How do dropping interest rates drive the rotation of capital among asset classes and the attractiveness of REITs?

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by Rushi Shah

The concept of asset rotation has been around since the practice of investing in the market began. Today, however, investors have more alternative investment options that offer returns commensurate to the amount of risk investors are willing to carry. An alternative investment is an investment vehicle that is structured to generate income by investing in operating businesses and real estate. Examples include private equity and venture capital funds, business development companies, and real estate investment trusts (REITs). The advent of alternative investments was a big leap for the capital markets. When these tools first became available for both institutional and non-institutional investors, there was a general apprehension on their viability. Today, alternative investments are in demand and are an integral component of all types of investors’ strategies.

EXPLORING THE ALTERNATIVE INVESTMENTS
Private equity funds and business development companies are the structures typically used to raise capital from third-party investors to buy and manage operating businesses, such as manufacturing or distribution companies. Within real estate, there are also two ways to set up investment vehicles. The first is via a real estate private equity fund that raises capital through private networks of third-party investors and then invest it in real estate assets. The second method is to establish a REIT.

A REIT requires at least 100 unique investors contributing capital which the REIT manager uses to acquire real estate assets. Under a REIT, 90 percent of the income received from the real estate assets must be distributed back to the investors. This provides transparency into the REIT’s actions and ensures that investors are treated fairly. REITs can be private or public, and public REITS can be a listed or unlisted on a stock exchange. In the case of private REITS, sponsors typically raise capital through their own investor networks. Public REITs must have significant capital to justify the cost needed to support an exchange listed entity, as well as comply with higher-standard audited financials and controls. While there are no hard and fast minimums, a conventional baseline for forming a private or public REIT is $100 million in assets under management.

During a time of lower interest rates, a REIT can experience heightened interest from the non-institutional investor community, because of the income component attached to it. This can be a likely asset rotation strategy for many investors. However, not all REITs are the same and it is common for non-institutional investors new to the space to mistake the advantages and disadvantages of certain structures. Let’s examine the primary types of REITs.

OWNING ASSETS OR MAKING LOANS
An equity REIT invests in owning assets. Non-institutional investors often incorrectly assume that because it has an income component, an equity REIT has the same risk profile of a bond. Investors need to keep in mind that an equity REIT invests in the upside of the real estate assets. When interest rates are low, there could be higher economic distress in the market. In an economic slowdown, therefore, an equity REIT could lose value because the real estate assets are generating less income.

Rather than focusing on owning assets, a mortgage REIT engages in making loans on real estate assets. As a result, its behavior and risk profile mimics that of a bond. When interest rates are low, demand from institutional investors for mortgage REITs increases and capital flows into these types of instruments. This is because the loans throw off a spread on top of the benchmark rate, or the rate of return that an investment grade bond delivers, allowing investors to capture higher yield.

Hybrid REITs combine aspects of both equity and mortgage rates, engaging in both owning properties and investing in loans or mortgage-backed securities. The more diversified approach can minimize risk and help better insulate the REIT and its investors from future market changes.

INTEREST RATES & REITS
When interest rates drop, the capitalization “cap” rate (rate at which investors value assets per dollar of cashflow) on real estate assets follows. This is because more available capital fuels demand for real estate assets. Low rates and high demand trigger higher valuations and ultimately lower cap rates. When sponsors form an equity REIT when interest rates are low, the assets they are buying are also more expensive. When this situation occurs, any added advantage over bond deals is potentially wiped out.

There is a silver lining, however. During an era of low interest rates, sponsors may be able to attract capital from bond investors by forming a mortgage REIT or hybrid REIT. The risk-adjusted return for investing in a mortgage REIT is higher than if investing in a bond. This holds true because the return on a hybrid or a mortgage REIT is higher or about the same as that of a bond. However, a mortgage REIT carries less risk because it is invested in whole loans backed by real estate.

An equity REIT can also seem to be an attractive investment for people chasing pure yields. However, when there is heightened market volatility, the cash flow available to be distributed to the equity REIT investors after satisfying loan payments can also decrease depending on asset type.

A byproduct of lower interest rates that benefits equity REITs is lower interest rates on their loans and the increased ability to access cheaper, 10-year money as fixed-rate, non-recourse debt. Most equity REITS borrow against the assets they own. Equity REIT investors benefit immensely when the 10-year fixed rate drops (at the time of writing 10-year fixed interest rates on most hotels are at 3.5 percent) since lower rates beget improved returns. Hence, this is an attractive time to divert some capital from fixed rate bonds into private equity REITs. In this situation, private equity REITs hold an advantage over public equity REITs. Private REITs operate in an opaque market where there is no exchange grade, daily value, or price discovery process. Conversely, public REITs already reflect higher prices and lower yields as rates drop. Since valuations are reflected immediately in public REITs, there is little opportunity for upside.

While there are pros and cons for any investment structure, alternative investments, including equity and mortgage REITs, should be in every institutional or non-institutional investor’s toolkit as an attractive way to raise capital.

Rushi Shah is principal and CEO of the commercial mortgage and real estate investment banking firm and AAHOA Club Blue Member Mag Mile Capital. As a leader in hospitality financing, Shah specializes in structuring and placing high-leverage, non-recourse bridge and permanent debt with cash out for full – and limited-service hotels nationwide. Since joining the firm’s predecessor, Aries Capital, in 2015, Shah has structured and closed hundreds of millions in financing for all property types. Shah has held previous positions at Northern Trust and has an MBA from the University of Chicago’s Booth School of Business.

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