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REITs and the integration between capital markets and real estate markets.Navigation: Main page Author: Krainer, John
Traditionally, commercial real estate financing has not been well integrated with capital markets. Ownership has been concentrated, with wealthy individuals and large institutions such as insurance companies and pension funds as the primary investors in commercial real estate. These investors typically have held the real estate in portfolio rather than repackaging the ownership claims into shares that could be actively traded on an exchange. Banks have been among the primary financiers of commercial real estate, funding investment both in existing structures as well as new development. This lack of integration stands in contrast to other sectors of the economy. The assets of industrial corporations primarily are funded in the stock and bond markets. Ownership of these claims is broadbased the trading is frequent. Residential real estate is funded through mortgages that are pooled and then resold in the capital markets. Why have the links between capital markets and commercial real estate been slow to evolve? Prior to 1986, the tax treatment of losses on real estate gave wealthy individuals a comparative advantage in holding these assets. Other impediments such as the large number of parties to a transaction, the high degree of asset heterogeneity, and regulatory controls (such as zoning laws and environmental restrictions) all have contributed to commercial real estate's relatively slow pace of integration. Despite these impediments, the past decade has seen much more integration of commercial real estate markets with the capital markets. Two developments in particular stand out: the growth of the real estate investment trusts (REITs) and the increased securitization of commercial mortgages. This Economic Letter focuses on REITs and the possible implications of their growth for commercial real estate. Characteristics of REITsREITs provide a way for ordinary investors to take positions in real estate. Much like mutual funds, REITs are pass-through entities that distribute income and capital gains from investments to their shareholders untaxed. Also like mutual funds, REITs are specialized to offer investors ways to target specific asset classes and geographic regions. REITs, however, have significant restrictions on the types of investments they can make. At least 75% of portfolio assets must be in the form of real property or mortgages, and at least 75% of REIT income must be generated from these types of investments. The most interesting constraint on REITs is the requirement that they pay out at least 95% of their income as dividends to their shareholders. If the REIT management wishes to buy nw assets, more than likely it must raise the necessary finance through new equity or debt issue, or by tapping a line of credit at a bank. Either way, the absence of a retained earnings buffer forces REITs to submit their plans to investor review every time they buy or build. The REIT is actually an old organizational form, dating back to 1960. Early REITs were allowed to own real estate, but they could not manage it, forcing them to contract out the operations to third parties. The potential for conflict of interest with these arrangements and the cyclical nature of real estate itself did much to hamper REIT growth in these early years. The REIT structure enjoyed a surge in popularity after 1986 when management restriction were removed and changes in the tax code reduced the appeal of the limited partnership ownership form. Investors, eager to capitalize on the recovery of the real estate market, poured money into REITs and fueled much of their growth. Today, REITs control approximately $300 billion in assets. While this is just a small percentage of the estimated $4 trillion value of the U.S. real estate stock, the REIT share of the total stock has been growing quickly (see Figure 1). Potential benefits of REITsREITs have provided real estate investors with a host of benefits. First and foremost, REITs are exchange traded and, hence, provide investors with liquidity. Absent an active market for real estate claims, investors cannot easily hedge their exposures, so, all other things equal, investing becomes more risky and required rates of return must adjust accordingly. There is no doubt that the growth of REITs has coincided with improved liquidity for investors. Bid-ask spreads on REIT shares have narrowed significantly over the past ten years (see Nelling, et al. 1995). The fact that REIT returns are not highly correlated with stock market returns implies that investors can buy REIT shares in order to diversify. A second benefit of REITs is that capital markets can send valuable signals to real estate operators about the wisdom of their projects. Figure 2 reveals that the market has mainly disapproved of the REITs' prospects over the past few years. Note that REIT share prices started declining at approximately the same time that dividend payments fell. During this period, the national vacancy rate also increased slightly. Many commentators have hailed this episode as a triumph of market discipline over a sector perceived to have dwindling growth opportunities. Of course, we can never know for sure whether this forecast was prescient or not. But warranted or unwarranted, the financing problems currently plaguing REITs have caused them to curtail their investment strategies. A third benefit that has been proposed is that improved integration between capital markets and real estate markets reduces the importance of bank finance, and thus partially insulates the end users of capital from shocks that might impede the flow of capital. Allegedly, real estate developers faced just this sort of problem in the early 1990s when banks drastically cut their real estate lending. REITs, of course, borrow from banks, so the growth of the REITs hardly signifies perfect insulation from bank shocks. What is interesting to note, however, is that by expanding their sources of finance, real estate markets now face an expanded array of shocks. Indeed, during the fall of 1998, spreads on virtually all classes of risky debt widened after the Russian default. This event caused a disruption in the real estate markets quite unrelated to real estate fundamentals or to bank health. ConclusionThe advent of REITs represents an increase in the integration between real estate markets and capital markets. Liquidity has improved, and recent events suggest that if capital market participants view the real estate industry unfavorably, then they will enforce discipline through market prices. This is surely a positive development and will force greater scrutiny on real estate deals. Of course, it is premature to proclaim an end to the real estate cycle, or even an end to a real estate cycle driven by funding considerations. Capital markets are vulnerable to shocks in the same way that banks are. ReferenceNelling, et al. 1995. "Real Estate Investment trusts, Small Stocks, and Bid-Ask Spreads." Real Estate Economics 23, pp. 45-63. GRAPH: Figure 1: Total REIT assets GRAPH: Figure 2: REIT performance BANKS HEADQUARTERED BY REGION SEPTEMBER 30, 1999 (NOT SEASONALLY ADJUSTED, PRELIMINARY DATA) BANKS WITH ASSETS LESS THAN OR EQUAL TO 300 MILLION ARE DEFINED AS SMALLLegend for Chart:
A - U.S.
B - SMALL U.S.
C - 12th DISTRICT
D - SMALL 12D
E - CA
F - SMALL CA
A B C
D E F
ASSETS AND LIABILITIES -- $ MILLION
ASSETS TOTAL
5,466,88 66,563 449,043
45,933 71,656 27,138
FOREIGN
686,624 420 5,893
15 2,260 15
DOMESTIC
4,780,204 626,143 443,150
45,919 269,396 27,123
LOANS TOTAL
3,336,921 386,621 308,109
29,018 183,901 16,743
FOREIGN
288,946 563 4,589
11 1,985 11
DOMESTIC
3,047,976 386,057 303,520
29,008 181,916 16,732
REAL ESTATE
1,388,285 234,533 137,131
18,137 95,067 11,404
COMMERCIAL RE
401,633 76,591 58,880
9,674 44,327 6,556
SINGLE FAMILY RES
781,459 111,496 50,738
3,950 32,641 2,059
COMMERCIAL
783,429 67,325 77,491
6,579 55,219 3,584
CONSUMER
481,707 51,334 62,085
3,066 15,156 1,256
CREDIT CARDS
187,955 4,061 39,934
926 2,447 103
AGRICULTURAL
45,456 27,164 5,098
964 3,596 341
OTHER LOANS
349,098 5,702 21,715
263 12,878 147
INV. SECURITIES TOTAL
1,018,752 167,625 70,065
9,002 41,588 5,510
U.S. TREASURES
112,494 18,330 7,220
9,002 41,588 5,510
U.S. AGENCIES, TOTAL
597,242 107,878 40,043
5,805 24,159 3,738
U.S. AGENCIES, MBS
400,897 35,755 25,054
1,720 14,131 1,189
OTHER MBS
49,065 1,583 4,392
126 3,183 103
OTHER SECURITIES
259,952 39,834 18,411
2,110 8,728 1,133
LIABILITIES TOTAL
5,000,790 563,189 399,944
40,988 241,467 24,318
DOMESTIC
4,314,166 562,769 394,051
40,973 239,207 24,303
DEPOSITS TOTAL
3,680,527 526,512 317,862
39,014 219,282 23,508
FOREIGN
602,571 485 12,637
36 4,934 36
DOMESTIC
3,077,956 526,027 305,225
38,978 214,347 23,472
DEMAND
510,673 79,184 54,384
7,962 39,090 5,085
NOW
139,495 66,962 11,195
3,786 6,526 2,189
MMDA & SAVINGS
1,248,616 123,483 136,309
11,584 99,022 6,600
SMALL TIME
736,178 181,337 54,496
9,081 35,907 5,468
LARGE TIME
439,937 73,630 48,304
6,473 33,379 4,105
OTHER DEPOSITS
3,057 1,431 538
90 422 25
OTHER BORROWINGS
437,511 13,056 20,297
416 5,912 112
EQUITY CAPITAL
466,039 63,374 49,099
4,945 30,189 2,821
LOAN LOSS RESERVE
57,860 5,464 7,133
516 3,772 268
LOAN COMMITMENTS
3,892,782 235,628 474,553
104,458 99,098 4,135
TIER1 CAPITAL RATIO
0.096 0.151 0.106
0.136 0.098 0.130
TOTAL CAPITAL RATIO
0.123 0.162 0.130
0.148 0.122 0.141
LEVERAGE RATIO
0.078 0.101 0.092
0.105 0.083 0.099
LOAN LOSS RESERVE RATIO
1.734 1.413 2.315
1.779 2.051 1.599
QUARTERLY EARNINGS AND RETURNS -- $ MILLION
INCOME TOTAL
140,966 13,522 12,345
1,218 6,113 600
INTEREST
100,055 11,563 8,657
907 4,827 504
FEES & CHARGES
6,320 671 519
40 382 24
EXPENSES TOTAL
107,843 10,983 9,193
1,011 4,751 495
INTEREST
46,970 4,989 3,116
311 1,649 176
SALARIES
2,241 2,719 1,857
276 1,262 146
LOAN LOSS PROVISION
5,573 439 777
82 302 23
OTHER
32,059 2,836 3,442
341 1,539 149
TAXES
11,983 707 1,204
74 543 38
NET INCOME
21,140 1,833 1,947
134 818 67
ROA (% ANNUALIZED)
1.57 1.18 1.76
1.20 1.21 1.01
ROE (% ANNUALIZED)
18.14 11.57 15.86
10.85 10.84 9.52
NET INTEREST MARGIN (% ANNUALIZED)
3.94 4.24 5.01
5.31 4.72 4.91
ASSET QUALITY -- PERCENT OF LOANS
NET CHARGEOFFS (%ANNUALIZED) TOTAL
0.60 0.27 0.88
0.43 0.34 0.26
REAL ESTATE
0.09 0.03 0.03
0.03 0.02 0.03
COMMERCIAL
0.60 0.65 0.81
0.66 0.66 0.61
CONSUMER
2.30 1.03 3.00
2.46 1.05 1.35
CREDIT CARDS
4.52 6.23 4.27
5.73 2.84 2.30
AGRICULTURAL
0.32 0.20 0.43
0.22 0.49 0.54
PAST DUE & NON-ACCRUAL TOTAL
2.12 2.22 1.99
2.15 1.53 1.70
REAL ESTATE
1.83 1.75 1.37
1.36 1.23 1.25
CONSTRUCTION
1.71 1.31 1.54
1.58 1.36 1.30
COMMERCIAL
1.53 1.48 1.13
1.00 0.98 0.98
FARM
2.25 2.02 3.22
2.96 3.25 2.18
HOME EQUITY LINES
1.09 1.16 0.82
1.04 0.77 0.80
MORTGAGES
2.03 2.06 1.82
2.06 1.78 2.17
MULTI-FAMILY
1.75 1.24 0.74
1.27 0.59 1.29
COMMERCIAL
2.01 4.16 2.38
3.38 2.14 3.15
CONSUMER
3.89 3.09 3.22
4.97 1.61 2.15
CREDIT CARDS
4.69 7.33 3.87
10.63 1.24 1.58
AGRICULTURAL
2.43 2.30 2.64
2.19 2.87 2.55
NUMBER OF BANKS
8,604 7,515 605
452 328 236
NUMBER OF EMPLOYEES
1,617,356 273,996 138,014
24,448 83,773 12,006
Opinions expressed in the Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Judith Goff, with the assistance of Anita Todd. Permission to reprint portions of articles or whole articles must be obtained in writing. Permission to photocopy is unrestricted. Please send editorial comments and requests for subscriptions, back copies, address changes, and reprint permission to: Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco, CA 94120, phone (415) 974-2163, fax (415) 974-3341, e-mail Pubs.sf@sf.frb.org. The Economic Letter and other publications and information are now available on our Website-http://www.sf.frb.org or http://www.frbsf.org. INTEREST RATES ON LOANSLegend for Chart:
A - TYPES OF LOAN
B - AUG 1997
C - NOV 1997
D - FEB 1998
E - MAY 1998
F - AUG 1998
G - NOV 1998
H - FEB 1999
I - MAY 1999
J - AUG 1999
K - NOV 1999
A B C D E F
G H I J K
COMMERCIAL and INDUSTRIAL LOANS
TOTAL U.S.
6.82 6.85 6.87 6.80 6.93
6.63 6.32 6.52 6.78 7.03
DISTRICT
6.60 6.67 6.51 6.42 6.70
6.33 5.99 6.54 6.69 6.98
BY RISK RATING:
MINIMAL RISK U.S.
6.08 6.29 6.10 6.13 6.33
5.91 5.84 5.59 6.05 6.01
DISTRICT
5.65 5.87 5.77 5.68 6.52
5.51 5.30 4.88 7.19 6.36
LOW RISK U.S.
6.28 6.27 6.32 6.26 6.32
6.07 5.64 5.70 5.90 6.52
DISTRICT
6.28 6.05 6.23 6.28 6.27
5.77 5.67 5.91 6.20 6.74
MODERATE RISK U.S.
6.98 6.88 7.04 6.86 7.01
6.63 6.39 6.74 6.93 7.22
DISTRICT
6.47 6.55 6.36 6.20 6.55
6.25 5.81 7.08 7.15 7.15
OTHER U.S.
7.48 7.79 7.33 7.08 7.18
7.09 6.70 7.13 7.55 7.71
DISTRICT
7.32 7.88 6.94 6.78 6.95
7.38 6.45 6.92 6.66 6.93
BY MATURITY/REPRICING INTERVAL:
DAILY U.S.
6.23 6.22 6.27 6.19 6.40
6.18 5.71 5.87 6.15 6.43
DISTRICT
6.97 7.20 7.33 6.74 7.18
8.40 6.42 6.44 6.65 7.08
2 TO 30 DAYS U.S.
6.72 6.82 6.58 6.68 6.74
6.39 6.18 6.01 6.62 6.80
DISTRICT
6.66 6.57 6.43 6.23 6.50
6.15 5.73 6.35 6.56 6.86
31 TO 365 DAYS U.S.
6.69 6.95 6.86 6.96 7.08
6.67 6.45 6.82 6.88 7.58
DISTRICT
6.42 6.54 6.26 6.70 6.77
6.20 6.20 7.14 6.97 6.85
OVER 365 DAYS U.S.
8.39 8.44 8.33 7.97 7.92
7.71 7.50 7.44 7.73 8.02
DISTRICT
7.58 6.94 7.06 6.76 7.80
6.30 8.00 7.07 8.43 8.28
CONSUMER, AUTOMOBILE U.S.
8.99 8.96 8.87 8.69 8.71
8.62 8.34 8.30 8.44 8.66
DISTRICT
9.19 8.78 8.87 8.69 9.20
9.77 8.80 8.92 8.98 9.07
CONSUMER, PERSONAL U.S.
13.84 14.50 14.01 13.76 13.45
13.75 13.41 13.26 13.38 13.52
DISTRICT
15.25 15.10 15.53 14.57 14.95
14.66 14.10 12.83 13.62 14.45
CONSUMER, CREDIT CARD U.S.
15.78 15.65 15.65 15.67 15.83
15.69 15.41 15.21 15.08 15.13
DISTRICT
16.38 15.62 15.80 15.81 15.76
15.44 15.17 15.41 15.73 15.63
SOURCES: SURVEY OF TERMS OF BUSINESS LENDING AND TERMS OF CONSUMER CREDIT ~~~~~~~~ By John Krainer, Economist in the Fair Use guidelines of the 1976 U.S. Copyright Act. info [at] singlearticles.com Powered by CommonSense |
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