The Alchemy of REITs
September 25, 2012 Leave a comment
LongShortTrader loves REITs (Real Estate Investment Trusts). The progression of headlines/developments in credit and REIT-land over the last few years (and especially within recent quarters) is getting LST very interested in this space. The below is one of the best explanations of REITs that LST has ever read:
My best documented encounter with a boom/bust sequence is that of Real Estate Investment Trusts. REITs, as they are called, are a special corporate form brought into existence by legislation. Their key feature is that they can distribute their income free of corporate taxation, provided they distribute all the income they receive. The opportunity created by this legislation remained largely unexploited until 1969 when a large number of REITs were founded. I was present at the creation and, fresh from my experience with conglomerates, recognized their boom/bust potential. I published a research report whose key part reads as follows:
THE CASE FOR MORTGAGE TRUSTS (February 1970)
Superficially, mortgage trusts seem to resemble mutual funds designed to provide high current yields. But the analogy is misleading. The true attraction of mortgage trusts lies in their ability to generate capital gains for their shareholders by selling additional shares at a premium over book value. If a trust with a book value of $10 and a 12% return on equity doubles its equity by selling additional shares at $20, the book value jumps to $13.33 and per share earnings go from $1.20 to $1.60.
Investors are willing to pay a premium because of the high yield and the expectation of per-share earnings growth. The higher the premium, the easier it is for the trust to fulfill this expectation. The process is a self-reinforcing one. Once it gets under way, the trust can show a steady growth in per-share earnings despite the fact that it distributes practically all its earnings as dividends. Investors who participate in the process early enough can enjoy the compound benefits of a high return on equity, a rising book value, and a rising premium over book value.
The conventional method of security analysis is to try and predict the future course of earnings and then to estimate the price that investors may be willing to pay for those earnings. This method is inappropriate to the analysis of mortgage trusts because the price that investors are willing to pay for the shares is an important factor in determining the future course of earnings.
Instead of predicting future earnings and valuations separately, we shall try to predict the future course of the entire self-reinforcing process. We shall identify three major factors which reinforce each other and we shall sketch out a scenario of the probable course of development. The three factors are:
1. The effective rate of return on the mortgage trust’s capital
2. The rate of growth of the mortgage trust’s size
3. Investor recognition, i.e., the multiple investors are willing
to pay for a given rate of growth in per-share earnings
Act One: At present, the effective yield on construction loans is at an optimum. Not only are interest rates high but losses are at a relatively low level. There is a pent-up demand for housing and new houses readily find buyers. There is a shortage of funds so that the projects which do get off the ground are economically well justified. Builders who are still in business are more substantial and more reliable than at the tail end of a boom. Moreover, they do their utmost to complete the construction phase as fast as possible because money is so expensive. Shortages of labor and material do cause defaults and delays but rising costs permit mortgage trusts to liquidate their commitments without loss. Money is tight and alternative sources of interim financing are in short supply. Investor recognition of the mortgage trust concept has progressed far enough to permit the formation of new trusts and the rapid expansion of existing ones. The self-reinforcing process gets under way.
Act Two: If and when inflation abates, the effective yield on construction loans will decline. On the other hand, there will be a housing boom and bank credit will be available at advantageous rates. With higher leverage, the rate of return on equity can be maintained despite a lower effective yield. With a growing market and growing investor recognition, the premium over book value may continue to increase. Mortgage trusts are likely to take full
advantage of the premium and show a rapid rise in both size and per-share earnings. Since entry into the field is unrestricted, the number of mortgage trusts will also increase.
Act Three: The self-reinforcing process will continue until mortgage trusts have captured a significant part of the construction loan market. Increasing competition will then force them to take greater risks. Construction activity itself will have become more speculative and bad loans will increase. Eventually, the housing boom will slacken off and housing surpluses will appear in various parts of the country, accompanied by a slack real estate market and temporary declines in real estate prices.
At this point, some of the mortgage trusts will be bound to have a large number of delinquent loans in their portfolios and the banks will panic and demand that their lines of credit be paid off.
Act Four: Investor disappointment will affect the valuation of the group, and a lower premium coupled with slower growth will in turn reduce the per-share earnings progression. The multiple will decline and the group will go through a shakeout period. After the shakeout, the industry will have attained maturity: there will be few new entries, regulations may be introduced, and existing trusts will settle down to a more moderate growth.
The shakeout is a long time away. Before it occurs, mortgage trusts will have grown manifold in size and mortgage trust shares will have shown tremendous gains. It is not a danger that should deter investors at the present time.
The only real danger at present is that the self-reinforcing process may not get under way at all. In a really serious stock market decline investors may be unwilling to pay any premium even for a 12% return on equity. We doubt that such conditions would arise; we are more inclined to expect an environment in which a 12% return is more exceptional than it has been recently and in which
the self-reinforcing processes of the last few years, notably conglomerates and computer leasing companies, are going through their shakeout period. In such an environment there should be enough money available for a self-reinforcing process which is just starting, especially if it is the only game in town.
If the process fails to get under way, investors would find downside protection in the book value. The new trusts are coming to the market at book value plus underwriting commission (usually 10%). Most recently formed trusts are selling at a premium which is still modest. It will be recalled that when their assets 3fe fully employed in interim loans, mortgage trusts can earn 11% on their book without leverage and 12% with a 1:1 leverage. A modest premium over book value would seem justified even in the absence of growth.
If the self-reinforcing process does get under way, shareholders in well-managed mortgage trusts should enjoy the compound benefits of a high return on equity, a rising book value, and a rising premium over book value for the next few years. The capital gains potential is of the same order of magnitude as at the beginning of other self-reinforcing processes in recent stock market history.
My report had an interesting history. It came at a time when go-go fund managers had suffered severe losses in the collapse of the conglomerates. Since they were entitled to share in the profits but did not have to share in the losses of the funds they managed, they were inclined to grasp at anything that held out the prospect of a quick profit. They instinctively understood how a self-reinforcing process works since they had just participated in one and they were anxious to play. The report found a tremendous response whose extent I realized only when I received a telephone call from a bank in Cleveland asking for a new copy because theirs had gone through so many Xerox incarnations that it was no longer legible. There were only a few mortgage trusts in existence at the time but the shares were so eagerly sought after that they nearly doubled in price in the space of a month or so. Demand generated supply and there was a flood of new issues coming to market. When it became clear that the stream of new mortgage trusts was inexhaustible, prices fell almost as rapidly as they had gone up. Obviously the readers of the report failed to take into 4 account the ease of entry and their mistake was corrected in short order. Nevertheless their enthusiastic reception helped to get the self-reinforcing process described in the report under way. Subsequent events took the course outlined in the report. Mortgage trust shares enjoyed a boom that was not as violent as the one that followed the publication of the report but turned out to be more enduring.
I had invested heavily in mortgage trusts and took some profits when the reception of my study exceeded my expectations. But I was sufficiently carried away by my own success to be caught in the downdraft with a significant inventory. I hung on and even increased my positions. I followed the industry closely for a year or so and sold my holdings with good profits. Then I lost touch with the group until a few years later when problems began to surface. I was tempted to establish a short pcsitioo but was handicapped
in that I was no longer famiiiar with the terrain. Nevertheless, when I reread the report I had written several years earlier, I was persuaded by my own prediction. I decided to sell the group short more or less indiscriminately. Moreover, as the shares fell I maintained the same level of exposure by selling
additional shares short. My original prediction was fulfilled and most REITs went broke. The result was that 1 reaped more than 100% profit on my short positions-a seeming impossibility since the maximum profit on a short position is 100%. (The explanation is that I kept on selling additional shares.)
Self-reinforcing/self-defeating cycles like the conglomerate boom and the REITs do not occur every day. There are long fallow periods when the specialist in such cycles remains unemployed.
He need not starve, however. The divergence between underlying trends and investor recognition persists at all times and the astute investor can take advantage of it.
— The Alchemy of Finance , George Soros
— UPDATE —
Make no mistake, you should get to know your prevailing cap rates, drivers of NOI (rental rates, lease expiry schedule, expenses/costs, etc.), CRE supply/demand dynamics, capital markets activity (Interest rates, IPOs, credit/equity activity, etc), and a few other things, but let’s be serious… this aint rocket science. Or brain surgery.