This is an HTML version of an article that ran in the May 2014 issue of Real Estate Forum. To see the story in its original format, click here.

In January the REIT industry began to get a glimmer that 2014 might be a good year. Certainly, the thinking went, it would have been difficult to be any worse than 2013, when REITs were routed by the S&P 500 Index by a good 30 percentage points or so.

And as it turned out, January 2014 rocked for REIT investors. On a total return basis, the FTSE NAREIT All REITs Index rose 3.38%, the FTSE NAREIT All Equity REITs Index increased by 3.31% and the FTSE NAREIT Mortgage REITs Index was up 5.96%, according to NAREIT figures. Meanwhile, the S&P 500 was down 3.46%.

Could it be that the S&P was merely spooked by the emerging market turmoil characterizing those weeks? Perhaps.

But then… it happened again in February. On a total return basis, the FTSE NAREIT All REITs Index rose 4.69%, the FTSE NAREIT All Equity REITs Index increased 4.67% and the FTSE NAREIT Mortgage REITs Index was up 4.30%. The S&P 500, for its part, rose 4.57%.

By the end of March the trend was clear: the FTSE NAREIT All REITs Index rose 8.57% on a total return basis for the quarter and the FTSE NAREIT All Equity REITs Index was up by 8.52%. The FTSE NAREIT Mortgage REITs Index gained the most at 11.16%. All of these indices bested the S&P 500, which was up 1.81% for the quarter.

For Brad Case, VP of research for the National Association of Real Estate Investment Trusts, it was surely a “told you so” moment. Case and executives from the REIT space watched as investors fled REIT stocks when, in May 2013, the Federal Reserve Bank announced that its quantitative easing policy would be coming to an end.

The established school of thought is that REITs suffer when interest rates rise and other investment options become more attractive—hence the dumping of these securities.

But in reality—and certainly in the current cycle—it isn't that simple, the REITs argued, and as events played out, they turned out to be correct. The market had unfairly penalized REITs.

As the dust settled, they reevaluated the landscape and came to new conclusions, namely that the S&P 500 was probably overvalued after its rocket ascent in 2013, and fundamentals were strong for real estate.

“It's not that the market ignores interest rate rises but improvements in the economy are more important,” Case said at the time.

Back to Square One?

And so here we are, one year after the Fed threw the REIT industry into turmoil. In many ways, the industry looks the same; capital raising is still very robust and with full coffers, REITs are both active buyers and sellers of assets.

But it is not exactly the same. As REITs continue their reboot this year, a number of emerging trends are poised to shake things up a bit.

Non-traded REITs are a growing force, with the New York City-based American Realty Capital serving as exhibit A. Eventually these non-traded REITs will be seeking a liquidity event for its endgame, whether it is a public listing—as ARC has done on many occasions—or a sale of its assets.

And while debt and equity markets are wide open to REITs, many have concluded they would be even more generous with a carefully culled portfolio of assets. Hence, the flurry of single-asset REIT spin-offs.

At the same time, the universe of REIT assets is expanding to include everything from cell towers to electronic billboards. The Internal Revenue Service indicated at one point it would carefully scrutinize these transactions. Then, earlier this year it gave a favorable ruling to CBS' proposal to convert its outdoor advertising subsidiary, CBS Outdoor Americas, into a REIT. Other proposals to turn unorthodox asset classes into REITs are taking heart from the ruling.

Despite these changes—or, rather, in part because of them—the bottom line is that REITs are back in business, following the same upward trajectory that they always do during their extended cycle.

Liquidity End Games

One doesn't have to be an investor, or even a fan, of ARC to realize that non-traded REITs have made serious inroads in the larger REIT universe. These entities have become serious acquirers and capital raisers, as industry statistics show.

Assets under management for the non-traded REIT industry were estimated to be $77 billion as of the end of 2013, down from $84.9 billion at the close of 2012, according to the Real Estate and Investment Securities Association and Blue Vault Partners.

Estimates indicate that the non-traded REIT industry raised more than $19 billion in new capital during 2013, the highest amount raised in one calendar year and nearly double the amount raised in 2012.

Investors are flocking to non-traded REITs because of their returns, which Blue Vault and REISA quantified in a recent joint study. It found that two-thirds of the full-cycle REITs outperformed the S&P 500 Index and 20 of 27 outperformed Intermediate-Term US Treasury Bonds when compared over matched holding periods, noted Vee Kimbrell, managing partner of Blue Vault, when announcing the study's results.

“Our study showed that full-cycle non-traded REITs averaged annual returns of 8.27%, outperforming both the S&P 500 Stock Index total return of 6.08%, and the Intermediate-Term Treasury Fund benchmark's average returns of 6.22% over matched holding periods,” he said.

Ultimately, full-cycle events returned an estimated $16 billion to non-traded REIT equity investors during 2013.

Increasingly these “events” include going public and starting a new cycle in the capital markets. ARC, to again cite the ultimate poster child for non-traded REITs, has taken a number of its funds public, including, recently American Realty Capital Healthcare Trust. It listed on the NASDAQ Global Select Market in April boasting a 141-property portfolio focused on medical office buildings and seniors housing communities, along with hospitals, post-acute care facilities and other assets.

With a new channel to the capital markets thanks to its NASDAQ listing, the REIT is planning on more acquisitions.

New Players

Such listings are giving a much-needed boost to the real estate companies launching IPOs this year—a pipeline that is admittedly not as robust as otherwise might be.

As of April 25, only three US REITs have gone public for 2014, raising an aggregate $747.2 million, according to SNL Financial. The total return spreads, though, show why: they range from 5.18 percentage points to four percentage points.

One of those IPOs was CBS Outdoor Americas. It wound up raising $644 million, accounting for more than 86% of the total value raised by the three REITs. Between March 27, the date of its IPO, and April 25, it posted a total return value of 7.18%, besting the SNL US REIT Equity index by four percentage points—to become the only company among the three new REITs to outperformed the index, SNL said.

With the IRS presumably on board with such non-traditional asset classes taking the REIT route, it is expected more proposals will follow.

Watching the IRS

“Presumably” and “expected” in the preceding sentence, though, are used with large measures of hope and faith. Some background on this issue is necessary, first, to understand what is at stake.

In June of 2013 the IRS announced it had formed a Working Group to examine the legal definition of real estate for the purposes of forming, or converting to, a REIT. Iron Mountain, Equiniz and Lamar Advertising were all reportedly informed that the IRS plans to study this issue closely and that it may delay some conversions.

As it turned out, the IRS placed a moratorium at the time on such conversions even though it never said so, according to a published note in April 2014 by Jonathan R. Talansky of Mintz Levin Cohn Ferris Glovsky and Popeo PC.

It confirmed that moratorium retrospectively, Talansky wrote, “by commenting later in 2013 that it had 'temporarily placed pending ruling requests concerning assets other than land, buildings and structures traditionally held by REITs on hold to allow for a thorough review to ensure a uniform and consistent approach to addressing the definition of REIT real property based on applicable law.'”

The IRS review is expected to be completed this month; hence the hope that the favorable ruling for CBS is a precursor of good news on this front.

If the IRS does approve a more expansive definition of real estate, it will open new avenues for investors and capital raising. Last year Deloitte highlighted this trend of placing non-traditional assets in a REIT, noting that over five-year, 10-year and 20-year periods, “new-age trusts,” as it called them, outperformed their more traditional brethren. From a valuation perspective too, average price/funds from operations (FFO) of non-traditional REITs exceeded the traditional ones in all three periods.

The reason for this performance, it speculated, is likely due to the “distinctive features” of the non-traditional REIT subsectors. It noted, as an example, that data center REITs are posting strong top-line growth propelled by the increase in adoption of cloud computing and demand for analytics and data storage.

Pure-Play Spinoffs

The growing focus on pure-play REITs is another variant of this trend. The retail sector in particular has seen a number of these transactions.

Again, ARC figures prominently in this trend: it is separating out its shopping centers into a separate, publicly traded REIT valued at more than $2.2 billion. Vornado Realty Trust is spinning off its suburban shopping center portfolio, as is Simon Property Group into a company called Washington Prime Group.

Performance is certainly one reason why. Freestanding retail has been the leading REIT sector year to date, delivering returns of 16.37%, according to NAREIT. The retail sector as a whole, which also consists of shopping centers and regional malls, is doing a more moderate 8.85%, but that is still a high-level return, especially compared to the S&P 500's gain of 0.96%.

One driver behind Vornado's spin-off is its desire to focus more on its New York and Washington, DC-based portfolios. Following the spin-off, the REIT expects that 91% of its EBITDA generated from properties in these two markets.

Deleveraging is also a driver, at least according to SNL's analysis of ARC's spin off. The REIT anticipates that its net debt will slide to $8.44 billion from $9.38 billion and it expects its ratio of net debt to 2014 estimated EBITDA to move down to 7.0x from 7.2x, it said.

First-Quarter Earnings

Even without these twists and turns in the REIT story over the past year, it is safe to assume the industry would have continued at a steady pace. Ultimately REIT performance is based on the underlying fundamentals of the assets and commercial real estate in general.

For the most part, there is little to worry about in this respect. Pricing continues to rise for real estate assets, albeit at a slower pace than last year. According to the Green Street Commercial Property Price Index, pricing increased by 1% in April. Prices are now, on average, 7% above the then-peak levels seen in '07, it reports.

There are clouds, of course such as the slow and plodding improvement in employment and concerns that interest rates could somehow rise unexpectedly—-although that fear is diminishing, ironically in part because of the slow improvement in employment and the Fed's reluctance to move forward without significant job growth.

But as REITs get down to business, focusing on what they do best, in the markets they know best, those concerns are moving to the back burner.

Consider the comments of SL Green Realty CEO Marc Holliday during the REIT's earning call in April after the company proudly reported FFO of $150 million for the first quarter compared to $109.2 million for the same quarter in 2013.

The REIT has a substantial pipeline in investment and leasing ahead of it, he said. “So, clearly, we've got a lot of work cut out for us for the remainder of the year. But I don't think I could have asked for a better start or a better market at this point to be conducting it in.”