Investors warm to real estate equities

Real estate equities have until recently been much unloved by investors. The staggering under performance of the sector in both the US and Europe when compared with broader markets - and indeed, with the performance of the direct markets - prompts the question: is public ownership really the best way to invest in real estate?

Arguably not. That was clearly the conclusion that MEPC, the UK's fourth largest property company, came to when it agreed to be taken private by two institutional investors. Several smaller UK companies have done likewise and a number of US companies have taken a similar route, the most recent example being the $3.4bn sale of Urban Shopping Centres to Rodamco US.

Nevertheless, there is a case to be made that not only is public ownership a "correct" way to invest in real estate, but that public markets in real estate restrain its boom-bust cycles. Economists at New Jersey-based Prudential Real Estate Advisors make the point in a recent paper about trends shaping the industry.

"Over the long term, greater transparency and more diverse sources of capital brought about by the maturing public markets should help to reduce the industry's reaction time to developing trends and make capital flows to the industry more stable and more disciplined," Philip Conner and Youguo Liang conclude.

In defining public ownership, the authors note, it is necessary to look not only at equities but at publicly traded debt as well.

Since 1992, the US has developed a mature and deep market in commercial mortgage-backed securities (CMBS) which, according to John Kriz, managing director of real estate finance at Moody's Investors Service, is the ultimate fate of nearly half of all commercial real estate loans originated in the US this year. Roughly 25 per cent of all outstanding mortgage debt is now repackaged as public securities.

Each new offering of CMBS securities is accompanied by a bond indenture giving detailed financial information about the loan pool and the underlying properties. Study of this data, he says, allows analysts to come to conclusions fairly quickly about the state of various real estate sub-markets.

A quick look at US CMBS issuance suggests one possible reason why the real estate cycle has held up so well for the better part of 10 years. CMBS issuance peaked at $78.4bn in 1998, when the first signs of overbuilding in some markets began to appear and debt markets were affected by both Russia's default on its government bonds and the near-collapse of hedge fund manager Long Term Capital Management.

The data shows that, in effect, the capital markets turned down the tap at exactly the right moment.

In 1999, CMBS issuance slipped to $67.8bn, and is forecast to be no more than $65bn for the current year.

The reduction coincided with the severe underperformance of real estate investment trusts (REITs), making it much more difficult for buyers with access to the capital markets to buy or develop new properties. That made new developments more difficult to finance and, as a result, the over-expansion characterising boom-bust cycles appears not to have happened.

Peter Linnemann, professor of real estate at the University of Pennsylvania's Wharton School of Business and an early proponent of public ownership for real estate, says that despite the hiccups in the REIT market, the shift to public ownership is inexorable.

"Once an industry becomes public, it never goes back," Mr Linnemann says, adding that he expects the process, begun in 1990, to take 25 years. "I always compare it to the US settlers who moved west," he says. For long periods, they travelled over flat plains. Further on, they hit high mountains. At some point, he says, they run into Death Valley: "That's the point where the consolidations start to happen."

Richard Maine, managing partner at Connecticut-based Landmark Partners, a firm which buys participations in private limited partnerships, points out that real estate did not jump into the public market on its own accord. It was pushed.

The late 1980s, the peak of the last real estate boom, marked the first time since the 1930s that insurance companies had got themselves in trouble with property. Regulators retaliated by insisting on risk-adjusted capital requirements similar to those for banks. In addition, most of the US tax breaks which encouraged real estate investment were scrapped. "Real estate no longer has access to any subsidised form of capital," says Mr Maine.

Mr Linnemann points out that real estate came to the public capital markets for the same reasons other industries have; private equity capital is simply not available in sufficient abundance to allow companies to grow. "In the US, real estate never had to tap the public markets because they always had their friendly private banker ready to lend," he says. But the swingeing losses of the early 1990s changed that and real estate was forced into the public markets for both debt and equity.

The poor performance of REITs, says Mr Linnemann, has less to do with an imperfect ownership structure and more to do with the nature of management. "The industry always overpromised and under-delivered but the equities markets are always about underpromising and over-delivering," he says. As a result of the collapse in REIT share prices, many unwise deals did not get done, he says. "Being public doesn't stop mistakes from happening," he says. "They just happen more slowly."