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

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

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

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

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But then… it happened again in February. On a total returnbasis, the FTSE NAREIT All REITs Index rose 4.69%, the FTSE NAREITAll Equity REITs Index increased 4.67% and the FTSE NAREIT MortgageREITs Index was up 4.30%. The S&P 500, for its part, rose4.57%.

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

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

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The established school of thought is that REITs suffer wheninterest rates rise and other investment options become moreattractive—hence the dumping of these securities.

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

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As the dust settled, they reevaluated the landscape and came tonew conclusions, namely that the S&P 500 was probablyovervalued after its rocket ascent in 2013, and fundamentals werestrong for real estate.

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

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Back to Square One?

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

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

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Non-traded REITs are a growing force, with the New YorkCity-based American Realty Capital serving as exhibit A. Eventuallythese non-traded REITs will be seeking a liquidity event for itsendgame, whether it is a public listing—as ARC has done on manyoccasions—or a sale of its assets.

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And while debt and equity markets are wide open to REITs, manyhave concluded they would be even more generous with a carefullyculled portfolio of assets. Hence, the flurry of single-asset REITspin-offs.

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At the same time, the universe of REIT assets is expanding toinclude everything from cell towers to electronic billboards. TheInternal Revenue Service indicated at one point it would carefullyscrutinize these transactions. Then, earlier this year it gave afavorable ruling to CBS' proposal to convert its outdooradvertising subsidiary, CBS Outdoor Americas, into a REIT. Otherproposals to turn unorthodox asset classes into REITs are takingheart from the ruling.

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Despite these changes—or, rather, in part because of them—thebottom line is that REITs are back in business, following the sameupward trajectory that they always do during their extendedcycle.

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Liquidity End Games

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

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

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Estimates indicate that the non-traded REIT industry raised morethan $19 billion in new capital during 2013, the highest amountraised in one calendar year and nearly double the amount raised in2012.

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

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“Our study showed that full-cycle non-traded REITs averagedannual returns of 8.27%, outperforming both the S&P 500 StockIndex total return of 6.08%, and the Intermediate-Term TreasuryFund benchmark's average returns of 6.22% over matched holdingperiods,” he said.

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

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Increasingly these “events” include going public and starting anew cycle in the capital markets. ARC, to again cite the ultimateposter child for non-traded REITs, has taken a number of its fundspublic, including, recently American Realty Capital HealthcareTrust. It listed on the NASDAQ Global Select Market in Aprilboasting a 141-property portfolio focused on medical officebuildings and seniors housing communities, along with hospitals,post-acute care facilities and other assets.

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

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New Players

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Such listings are giving a much-needed boost to the real estatecompanies launching IPOs this year—a pipeline that is admittedlynot as robust as otherwise might be.

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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 5.18percentage points to four percentage points.

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One of those IPOs was CBS Outdoor Americas. It wound up raising$644 million, accounting for more than 86% of the total valueraised 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 theSNL US REIT Equity index by four percentage points—to become theonly company among the three new REITs to outperformed the index,SNL said.

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With the IRS presumably on board with such non-traditional assetclasses taking the REIT route, it is expected more proposals willfollow.

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Watching the IRS

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

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In June of 2013 the IRS announced it had formed a Working Groupto examine the legal definition of real estate for the purposes offorming, or converting to, a REIT. Iron Mountain, Equiniz and LamarAdvertising were all reportedly informed that the IRS plans tostudy this issue closely and that it may delay someconversions.

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

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

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

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If the IRS does approve a more expansive definition of realestate, it will open new avenues for investors and capital raising.Last year Deloitte highlighted this trend of placingnon-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 valuationperspective too, average price/funds from operations (FFO) ofnon-traditional REITs exceeded the traditional ones in all threeperiods.

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

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Pure-Play Spinoffs

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The growing focus on pure-play REITs is another variant of thistrend. The retail sector in particular has seen a number of thesetransactions.

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Again, ARC figures prominently in this trend: it is separatingout its shopping centers into a separate, publicly traded REITvalued at more than $2.2 billion. Vornado Realty Trust is spinningoff its suburban shopping center portfolio, as is Simon PropertyGroup into a company called Washington Prime Group.

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Performance is certainly one reason why. Freestanding retail hasbeen the leading REIT sector year to date, delivering returns of16.37%, according to NAREIT. The retail sector as a whole, whichalso consists of shopping centers and regional malls, is doing amore moderate 8.85%, but that is still a high-level return,especially compared to the S&P 500's gain of 0.96%.

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

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

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First-Quarter Earnings

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Even without these twists and turns in the REIT story over thepast year, it is safe to assume the industry would have continuedat a steady pace. Ultimately REIT performance is based on theunderlying fundamentals of the assets and commercial real estate ingeneral.

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For the most part, there is little to worry about in thisrespect. Pricing continues to rise for real estate assets, albeitat a slower pace than last year. According to the Green StreetCommercial 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.

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

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

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

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

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