Nobody likes the Fed to catch them by surprise, but especially not the REIT market.

When Federal Reserve Chairman Ben Bernanke said June 19 that the central bank would start scaling back quantitative easing, tapering off Treasury bond purchases until they stop completely in mid-2014, all markets declined, but the REIT markets got slaughtered as an imagined future of rising interest rates frightened all current holders of yield-bearing assets.

“The market is [saying] shoot first ask questions later,” says Marc Halle, managing director of Prudential Real Estate Investors. “They are selling real estate down as an income product as opposed to a real estate product.”

2013 has marked the end of the incredible run-up in REIT values. From its nadir on March 2, 2009, the MSCI U.S. REIT Index had soared almost 360% to its peak on May 21 this year. But the crash was sudden and harsh; after the Fed’s comments, REITs had tumbled 16% off their high by June 20. (This loss was trimmed back to 10% by July 10.)

Higher interest rates worry REIT investors for myriad reasons. One worry is that REITs are going to lose their appeal next to the empowered 10-year bond.
“The opportunity cost of your capital has changed,” says Scott Crowe, a managing director at Resource Real Estate’s New York office. “If REIT stocks were yielding 3.5% prior to the Fed talking about tapering and the 10-year bond yield was at 1.7%, the REIT market doesn’t look nearly as attractive at a 3.5% yield with a 3% 10-year-bond yield.”

But it’s more than that—it might mean the end of cheap capital and thus the spree of property buying and merging. REITs have positively thrived in the QE world, piling up record levels of capital from financing and new investor proceeds to buy iconic skyscrapers, mortgages, houses—and even each other.
Listed REITs acquired $41 billion in new properties in 2012, according to New York firm Real Capital Analytics. In the first quarter of this year alone, they acquired almost $24 billion, almost three times more than they had during the same quarter the year before. But in the post-QE world, their cost of capital could rise and curtail the feeding frenzy. Is the party over?

“U.S. REITs were financing at astronomically low interest rates, you know sub-3%,” says Crowe, who was recently brought to Resource Real Estate to help build its real estate securities business. “I think on one hand their marginal cost of capital is going to be more pricy.”

But REITs could have been buying more, he says. They have been much more conservative since the mid-2000s, when they were heavily leveraged with the sort of unwanted debt they couldn’t scrape off their books. Now, he says, “people are very mindful of who they are raising capital from, how well they are laddering their maturities, whether they have a diversified syndicate of people they can borrow from. They are very focused on their absolute levels of leverage in terms of loan-to-value, Ebitda and they are also sitting on a lot of cash.”

The Fundamentals
The violence done to REITs is also unfair because the fundamentals are sunny, say the vehicle’s advocates. The big worry about higher interest rates is that they supposedly push up real estate cap rates (a property’s net operating income divided by its value). When cap rates rise, the property values are then usually tweaked downward, unless they can make up for it with increased cash flow.

And they can, says Halle, because of the very same economic recovery implied by the Fed’s rate move. Better economic conditions mean more people are employed and need places to work. At the same time, there’s a supply-demand imbalance. There’s been no new construction since the financial crisis, and it takes two to three years to ramp up building projects. In a market with no new supply, rents will rise, and those people who are part of the landlord class—i.e., REIT owners—are going to have the advantage. This will have a salutary effect on the earnings, cash flow and profit margins of REITs, which should be able handle the increased cost of capital.

“I think we hit the all-time low of supply in 2011. We haven’t seen a lot of new construction and development since then and with the economy growing at 3%, 3%-plus GDP growth, you don’t expect to see any significant starts. So if your supply is limited for the next two, three, four years, then you look to the demand side of the equation. If we’re creating new jobs, which we have been pretty steadily, between 150,000 and 175,000 a month, that’s a lot of jobs being created, and those people need a place to sit.”

Chip McKinley, a portfolio manager for global real estate securities at Cohen & Steers in New York, adds that the spreads over borrowing costs are still attractive because REIT cash flow is still growing.

Funds from operations, he says, “grew over 9% in the U.S. on average for all REITs in 2012. They are on track to grow by over 10% this year and over 10% in 2014.”

Crowe says that the selloff spurred by Bernanke’s remarks might have been somewhat warranted for those REITs with less attractive cash-flow prospects, but he adds that much of the investor sentiment was irrational.

“The 20% decline in REIT values, roughly half has been what I would say is a rational pricing in of a higher level of the U.S. bond yields, which will probably be sustained,” says Crowe. “And half of it is just overreaction, panic and uncertainty.” That spells opportunity for astute REIT buyers, he says. “The other 10%, I’d classify that as the opportunity that we’ve been taking advantage of by returning more capital into U.S. REITs versus the other real estate securities markets we invest in,” he says.

The Best Plays
In this environment, the REITs most vulnerable to the interest-rate hikes will be the ones that are more bond-like, says McKinley. That means properties with longer-term leases such as health-care REITs (think Ventas Inc. and Health Care REIT Inc.).

“These health-care names have longer and more stable leases predominantly paid basically by Medicare, which is basically government reimbursement, and that’s completely noncyclical or almost entirely noncyclical. So they are very, very bond-like. They are very secure, very income-oriented, very defensive. But [that’s] what has made them completely undefensive in the last month—leading REITs on the way down.”

Halle agrees and likes properties with shorter lease durations such as hotels and storage where he sees landlords able to spike rents in the near term.
“We like industrial and retail class A retail despite all the talk about the Internet,” he says. “I go back many years in real estate when people used to say … malls are dead because we’ve got catalogues. Who is going to shop at a mall when you’ve got catalogues? Rumor No. 1 shot. Rumor No. 2 was with the introduction of computers we’re going to have a paperless office. I have yet to see a paperless office. And Rumor No. 3 is that when the Internet comes it’s going to kill retail for any type of commodity product. Walk into an Apple store and tell me if the ultimate commodity product is at all busy.”

Like McKinley, he is less optimistic about health-care REITs. He is also pessimistic about net lease asset REITs (which lease to one corporate tenant) because of their longer durations. “I do think the fundamentals are getting better, and if you’re in a long-term lease as the market goes up, you don’t have the ability to raise your rents. You almost become like a bond. That cost to capital goes up, but you don’t have the offsetting increase in value.”

McKinley likes industrial REITs like Prologis, but says this sector is otherwise a mixed bag and success depends mostly on a property’s location and access to key logistical routes.

“Some of the better-positioned public industrial REITs,” he says, “and I’m thinking about Prologis more than anyone else, have a greater dominance in the key transportation nodes in the U.S., which are Port of L.A., the Inland Empire, Chicago, places like that where warehouse logistic space is more critical to shipping to major shipping points and where occupancy and pricing power is coming back at a faster pace than the rest of the country.”

To Trade Or Not To Trade?
Another sector going through rapid upheaval in the cheap capital environment is nontraded REITs. These securities, which are not listed on exchanges but sold through brokers, are an obscure sub-sector of the REIT world, scorned by many financial advisors and portfolio managers for their lack of transparency and high fees, which eat into real estate’s already fragile return. Like variable annuities, they are often criticized for being sold rather than bought and often require big up-front commissions.

Halle says many investors who get into these funds are not astute and can’t see what they are investing in. “The private REITs have a very high load to get into,” he says. “What makes you competitive in real estate is having the lowest cost of capital, and when you give a REIT a hundred dollars, they raise a hundred, they can invest that hundred with a very minimal leakage to expenses. When you give a private REIT a hundred, there is a big leakage of expenses that goes to lots of underwriting fees.”

That’s why some advocate waiting to buy them until they are trading in the secondary markets, often at substantial discounts to the offering price. Regulators are also looking at them with a wary eye. Finra has worried that brokers are misleading customers by recommending nontraded REIT investments that aren’t suitable for clients and has developed a tip sheet full of caveats for the products (at

Crowe says he’s also biased against them, but confesses that he likes some nontraded REITs. They offer more of a real estate type return than their publicly traded brethren, which behave more like stocks and have lower yields and more volatility, he says. “And we’re also somewhat going to get a real commercial real estate return in terms of a high level of yield and a lower correlation with equities.”

Nor does he think investors are unaware of the fees. “I don’t know what rock everyone’s been hiding under, but it’s been well publicized the kind of fees that have been charged in nontraded REITs,” he says. “An analogy is the hedge fund world. The hedge fund world charges a lot of fees too, but people are willing to pay them.”

Furthermore, he thinks the REIT and nontraded REIT worlds are working more symbiotically and in a way quietly merging—as many nontraded securities become “incubators” for properties that will eventually be publicly listed. “They aggregate these large portfolios and they actually find their way onto the publicly traded space either through acquisitions or a listing,” he says. That’s good for nontraded investors because it offers them a way to cash out. The bigger yields are also a selling point.

He points out two unlisted companies, American Realty Corp. and Cole Real Estate Investments, which have both been on mad purchasing sprees for single-tenant net-lease properties. These companies rent to strong corporate tenants like Target, Costco, Walmart, Walgreens, etc.

“That’s been a huge growth sector for the net-lease space in the publicly traded space because people love the yield that they can get from these kinds of assets,” says Crowe. These properties act like high-yielding bonds since the renters pick up operating costs and landlords collect the money. “The yields have come in a little, but the yields were 7% plus for that kind of property and that’s very attractive in a low-interest-rate environment.”

Cole has been around since 1979, building up a huge portfolio that it finally listed in June after gathering $7.7 billion of gross assets. Now competing head-to-head with Cole is a voracious upstart, American Realty Corp.—a sponsor of nontraded REITs that has dramatically parachuted into the middle of the stage of net-lease action. One of its sponsored firms, American Realty Capital Properties, went public in 2011. Its enterprise value was $279 million at the beginning of this year and the pro forma figure had ballooned to $10 billion by July.

“American Realty Capital I guess five years ago was a very, very small player in the nontraded REIT space,” says Crowe. “In the first quarter of this year, they raised 54 cents out of every dollar raised in the nontraded REIT space. So they’ve gone from zero miles an hour to 100 kilometers an hour in a very short space of time.”

In its latest huge deal, American Realty Capital Properties bought its nonlisted sister company, American Realty Capital Trust IV, for $3.1 billion. In May it bought CapLease for $2.2 billion. In June it bought 447 net lease properties for $774 million from GE Capital, which rents to several famous freestanding restaurants like Golden Corral, IHOP, Burger King, Taco Bell and Wendy’s.

ARC even twice tried to buy its $7.7 billion rival Cole this spring in an unsolicited and ultimately rejected bid before the latter company went public. After the ARC Trust IV acquisition, American Realty Capital Properties will have more than 2,500 single-tenant properties.

Crowe says the parent firm and its CEO, Nicholas Schorsch, have been able to dominate the space by playing both sides of the fence and arbitraging pricing disparities. “They’ve got a vehicle on one side [publics] that are trading at a big premium [to NAV] to basically acquire assets in the nontraded space at attractive prices,” he says. That makes it a “win-win” for both types of investor, he says.

“If you think of the force of low interest rates as a wave that reverberates through asset classes, it doesn’t all happen simultaneously to every asset class at the same time,” Crowe explains. “Just like a wave, like a sound wave, the more liquid assets are going to be repriced first before the less liquid assets, so what tends to happen in markets is that equity markets, and that includes REIT equity markets, are much more quick to price in low interest rates. And in a less liquid market like the direct underlying real estate markets, where capital moves more slowly, that takes more time. That’s set up an arbitrage opportunity for publicly traded REITs to acquire in the direct real estate market and it’s particularly apparent in the net-lease space because they have such high yields.”