position for the direct investor. Fluctuations in the debt markets also can be to investors' advantage. Additionally, refinancing can return an owner's investment as well as some profit without tax exposure because the funds are borrowed. Profits generated by direct investment correspond to traditional real estate expectations, depending less on general market conditions and more on the property's underlying market conditions and sound management. Hence, entrepreneurial returns are better achieved outside the "institutional real estate" venue, even though direct investments may not be as liquid as marketable securities.

New property development also can provide an investment strategy that adequately rewards entrepreneurial risk. Typically, a strong sponsor can find construction financing that will cover between 70 percent and 80 percent of the total costs. When the remaining funds are contributed at the beginning of construction by an investor or investment group, the funds are used during the construction and lease-up periods, which usually last between 18 and 24 months. Then the projects typically are refinanced or sold to return the investors' capital and/or profits. A properly conceived and planned development can generate an internal rate of return (similar to an average annual yield) of 23 percent to 27 percent.

REIT Limitations
REITs, on the other hand, do not always have access to capital. Their ability to attract funds depends on market conditions at a given time, therefore limiting their ability to take advantage of some opportunities. REIT management must pay attention to the public owners and stay abreast of the changing investment and regulatory environment, rather than devote themselves to running the operational side of the business. REIT managers must struggle to maintain an expertise about a variety of investments, whereas direct investors can become more knowledgeable about an individual property. REITs also must pay out 95 percent of their profits to maintain a tax advantage or they risk losing their REIT status. In addition, REITs must not make profits from selling properties held less than two years or they risk their tax status. Finally, where entrepreneurial real estate ventures tend to use higher leverage to maximize yield, REITs typically do not use leverage to their best advantage. REITs are hampered by the fact that a lower percentage of debt capital dilutes the gains across the relatively unleveraged capital structure.

Of course, ultimately suggesting a monolithic real estate recovery may be somewhat misleading, particularly when considering direct investment. Like any other asset class discussed in the aggregate, individual examples of direct investment exhibit unique behavior while still being influenced by the overall environment. However, because of the uneven manner in which real estate recoveries occur, opportunities do exist where the "old-fashioned" practice of leveraged real estate development, acquisition, and rehabilitation makes eminent sense and can return the type of successful, entrepreneurial yields traditionally associated with direct real estate investment.