risks and
Future
Prospects
P A R T
C H A P T E R
What Can
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N
ow that you know the beauties and benefits of REITs
and REIT investing, it’s time that you also understand what
can go wrong. Alas, no investment is risk free (except per
-
haps T-bills, which don’t provide anything except a safe yield).

In general, the risks of REIT investing fall into two broad catego
-
ries: those that might affect all REITs, and those that might affect
individual REITs. There is also a third category, which is related to
REITs’ investment popularity at various times. First we’ll address
the broad issues.
I S S U E S A F F E C T I N G A L L R E I T S
All REITs are subject to two principal potential hazards: an
excess supply of available rental space and rising interest rates.
A supply/demand imbalance, with the excess on the supply side, is
often referred to as a “renters’ market,” because, in such a market,
tenants are in the driver’s seat and can extract very favorable rental
rates and lease terms from property owners. Excess supply can be a
result of more new construction than can be readily absorbed, or of
a major falloff in demand for space, but there’s an old saying that
it doesn’t matter whether you get killed by the ax or by the handle.

bate the real estate cycle by causing occupancy rates and rents to
decline, which in turn may cause property prices to fall. Over time,
of course, demand catches up with supply, and the market ulti
-
mately recovers.
Whereas a recessionary economy sometimes results in a tempo-
rary decline in demand for space, the excess supply that is brought on by
overbuilding will sometimes be a larger and longer-lasting problem.
Overbuilding can occur locally, regionally, or even nationally; it
means that substantially more real estate is developed and offered
for rent than can be readily absorbed by tenant demand, and, if an
overbuilt situation exists for a number of months, it puts negative
pressure on rents, occupancy rates, and “same-store” operating
income. Overbuilding will discourage real estate buyers and can
cause cap rates in the affected sector or region to increase, thus
reducing the values of REITs’ properties—and, perhaps, their stock
prices. To the extent that a REIT owns properties in an area or
sector affected by overbuilding, the REIT’s shareholders often sell
their shares in anticipation of declining FFO growth and reductions
in net asset values, which, in turn, drives down the share price of
the affected REIT. The share prices of most office REITs lagged
the REIT market in the early years of the current decade, due in
large part to rising vacancy rates and falling market rents for office
properties. This resulted not from overbuilding but rather from
softening demand and an increased amount of sub-lease space
tossed onto the market by busted dot-coms and other shrinking
businesses. In extreme cases, the reduced prospects for a REIT may
cause lenders to shy away from renewing credit lines, preventing a
REIT from obtaining new debt or equity financing, perhaps even
forcing a dividend cut. Not a pretty picture.

space, can be blamed on a number of factors. Sometimes over
-
heated markets are the problem. When operating profits from real
estate are very strong because of rising occupancy and rents, prop
-
erty prices seem to rise almost daily. Everybody “sees the green”
and wants a piece of it. REITs themselves could be a significant
source of overbuilding, responding to investors’ demands for ever-
increasing FFO growth by continuing to build even in the face of
declining absorption rates or unhealthy levels of construction starts.
Today there are many more REITs than ever before that have the
expertise and access to capital to develop new properties, and those
that do business in hot markets will normally be able to flex their
financial muscles and put up new buildings.
In the past, new legislation has sometimes been a major cause
of overbuilding. In 1981, when Congress enacted the Economic
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Recovery Act, depreciation of real property for tax purposes was
accelerated. The tax savings alone justified new projects. As we dis
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cussed in previous chapters, investors did not even require build
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ings to have a positive cash flow, so long as they provided a generous
tax shelter. The merchandise was tax shelters, not real estate, and
tax shelters were a very hot product. This situation was a major con
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tributing factor to the overbuilt markets of the late 1980s. Similar
legislation does not seem to be a danger today, but because REITs

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new construction was becoming excessive; nevertheless, builders and
developers could not seem to stop themselves, and they continued
to build new offices well into the early 1990s. Similarly, an inordinate
amount of office building was done in the late 1990s, particularly in
“high-tech” markets, even after many observers and lenders realized
that the pace of absorption was unsustainable. Although some would
explain this by the long lead time necessary to complete an office
project once begun, it’s more likely that there were some big egos
at work among developers—each believing that
his project would
become fully leased—and that too many lenders were too myopic to
detect the problem early enough. Just as dogs will bark, developers
will develop—if provided with the needed financing.
Today, however, excessive new development is not a significant
issue, and one may dare to hope that perhaps major real estate devel
-
opers and their lenders have become more intelligent and care
-
ful. The tax laws no longer subsidize development for its own sake.
Lenders, pension plans, and other sources of development capital
that were “once burned” are now “twice shy,” and very circumspect
with respect to development loans for largely unleased projects.
Further, there is much more discipline in real estate markets
today. The savings and loans, a major culprit of the 1980s’ over
-
building, are no longer the dominant real estate lenders. The banks,
which often funded 100 and sometimes 110 percent of the cost of
new, “spec” development during that decade, have “gotten religion”
and subsequently adopted much more stringent lending standards,

environment, many owners of such stocks will be lured into safer
T-bills or money markets when yields on them become competitive
with high-yielding stocks, adjusted for the latter’s higher risk. Of
course, a substantial number of shareholders will continue to hold
out for the higher long-term returns offered by REIT shares, but
selling will occur—driving down REIT share prices (and the prices
of virtually all bonds and equities).
A sector of stocks might also be interest-rate sensitive for reasons
other than their dividend yields. Homebuilders are but one exam
-
ple, as they rely upon the availability of reasonably low mortgage
rates to their customers. Also, the profitability of a business might
be very dependent on the cost of borrowed funds. In that case, in a
rising interest-rate environment, the cost of doing business would
go up, since the interest rates on borrowed funds would go up. If
increased borrowing costs cannot immediately be passed on to con
-
sumers, profit margins shrink, causing investors to sell the stocks.
Whether their perception is correct or incorrect, if investors per-
ceive that rising interest rates will negatively affect a company’s prof
-
its, then the stock’s price will vary inversely with interest rates—rising
when interest rates drop, and dropping when interest rates rise.
How, then, are REIT shares perceived by investors? Are they
interest-rate sensitive stocks? Is a significant risk in owning REITs
that their shares will take a major tumble during periods when
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rates are rising briskly? Before we try to answer these questions,

tion with a domestic high-yield corporate bond index for the period
January 1995 through January 2005 was just 0.32).
Nevertheless, the reality remains that a large segment of REIT
stock owners invest in them for their substantial yields, and the rest
rely upon dividend yields for a significant part of their expected
total returns; some of these investors may shift their assets into
bonds and other high-yielding securities when the yields on them
become competitive with the yields offered by REIT shares. Fur
-
thermore, some large investors will sell, or even short, REIT stocks
before interest rates rise if they believe that rates will increase in
the near future. As a result, REIT investors should assume that
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REIT prices, like the prices for almost any investment, will weaken
in response to higher rates.
A second, related, and very important question is whether a rise
in interest rates might cause significant problems for REIT investors
by causing FFO growth to decelerate, weakening balance sheets,
diminishing their asset values, or otherwise affecting REITs’ merits
as investments. This is a multifaceted issue, and of course it also
depends upon the individual REIT, its sector, its properties’ loca
-
tions, and its management, but let’s consider the possibilities.
Higher interest rates are generally not good for any business,
since they soak up purchasing power from the consumer and can eventu
-
ally lead to recession.
A

the impact on its profit margins and FFO. But, even with fixed-rate
debt, REITs must be concerned with interest rates—when they are
rolling over a portion of their debt and when they are taking on new
debt. New developments, too, will often be funded with short-term
variable-rate debt, then permanently financed upon completion
with long-term fixed-rate debt. Rising interest rates can significantly
impact the investment returns from these new developments.
Even when a REIT chooses to raise capital through equity offer
-
ings rather than debt financing, higher interest rates can have an
adverse effect if rising interest rates depress REIT share prices; this
will raise a REIT’s nominal cost of equity capital.
Another negative aspect of rising interest rates relates to the value
of a REIT’s assets. Although real estate cap rates are influenced by
many factors, it’s almost intuitive that a major increase in interest
rates will exert upward pressure on cap rates. All things being equal,
property buyers will insist on higher real estate returns when inter
-
est rates have moved up; correspondingly, property values will tend
to decline, which affects the asset values of the properties owned
by REITs. Asset values are very important in determining a REIT’s
intrinsic value, as we’ve seen in Chapter 9, and thus falling asset
values will often have an impact on REIT share pricing.
Any significant decline in the value of its underlying real estate
properties could affect the share price of a REIT.
The foregoing discussion shows how rising interest rates can
negatively affect a REIT’s operating results, balance sheet, asset
value, and stock price. However, we might also note that in one
important respect REITs may actually be
helped by rising interest

is calculated after a depreciation expense, most of which does not
require the immediate outlay of cash. As a result, REITs are unable
to retain much cash for new acquisitions and development and are,
therefore, dependent to a substantial extent on the capital markets
if they want to grow their FFOs at rates higher than what can be
achieved from real estate NOI growth. Their FFO growth, without
new acquisitions and development, will therefore depend only on
how much REITs can improve the bottom-line income from existing
properties.
As a result of this inherent legal limitation, investors must be
mindful that even the most highly regarded REIT may not, dur
-
ing most economic and real estate climates, be able to grow its
FFO at a pace beyond a mid–single digit rate unless it has access to
additional equity capital. There will always be another bear market
and, when it comes, many REITs will find it difficult to sell new
shares to raise funds for new investments. The equity market for
REITs slammed shut in early 1998 and re-opened only in 2001.
Such recurring events will tend to retard FFO growth until such
time as the markets return to “normalcy.”
However, bear markets are not the only circumstance in which
REITs could find their flow of capital shut off. There is also the
great specter of overbuilding that can only be beaten back but never
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A B U B B L E ? O R J U S T H O T A I R ?
EVER SINCE THE 2000–2001 crash of technology and dot-com stocks
rattled investors, we’ve seen the word “bubble” used often in the
financial press. But the term isn’t a new one; indeed, many of us

does, in some locations, exhibit some aspects of the typical invest
-
ment bubble. Prices have risen dramatically in many coastal markets,
despite modest growth in personal incomes and job growth. Many
baby boomers appear to have decided that the stock market won’t
provide them with sufficient assets with which to retire, and have
taken advantage of “hot” real estate markets and low (e.g., 5 percent)
down payments to speculate in residential real estate. The number
of homes bought for investment jumped 50 percent during the four-
year period ending in 2004, according to the San Francisco research
firm LoanPerformance.
In many neighborhoods, a home bought at today’s prices can
-
not be rented out for anywhere near what it would cost to service
the mortgage. Furthermore, risks are increasing. The percentage of
homes priced above $359,650 financed with adjustable-rate mort
-
gage loans (vs. fixed-rate loans), according to Freddie Mac, has risen
to about two-thirds as of March 2005. LoanPerformance has calculat
-
ed that California homes bought with interest-only loans rose from
2 percent in 2001 to 48 percent in 2004. If interest rates should rise
significantly, or if buyers’ ardor cools, residential real estate prices in
a number of markets are likely to weaken considerably.
Equity REITs, fortunately, don’t own residences or condos; they
own commercial real estate. And while commercial real estate pric
-
es have been strong, in response to demand for these assets from
institutions and even smaller investment groups, they don’t appear
to be out of touch with reality. Real estate cap rates hovered in the

“bubbles.”
Just what is a “bubble?” According to Dictionary.com, a “bubble”
is something “insubstantial, groundless, or ephemeral” or, more
applicable to the financial world, “a speculative scheme that comes
to nothing.” Alternatively, according to Life Style Extra’s glossary of
financial definitions, a “bubble” is “an explosive upward movement
in financial security prices not based on fundamentally rational fac
-
tors, followed by a crash.” Real estate prices, particularly for homes in
California and some cities on the East Coast, including Florida, have
been rising rapidly in the early years of the twenty-first century. It
has been estimated by the California Association of Realtors that
the median home price in California jumped 17 percent in 2003 and
another 22 percent in 2004. And prices for many high-quality com
-
mercial real estate assets have also been rising, even though 2001–
2004 was a very difficult period for owners with respect to vacancies
and rental rates.
So, is real estate in a “bubble” mode, making a substantial drop in
prices likely? If so, how would this affect REIT stocks? Unfortunately,
investment bubbles are labeled as such only with hindsight. How
-
ever, as we are in the “Risks” section of the book, I’ll climb out onto
the proverbial limb with some observations.
Residential real estate, that is, single-family homes and condos,
does, in some locations, exhibit some aspects of the typical invest
-
ment bubble. Prices have risen dramatically in many coastal markets,
despite modest growth in personal incomes and job growth. Many
baby boomers appear to have decided that the stock market won’t

the 10-year Treasury note and intermediate-grade corporate bonds
yielding 5.5–6.0 percent in effect during that time period.
Further, many seasoned investors and noted academics have
been forecasting a lower rate of investment return for stocks com
-
pared with their historic averages over the last fifty to seventy years.
Thus, in a period of low return expectations for stock and bonds, a
real estate cap rate of 5–7 percent is not out of line; this is particular
-
ly so when real estate fundamentals are stable and improving. Was
it crazy for Regency and Macquarie to pay a 6.25 percent cap rate
for the Calpers/First Washington neighborhood shopping center

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eliminated entirely. In mid-1995, when a few apartment REITs own-
ing properties in the Southeast tried to raise new equity capital by
selling additional shares, there were few takers. This was due to per
-
ceptions that these markets were rapidly becoming overbuilt.
Individual REITs with lackluster growth prospects, excessive debt,
or conflicts of interest will also have problems attracting potential
investors, as will REITs that are perceived as being unable to earn
returns on new investments that exceed the REIT’s cost of capital.
Although some REITs, due to new “asset recycling” and joint venture
strategies, have been able to substantially reduce their dependency
upon fresh equity offerings, attracting new capital remains a very
important tool for most growing REIT organizations. External and
even internal events over which management may have little or no

LEGI SLAT ION
If the cynic’s view that “no man’s life, liberty, or property is safe
when Congress is in session” is correct, we must recognize that Con
-
gress giveth, but Congress also taketh away. But it is highly unlikely
that Congress would enact legislation to rescind REITs’ tax deduc
-
tion for the dividends paid to their shareholders, thus subjecting
REITs’ net income to taxation at the corporate level.
There are several public policy reasons for this. First, because of
REITs’ high dividend payments to their shareholders, they prob
-
ably generate at least as much income for the federal government
as they would if they were conventional real estate corporations that
could shelter a substantial amount of otherwise taxable income by
increasing debt and deducting their greater interest payments. (It’s
just that the taxes are paid by the individual shareholders rather
than the corporation.) Second, property held in a REIT most likely
provides more tax revenues than if it were held, as it historically has
been, in a partnership. Finally, REITs have shown that real estate
ownership and management can generate excellent returns with
-
out using excessive debt leverage, which, if not for the REIT format,
would be the way real estate would probably be universally held.
Excessive debt can be a very destabilizing force in the U.S. economy,
and it’s unlikely that Congress would want to contribute to that.
Encouraging greater debt financing of real estate could sub-
stantially exacerbate the swings in the normal business and real estate
cycles, harming the economy over the long term.
In early 1998, the Clinton administration proposed legislation as

tinct asset class. Furthermore, despite their stable and predictable
cash flows and steady dividends, REIT stocks have, at times, been very
unpopular with investors. In 1998 and 1999, despite rising cash flows
and strong real estate markets, investors didn’t seem to want any
part of them (although valuation issues and excessive stock offerings
may have played a large role in the bear market of those years). That
difficult cycle for REITs was followed by another in which REIT stocks
could do no wrong—despite very weak real estate markets almost
everywhere.
This conundrum should teach us REIT investors an important lesson:
We need to be prepared for periods in which REIT stocks are simply
unpopular and won’t perform well even when all the stars are properly
aligned. This means that one additional risk in owning REIT shares is
that these investments may decline in value for reasons having noth
-
ing to do with their intrinsic valuations or growth prospects.
How can we protect ourselves from this risk? Simply put, we can
-
not. However, our best defense is a simple one: We must think of REIT
stocks as long-term investments and, aside from those who desire to
be stock traders, own them over long time horizons as a permanent
part of our investment portfolio, secure in the knowledge that over
all meaningful time frames REIT stocks have delivered outstanding
returns in line with our expectations.
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flow of funds into the real estate sector of the economy and has
enabled individuals as well as institutions to own real estate through
the REIT vehicle. Over the years, thanks in large part to both the

real estate owners even when supply and demand for space in a
particular market was previously in equilibrium—or even unusually
strong. A retail property, for example, located in a healthy prop
-
erty market may be 95 percent leased, but its tenants’ sales might
decline in response to a severe local recession. This will result in
lower “overage” rentals (additional rental income based on sales
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exceeding a preset minimum), lower occupancy rates, and even
tenant bankruptcies. Apartment units, especially newly built ones,
may be slow to lease, perhaps because of declining job growth in
specific local markets. Generally speaking, during recessionary
conditions, both consumers and businesses will cut back on their
spending patterns. In this situation, rents cannot be raised without
jeopardizing occupancy rates.
We’ve mentioned that focusing on a specific geographical area is
something that REIT owners like to see, due to focused local exper
-
tise, but the downside is that local or regional recessions can be
more damaging for a geographically focused REIT. Despite national
recessions that take place from time to time, such as the one begin
-
ning in 2001, we’ve learned that economic conditions in the United
States aren’t always the same in every geographical area, and local
recessions are not uncommon. We can have an oil-industry depres
-
sion in the Southwest, while the rest of the country is doing fine.
Or the Northeast can be in the dumps, while Florida’s economy is

make a major dent in the demand for traditional office space?
And will businesses seek out locations in major cities, or look more
favorably on suburban locations? What effect will Internet shop
-
ping have on traditional retailers? Will malls lose their allure as
a fun destination? How much competition will “lifestyle” centers
provide? These are questions about basic trends in how we live,
how we play, and how we work. No one can answer them now with
absolute certainty, but if REIT investors ignore signs of chang
-
ing trends, their investment returns from some REIT stocks may
prove disappointing.
CRED IBIL ITY ISS UES
Probably the most common type of REIT-specific problem that can
cause investor headaches is the error in judgment that raises signifi
-
cant management-credibility questions.
Here, for example, are just some of the unpleasant situations that
have occurred in past years:
◆
Overpaying for acquired properties and later having to sell them at a loss
(e.g., American Health Properties)
◆
Expanding too quickly and taking on too much debt in the process (e.g.,
Patriot American Hospitality and Factory Stores of America)
◆
Underestimating the difficulty of assimilating a major acquisition (e.g.,
New Plan Excel)
◆
Expanding into entirely new property sectors, especially without adequate

business, that it lacks discipline, or that it is otherwise taking undue
risks with the shareholders’ capital.
Yet another kind of credibility issue arises when there is a material
conflict of interest between management and shareholders. REITs
that are externally managed are always subject to such conflicts, but
even those that are managed internally can sometimes exhibit con
-
flicts. The most serious of these are when a REIT’s executive officer
sells his or her own properties to the REIT, or when an executive
officer is allowed to compete with the REIT for potential acquisi
-
tions. Excessive executive compensation for mediocre operating
results, on the other hand, while annoying to shareholders, is not
usually as damaging as the other types of conflicts mentioned.
Many investors are wary of the UPREIT format, which poses
knotty conflict-of-interest issues. UPREITs, as you may recall from
an earlier chapter, are those whose assets are held by a limited part
-
nership in which the REIT owns a controlling interest and in which
REIT “insiders” may own a substantial interest. Since these insiders
may own few shares in the REIT itself, the low tax basis of their part
-
nership interests creates a conflict of interest should the REIT be
subject to a takeover offer, or in the event it receives an attractive
offer for some of its properties.
Most problems like these can be remedied by a REIT’s manage
-
ment if it is forthright with investors, quickly recognizes any mistakes
it has made, and promptly takes action to rectify the situation.
In September 1999, Duke Realty sold $150 million of new com

Loss of management credibility can be crippling to a REIT.
There is obviously no way for REIT investors to avoid such prob-
lems altogether; human nature is such that no executive is immune
to the occasional lapse in judgment; furthermore, some of these
problems become apparent only with hindsight. The most conser
-
vative strategy is to invest only in those blue-chip REITs that have
demonstrated solid property performance, good capital allocation
discipline, and excellent balance sheets over many years (and pref
-
erably over entire real estate cycles). Of course, this policy of going
only for pristine quality will often mean investors will have to pay
significant price premiums and will miss out on lesser-known REITs
or those REITs that are primed for a rebound.
Another conservative strategy is to avoid REITs that have been
public companies for only a short time, since most of these manage
-
ment credibility issues seem to have arisen in “unseasoned” REITs.
Again, this approach could mean missing out on some very promis
-
ing newcomers. The “right” investment strategy depends, in large
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part, upon the individual investor’s risk tolerance, as well as his or
her total return requirements. There is rarely a “free lunch” in the
investment world.
BALA NCE SH EET WOE S
Debt will always be a potential problem, as well as an opportu-
nity—for people, for nations, and, no less, for REITs. If manage
-

REIT will be exposed to a rapid deterioration in cash flows.
The market has usually factored potential problems like these
into the stock price before the REIT actually feels their effects.

A REIT, therefore, that is perceived to be overleveraged or to have