Real estate securitization was widely blamed for causing the destructive housing bubble that rocked the U.S. economy in 2008, yet the commercial real estate sector recovered relatively quickly after the crisis. Why?
My research indicates that listed equity real estate investment trusts (REITs) play a central role in moderating the construction and development of new commercial properties, which has a balancing effect on the commercial real estate market as a whole.
The transmission mechanism is relatively straightforward. REITs enable investors to receive reliable pricing information quickly in real time, thereby discouraging speculation. Analysts, ratings agencies and market experts monitor REITs daily, which further reinforces transparency.
In addition, when publicly traded share prices experience significant price fluctuation, market participants respond more cautiously when making investment, lending, and spending decisions, which further inhibits boom-bust cycles in commercial property markets.
On the other hand, private-unlisted ownership markets offer information with greater lag times, which can be exploited by agents who push sales and prolong investment activity. This enables misallocations and distortions to continue for long periods of time, spurring boom-bust cycles.
Maintaining a reliable, consistent management reputation is crucial to REITs’ survival and success. REITs deliver relatively high dividend payouts to shareholders and must continually return to capital markets for new investment funding. REITs need to consistently deliver on their promises in order to have continued affordable access to capital markets.
REITs also operate at lower leverage levels, which is an important moderating factor. The debt-to-value ratios of private firms’ mortgage debts often exceed 70 percent, while most REITs operate at less than 50 percent leverage ratios. In the 2008 real estate meltdown, fewer REITs went bankrupt; less leverage and stress in part led to a swift rebound of REIT prices as early as 2009.
Lenders, investors and developers all pay close attention to the information generated by REIT managers, considering it when making decisions to issue loans and build new commercial properties. For example, when new office construction is announced and occurs in Washington D.C., and share prices of REITs that hold office property in Washington D.C. decline, that sends a signal to construction lenders and other market participants that further supply of office space may negatively impact rents going forward.
The increasing attention paid to REITs has ultimately helped moderate the office construction supply cycle: there were no major commercial real estate booms or busts from 1991-2011, in marked contrast to the housing market during this period.
A larger point of this research program is that securitization is not a social “bad” to be avoided at all costs. The information that REITs provide helps moderate the supply of credit in a way that can avert boom-bust cycles that are disruptive to the U.S. economy.
This research, originally published in Journal of Portfolio Management, was featured in Bloomberg Businessweek in June.