REITs debate growth versus income

By Mark Noble | April 14, 2009 | Last updated on April 14, 2009
5 min read

Like most of the real estate investment industry, real estate investment trusts (REIT) are struggling. They have an additional hurdle, which is deciding whether to continue to pay out substantial tax-advantaged distributions to income investors, or cut payouts and save money for future growth.

To cut or not to cut became a subject of panel debate at CIBC’s recent 14th Annual North American Real Estate Conference. The CEOs of a number of prominent Canadian REITs were torn on the issue.

REITs were exempt from the taxes imposed on income trusts by the federal government, so they have become a popular alternative for income investors. Thomas Hofstedter, president and CEO of H&R REIT, does not believe that investors should view REITs as the de facto replace of income trusts. H&R has cut it’s distributions by 50% in order to continue building The Bow, which will become the tallest skyscraper in Calgary.

In Hofstedter’s opinion, it is essential that REITs look to cut distributions in order to preserve capital and to continue to build a foundation for future growth.

“In the U.S., REITs are more of a real estate play than an income vehicle. H&R has turned into more a stock, so to speak, that has more potential upside value as we get closer to the value The Bow will create upon its completion,” he said. “REITs should be cutting distributions, otherwise you’re raising equity at a time when you’re losing net asset value.”

For some of the other panelists at the conference, the tax advantaged distribution is the main selling point of a REIT. Simon Nyilassy, president and CEO of Calloway REIT, says institutional investors tend to invest on long-term prospects of the underlying business.

He noted a significant contingent of retail investors are looking to REITs as income yielding vehicles, meaning a cut to distributions could put further downward pressure on the capital value of trust units.

“I disagree with Tom a little bit. The REIT sector is going to be in a pretty unique situation as an income vehicle. It’s one of the few investment vehicles left standing on tax effective basis. The income investors are not going away,” he says. “The retail investors are confused because they the see the volatility of prices and don’t know what to make out of it. Some of them are running for the hills and some are saying ‘I’m getting a decent yield I might as well stick with it.'”

However, even Nyilassy conceded that running a real estate business in these conditions is exceedingly difficult, due to the collapse of the secured debt market — which parceled off mortgages and debt into mortgage backed securities. Calloway is one of the few REITs to go forward with new equity issuance as a way to raise capital.

“At these prices it doesn’t make sense to issues equity at a mid- to high-double digit costs to pay down debt, unless you have too,” he said. “When the market is as volatile and unpredictable as it is, the prudent thing to do is take the opportunity.”

Equity issuances are used either to fund distributions or to shore up capital to ride out the market until more sources of financing are found. Nyilassy says that buying opportunities right now are far and few between, because nobody wants to sell property unless they have too.

Capitalization rates — the real estate equivalent of price to earnings ratios — are currently rising, not because revenues are rising, but because property values are going declining. Fortunately, occupancy rates remain high; great news if you’re a buyer, but there is currently nothing for sale.

“Real estate investing is not like calling up your broker and asking buy 1,000 shares of Calloway. You can’t call up a broker and ask to buy a large un-enclosed shopping centre. That’s not how the market works. If there is great opportunity at the right price and issuing equity works, you’re going to do it. At this point in the market though, I don’t see those opportunities there,” he said. “Ask any strong holders of real estate in Canada, ‘are you going to sell your assets for an 8% cap rate?’ and they are going to say ‘no.’ An 8% cap rate doesn’t mean anything unless you’re going to buy something. You have to gauge whether there is real estate in hands weak enough they are going to be forced to sell.”

Hofstedter said anybody raising equity while NAVs are so low is further diminishing their unitholder value.

“Raising capital is to shore up our balance sheets and not to buy strategic assets,” he said. “I think [as an industry] we will consistently raise equity at very high prices and debt at very high prices just to have a strong balance sheet until we see some light at the end of the tunnel.”

Hofstedter went on to suggest that REITs should consider eliminating their distribution reinvestment programs (DRIP), if they are being used to fund future dividends.

“We’re issuing equity at huge discount to NAV,” he said. “We’re all very comfortable hiding that fact. The reality is we’re issuing equity through our DRIP [and eroding value].”

If a REIT cuts its distribution, it raises the question of how long it should wait before reinstating it. There was some consensus that the secured debt market needed to return before the real estate market can start to thrive again.

“The odd lender is suggesting they want a floor of 6% to get loans into play. We don’t have that equilibrium in the market yet. We do need the MBS market to revive itself, or we need the trillion dollars of stimulus to take hold and give our balance sheet lenders the motivation to lend more,” said Amrin Martens, the president and CEO of Artis REIT, which has no plans to issue any equity in the coming year.

Nyilassy suggested the secured lending market in Canada could get on its feet faster than in the U.S.

“That market, properly underwritten, made a lot of sense: to be able to split up the debt between those that want to take a little more risk and those that want to take less risk. The underwriting broke down, particularly in the U.S,” he said. “I suspect the default rates you’re seeing in the U.S. market are not the case in Canada. We had one convertible MBS loan that matured this year. We were able to replace it quite easily, we up and refinanced that by about 30%. We were able to do that with a non-convertible MBS lender.”

Michael Emory, president and CEO of Allied Properties, says he sees REITs thriving if they focus on their fundamental business of investing in good income earning properties and not letting their NAV dictate their actions.

“I think people understand that real estate is a long term business and the performance over time of the underlying real estate is ultimately more important that the particular value the capital market as assigning to the business at any particular time,” he said.


Mark Noble