Are REITs Too Volatile or Not?

MIAMI—There's so debate in the industry over whether REITs are too volatile. In my latest series of Q&As, I'm asking various experts from different industry perspectives what their take is on the topic.

First up is Jacob Farquharson, an attorney in the Capital Markets practice in Clifford Chance's New York Office. GlobeSt.com caught up with him to discuss REIT volatility, challenges, opportunities and more in this two-part exclusive interview.

GlobeSt.com: Some say now is not the right time for REITs—that it's time to reduce REIT holdings. Do you agree or disagree with that?

Farquharson: The volatility in REITs has been driven primarily by the prospect of rising interest rates due to the taper, and as we recently saw it could still be a while until rates meaningfully increase and impact REIT results. Furthermore, when interest rates inevitably increase, I think it will be a gradual rise. 

I don't think now is the time to go light on REITs. I also think that REITs tend to be moderately leveraged and many of them have locked in long-term debt at attractive rates.  REITs are a great way to be invested in real property, a traditional inflation hedge.

GlobeSt.com: In the last week of May, REITs began a multi-week correction that saw average share prices fall about 15 percent. Was this a sign of something bigger or just a bump in the road?

Farquharson: The recent volatility in REITs has been driven primarily by the taper. Not much has changed fundamentally. It's no secret that the taper is coming, and I think investors are going through the process of pricing that into REITs—the correction in May was part of this process.  

I do not believe it's the sign of something bigger, such as when the crisis hit, there was no liquidity in the market and asset pricing was anyone's guess. There is also a ton of liquidity in the market right now and we expect it to remain for the foreseeable future.

GlobeSt.com: Are REITs in some sectors performing better than others—or will they in the future?

Farquharson: REITs in some sectors that are not as dependent on interest rates or housing are performing well. Self-storage would be an example. REITs in sectors that are reliant on short-term funding, such as mortgage REITs, are more sensitive to increases in interest rates and may be disproportionately affected compared to equity REITs. We have seen this risk reflected in the recent pricing of mortgage REITs.

Looking forward, apartment REITs could benefit if rates rise and mortgage financing becomes more expensive, turning prospective buyers into renters. Hotel REITs, retail REITs and office REITs could also benefit—the extent to which rates rise will be presumably be driven, in large part, by the strength of the economy and job creation, and if the economy is actually performing better then discretionary spending would be up as would demand for corporate office space.  

Over the years, REITs have tended to perform in a very sector specific way. It tends to be that this year's star sector is tomorrow's has been and today's underperforming sector is tomorrow's star.  It is important to adopt a rotational approach to the sector.

GlobeSt.com: In 2007 and again in 2011, people were asking if the REIT run is over. That question is emerging again. Has the REIT run ever really ended? How has it evolved?

Farquharson: Real estate is a cornerstone of any investment portfolio, and REITs are the most efficient way to gain exposure to real estate. While the pace per mile of the REIT run may slow from time to time, I don't think it has ended or will end in the foreseeable future.

The REIT product is in the process of evolving and will continue to evolve. We are seeing REITs adapted to handle alternative real estate assets, such as cell phone towers and outdoor media assets/billboards. 

I think technology assets, such as data centers, have great REIT potential as well. Furthermore, companies looking for a more capital light model are spinning out their real estate assets to unlock the value of real estate.

We are also seeing the REIT product increasingly used in foreign jurisdictions.  For example, the Mexican REITs (or FIBRAs) have been performing extremely well over the past couple of years, and a significant amount of the capital pouring into those vehicles is coming from the US.

GlobeSt.com: So how long will the REIT run last?

Farquharson: It could be 2015 until we see a significant increase in interest rates compared to current levels. At that point, we could see the increase in interest rates start to impact REIT results. But REITs are here today. Some of the best real estate companies in the US are in REIT format. Many other jurisdictions around the world are adopting REIT like statutes, which should give investors even more choices.
 

GlobeSt.com: Are REITs in some sectors performing better than others—or will they in the future?

Farquharson: REITs in some sectors that are not as dependent on interest rates or housing are performing well. Self-storage would be an example. REITs in sectors that are reliant on short-term funding, such as mortgage REITs, are more sensitive to increases in interest rates and may be disproportionately affected compared to equity REITs. We have seen this risk reflected in the recent pricing of mortgage REITs.

Looking forward, apartment REITs could benefit if rates rise and mortgage financing becomes more expensive, turning prospective buyers into renters. Hotel REITs, retail REITs and office REITs could also benefit—the extent to which rates rise will be presumably be driven, in large part, by the strength of the economy and job creation, and if the economy is actually performing better then discretionary spending would be up as would demand for corporate office space.  

Over the years, REITs have tended to perform in a very sector specific way. It tends to be that this year's star sector is tomorrow's has been and today's underperforming sector is tomorrow's star.  It is important to adopt a rotational approach to the sector.

GlobeSt.com: In 2007 and again in 2011, people were asking if the REIT run is over. That question is emerging again. Has the REIT run ever really ended? How has it evolved?

Farquharson: Real estate is a cornerstone of any investment portfolio, and REITs are the most efficient way to gain exposure to real estate. While the pace per mile of the REIT run may slow from time to time, I don't think it has ended or will end in the foreseeable future.

The REIT product is in the process of evolving and will continue to evolve. We are seeing REITs adapted to handle alternative real estate assets, such as cell phone towers and outdoor media assets/billboards. 

I think technology assets, such as data centers, have great REIT potential as well. Furthermore, companies looking for a more capital light model are spinning out their real estate assets to unlock the value of real estate.

We are also seeing the REIT product increasingly used in foreign jurisdictions.  For example, the Mexican REITs (or FIBRAs) have been performing extremely well over the past couple of years, and a significant amount of the capital pouring into those vehicles is coming from the US.

GlobeSt.com: So how long will the REIT run last?

Farquharson: It could be 2015 until we see a significant increase in interest rates compared to current levels. At that point, we could see the increase in interest rates start to impact REIT results. But REITs are here today. Some of the best real estate companies in the US are in REIT format. Many other jurisdictions around the world are adopting REIT like statutes, which should give investors even more choices.