Joining the REIT club: What will it take to succeed?
May 2, 2013
In recent years, the Internal Revenue Service has broadened the types of assets that can qualify for real estate investment trust (REIT) status. This means that REITs — which already include a vibrant cross section of real estate securities — now encompass an even wider collection of traditional and not-so-traditional companies and industries.
In the sections that follow, we discuss the expansion of the REIT universe, issues that we believe may be faced by companies considering conversion to REIT status, and our approach to the market in light of some of the changes taking place.
REITs: An expanding universe
Based on research, many businesses have elected to recategorize themselves as REITs. At first glance, some of these firms might not seem like the typical real estate operators of yesteryear as U.S. regulations have expanded to allow more types of companies to qualify for REIT status.
As a result, the REIT asset class now provides access to a growing contingent of business types. Examples include:
||Investors may be tempted to classify these companies as somewhat predictable and staid product providers. But some of these companies care for their own forest tracts; as such, these enterprises can find a place under the REIT umbrella.
|Document storage providers
||Although their primary business is providing secure storage for sensitive documents, another interpretation is that these companies essentially rent space to their customers.
||This network of towers is part of the physical real estate that helps facilitate wireless communications. Viewed through a REIT lens, these companies are essentially property owners who rent "space" to tenants.
To REIT or not to REIT?
Potential conversion considerations
We believe a company’s decision to recharacterize itself as a REIT ought to be based on an honest assessment of its long-term business plan. This is because companies that pursue a REIT conversion face a potentially expensive and time-consuming process. Ultimately, they must meet two conditions in order to qualify for REIT status: (1) They need to derive 75% of gross income from owning and operating real estate, and (2) they are required to distribute 90% of profits as dividends. Given these complications, why are firms motivated to pursue a conversion? The incentives include:
- Tax advantages: So long as the company adheres to the 90% distribution requirement noted above, profits are exempt from corporate taxes.
- An opportunity to provide shareholders with regular dividend distributions: This is especially true for companies that are no longer classified as growth companies and are no longer reinvesting a substantial portion of earnings.
- An opportunity to support the company’s share price: This is particularly true in light of recent strength in stock valuations for listed REITs.
Where we see areas of particular interest
For many companies currently contemplating REIT conversions, we believe the transactions could make a lot of sense. For other companies, however, we are less convinced. We like to look at two main factors when considering the viability of any given conversion:
- the nature of the company’s cash flows
- the attributes of its physical real estate
Many potential REITs have cash flows that are similar to those of traditional real estate investment companies. Communications-tower businesses, for instance, have long-duration cash flows (with annual increases that are pegged to a particular indicator), paired with long-duration debt. In our opinion, this REIT-like environment gives tower operators an advantage.
On the other hand, some types of businesses have a harder time fitting their cash flows into a typical real estate model. Consider operators of data storage centers, for instance. These companies might indeed own real estate, but they are also responsible for providing customers with administrative services — services that consume resources and therefore affect the stability of their income streams.
In addition to considering cash flows, we believe investors should assess the fundamental nature of the real estate actually owned by the prospective REIT. Does the company own land outright, or perhaps own a building or a piece of infrastructure? This is important because by owning some form of physical real estate, the company can introduce a measure of downside protection to its overall risk profile.
While we’re talking about physical property, we should mention that we tend to prefer REITs that hold diverse real estate assets in their respective portfolios, and that the “useful lives” of their assets will not be exactly the same.
The quest to convert: Successes are likely, but so are failures
Ultimately, we believe there will be some genuine success stories, and we think the odds look good for companies like those that have a stake in communications towers. At the same time, we think it’s reasonable to presume that a number of conversions will not work. We believe the unsuccessful attempts will ultimately falter because they do not offer investors the same income streams or other essential characteristics that are provided by traditional real estate assets.
There is also the issue of access to capital markets. Remember that once a company becomes a REIT, it no longer has sole discretion over its cash flows, and is therefore more dependent on access to capital markets. This reliance may not be a source of pressure during times of high liquidity — as we are seeing today — but let’s remember that liquidity was sparse as recently as 2008, and REITs saw detrimental effects on their access to capital (as well as their valuations).
Possible investment implications
Across the portfolios we manage, it’s unlikely that we will make immediate allocation decisions based on the volume of newly converted REITs. In and of themselves, conversions won’t lead us to quickly initiate new positions or eliminate older ones. An increase in REIT conversions would simply expand our universe of investment possibilities, and our research coverage would expand accordingly. All along, each investment candidate would be put through the same long-standing research process that our team follows every day, maintaining our dual focus on property- and security-level analysis.
With the above observations as a general backdrop, here are specific thoughts on our day-to-day management amid a changing REIT market.
- In 2012, we initiated a position in a company that had recently achieved a REIT designation. The company is an operator of communications towers — a business that we like very much, not least because of its long-duration cash flows that are matched with long-duration debt (as mentioned earlier).
- We are monitoring for companies that lunge into conversions too aggressively (chasing a boost in share price, for instance). In other words, we are being careful of REIT transactions that seem too hasty or impatient.
- We remain cognizant of the fact that any abuse of REIT status could generate a governmental regulatory response. At the very worst, legislators could rescind the features of the REIT structure, and a widespread selloff could be sure to follow. (For a closer look at this type of shock, see Canadian REIT markets in 2006.)
- Since our investment portfolios are often measured against a stated index,* we continue to monitor changes to index composition. Index constituents don’t change on a frequent basis, but when changes do happen — if a reasonably young REIT is added, for instance — we will be following it closely.
Overall, we don’t expect newly converted REITs to disturb the key features of the asset class, namely the required dividend payouts and the built-in protection against inflation. That said, we believe investors should keep certain conditions and possible risks in mind, including those noted above.
*For REIT funds managed by Delaware Investments, the stated indices are the FTSE NAREIT Equity REITs Index (for domestic portfolios) and the FTSE EPRA/NAREIT Developed Index (for international portfolios).The FTSE NAREIT Equity REITs Index measures the performance of all publicly traded equity real estate investment trusts (REITs) traded on U.S. exchanges, excluding timber REITs. The FTSE EPRA/ NAREIT Developed Index tracks the performance of listed real estate companies and real estate investment trusts (REITs) worldwide, based in U.S. dollars. Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index.
The views expressed represent the investment team’s assessment of the market environment as of May 2013, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the investment team’s current views.
Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting the fund literature page or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.
Investing involves risk, including the possible loss of principal.
Narrowly focused investments may exhibit higher volatility than investments in multiple industry sectors. "Nondiversified" funds may allocate more of their net assets to investments in single securities than "diversified" Funds. Resulting adverse effects may subject these Funds to greater risks and volatility.
REIT investments are subject to many of the risks associated with direct real estate ownership, including changes in economic conditions, credit risk, and interest rate fluctuations.
A REIT fund's tax status as a regulated investment company could be jeopardized if it holds real estate directly, as a result of defaults, or receives rental income from real estate holdings.
International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.
There is no guarantee that dividend-paying stocks will continue to pay dividends.
Diversification may not protect against market risk.