“REIT and Commercial Real Estate Returns: A Post Mortem of the Financial Crisis.” Sheridan Titman and Garry Twite (McCombs School of Business); Libo Sun (California State Polytechnic University). April 2013.
During the financial crisis of the 2000s, real estate investment trust (REIT) prices were dramatically more volatile than commercial real estate prices, and they failed to completely recover their value once the crisis passed. The culprit was the overuse of debt financing, which forced REITs to issue equity and sell assets at distressed prices.
REITs provide a way to invest in real estate that is more simple, liquid, and (oftentimes) profitable than purchasing real estate directly. They can also provide a way for individuals to invest in property types such as retail space or hotels that they wouldn’t have access to on their own.
As an investment vehicle, REITs own and manage income-producing real estate and distribute 90 percent of their taxable income to shareholders as dividends, making them a good option for investors looking to include tangible assets as part of their financial portfolios. During the economic downturn that began in 2007, however, REITs were substantially more volatile than the underlying values of the real estate they owned, with share prices plummeting by as much as 67 percent by February 2009.
Overall, from September 2008 to February 2009, the NCREIF Property Index, which tracks private real estate performance, fell by only 15 percent, while the NAREIT index, which tracks REIT performance, dropped by 60 percent. By December 2011, the NCREIF had fully recovered its loss, but the NAREIT index was still below its pre-crisis high.
New research by McCombs School of Business professors Sheridan Titman and Garry Twite, with Cal Poly co-author Libo Sun, establishes a strong correlation between a REIT’s use of financial leverage and cumulative returns: The more heavily leveraged a REIT was, particularly if it had large amounts of debt coming due during the financial crisis, the worse it performed.
The authors examined 138 publicly traded REITs spanning all major property types, including healthcare, hotel, residential, office and industrial, shopping, and specialty. For the sample studied, the average proportion of total debt that came due in 2008 and 2009 was 20.36 percent. Those REITs that were saddled with excessive debt coming due at the height of the crisis — with many companies having in excess of 50 percent of total debt due in 2008 and 2009 — were often forced to sell property at unattractive prices and issue equity at a lower value in order to meet the terms of their loans. Just as important, REITs in the sample carried an average of 15.5 percent variable rate debt. The combination of shorter maturity loans and increasing interest rates was toxic and even led some REITs to declare bankruptcy.
“Excessive debt is costly. For a regular corporation, there’s a tax advantage associated with having debt. For REITs, that’s not true,” says Titman. “The reason why the REITs take on debt is because they want to see their returns amplified. They think they’re going to do well. They think that’s good. But they tend to be overconfident, and when things go bad, it can cause big problems.”
The authors surmise that financial distress also caused a distraction for REIT executives who no longer had the ability to devote the proper time and energy to managing their investments, which in turn harmed performance.
These findings offer guidelines for those managing REITs, as well as investors looking to optimize their REIT portfolios. In 2007, professors Titman and Greg Hallman helped launch a student-run REIT fund at the McCombs School of Business. At the start of the financial crisis, Titman and Hallman were concerned about the risks associated with heavy leverage and advised the student-managers to pay particular attention to both the short- and long-term financial conditions of the REITs included in the McCombs REIT Fund. Students assessed each REIT’s debt ratio and debt maturity structure before selecting it, and the McCombs REIT Fund outperformed the market.
“REIT and Commercial Real Estate Returns: A Post Mortem of the Financial Crisis” won the 2013 NAREIT Distinguished Research Prize and has been accepted for publication by Real Estate Economics. For more information about the McCombs REIT Fund, click here.