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REITs Hold Competitive Advantage
Over Private Market
Mike Kelly
Published: October, 2009
Finance Insider
Much recent commentary has focused on REITs and how they are the anticipated winners as the transaction market unwinds. Conventional wisdom suggests that REITs will be able to buy everything cheaply because they have access to capital that private buyers do not. Because the government-sponsored entities (GSEs) Fannie Mae and Freddie Mac are the only games in town, private buyers will have to hedge their purchase prices and terms based upon the loan-to-value (LTV) and rates provided by the GSEs.
REITs, on the other hand, will have a competitive advantage because they can easily utilize their existing credit lines to quickly buy assets. Some have even suggested that REITs will be able to buy an unlimited amount of properties at high cap rates and vastly improve the value of their portfolios. Only part of this logic is correct.
If the REITs did not already have legacy assets on their books or have existing corporate debt levels of 45 percent to 60 percent, they would absolutely dominate the transaction world for the foreseeable future. However, the increasing cap rate transaction market from which they benefit when making new deals also hurts them on the value of their existing portfolios.
If the REITs are able to buy highly desirable, newer assets at cap rates ranging from 7 percent to 8.5 percent, then it will be difficult for them to justify the value of their existing assets at substantially lower cap rates. This will create issues when they have to renew their credit lines or refinance their existing permanent financing.
Existing REITs have a limited amount of dry powder available under their current lines. Raising cash by issuing new equity is possible but highly dilutive to the existing shareholders. As of Sept. 1, approximately $19.3 billion of equity had been raised by the REIT industry in 2009 but apartment operators had raised only $285 million of that total.
Unquestionably, REITs have a competitive advantage over the private market in the short term. However, no company lives in a bubble forever. Similar to other investment classes, Wall Street and pension funds will figure out that if the current returns that REITs are getting on new acquisitions are too compelling, they will create vehicles to take advantage of the high cap rates.
The real risk to existing REITs is that if these new vehicles are large enough, they can end up being extremely strong competition to existing REITs because the new vehicles will not have the legacy assets acquired or developed between 2005 and 2008. The new REITs also can create a much more focused portfolio.
In short, REITs will be the winners in this market shake up. The question is, will they win a little or become dominant?
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