with ever‐rising prices, prompting developers to get involved even more heavily for their piece of the pie. And banks were more than happy to finance them – even up to 90% of costs.
Real estate was obviously overbuilt – and suffering for it – by the time the Tax Reform Act of 1986 repealed the tax shelter, leaving investors doubly stranded. Yet this was a significant milestone in the REIT industry, since it relaxed some of the restrictions they bore. For instance, they no longer had to hire outside companies to provide property leasing and management services. This gave them the chance to save both money and efforts should they so choose.
Over the years, most of them have done exactly that. The vast majority of today's REITs are fully integrated operating companies that can handle their business internally, including:
Property acquisitions and sales
Property management and leasing
Property rehabilitation, re‐tenanting, and repositioning
New property development.
As should be expected, that efficiency easily translates into more stable profits for shareholders over time.
The 1990s: The Modern REIT Era Begins
In the second half of the 1980s, REITs’ dividends had been rising faster than their earnings. Their stocks didn't suffer for it at the time, outperforming the S&P 500 in 1986 and 1987, and only slightly underperforming in 1985 and1988–89. But that changed the very next year as REIT share prices fell and fell hard.
That was quite the shock for their investors, who had only experienced one year of negative total returns between 1975 and 1990. That was in 1987, and they only dropped 3.6%. This time around though, they simply couldn't fight fate. The past overbuilding craze in office buildings and apartment communities finally caught up to them, no matter if they themselves hadn't participated in it. At the same time, the rise of Walmart and other discounters was beginning to encroach on traditional retailers and their landlords. Add to that their high payout ratios, which they themselves had encouraged and could no longer sustain, and a resulting round of dividend cuts. Combined, it was enough for investors to ditch greed as a motivator and let fear drive them instead.
REIT shares fell to unreasonable levels on that sentiment. Fortunately, they weren't a fledgling category anymore, and so the sector was able to bounce back by 1991. In fact, between 1991 and 1993, Nareit notes that their total annual returns averaged 23.3%. This was partially because they'd been so ridiculously undervalued and partially because they began aggressively taking advantage of the rest of the real estate world, which was still trying to emerge from its own bubble bursting back in 1986. That meant REITs were able to obtain properties at very good prices.
Speaking of that, the Federal Reserve was busy gradually lowering its interest rates to ease the shallow yet long recession the country had been stuck in. REITs benefited from that too, since their substantial dividend yields and ramped‐up earnings growth once again looked good to investors, who bought right in. The combined environment inspired a range of subsector‐specific IPOs, almost all of which were inspired by Nareit workshops. The trade association was spreading the word about its representatives to businesses, wealth managers, and legislators alike, and not only in the U.S. It went global too, holding more meetings in Paris, Frankfort, London, Edinburgh, Zurich, Amsterdam, Tokyo, and Singapore, sowing the seeds for REIT legislation around the world.
This is when U.S. REITs really came into their own in investor opinion. At the end of 1990, their market cap was estimated at $5.6 billion. By the close of 1994, it had risen to $38.8 billion. A year later, it was up to $60 billion – still a micro industry but a growing one nonetheless, with new subsectors such as malls, outlet centers, industrial properties, manufactured home communities, self‐storage properties, and hotels.
Plus, there were two new designations for REITs to take advantage of.
UPREITs and DownREITs
In studying different REITs, you might come across the term “umbrella partnership real estate investment trust,” or UPREIT. It's a corporate structure that allows management to offer operating property units (OPUs) in exchange for purchases instead of cold, hard cash. This gives the seller the opportunity to still benefit from the property without the associated hassle, and the REIT the opportunity to better maintain its expenses.
The UPREIT concept, which was first implemented in 1992 by creative investment bankers, means that the REIT itself might not own any properties directly. What it does own is a controlling interest in a limited partnership that, in turn, owns the real estate. Its fellow partners could easily include management and private investors who had indirectly owned the properties in question before they became part of a REIT portfolio.
Owners of the limited partnership units have the right to convert them into shares, to vote as if they already own shares, and to receive the same dividends too. In short, they enjoy virtually the same attributes of ownership as public shareholders.
DownREITs, meanwhile, are actually structured similarly but are usually formed after the REIT becomes a public company. And members of management aren't usually going to be limited partners in the controlled partnership.
Both corporate structures can exchange OPUs for interests in other real estate partnerships that own properties the REIT wants to acquire. That enables sellers to defer capital gains taxes and have a more diversified form of investment. And that, in turn, can give UPREITs and DownREITs a competitive edge over a regular REIT when it comes to making deals with tax‐sensitive sellers.
One negative aspect about them, though, is how they open the door to potential conflicts of interest. After all, management can own units in the partnership, which usually have a low‐cost basis. The sale of a property could therefore trigger taxable income to them – but not to the actual REIT's shareholders. This can make management reluctant to sell a property – or even the REIT itself – despite its not performing well or receiving a generous offer.
REIT Modernization Act, RIDEA, and Capital Recycling
REITs’ average total returns fluctuated significantly in the 1990s after that initial bear market, going from low single‐digits to 35.3% right up until 1998 and 1999. That was when they experienced their first consecutive down years since 1973 and 1974, at 17.5% and 4.6%, respectively. Part of those falls related to overenthusiasm in 1996 and 1997, including from speculators who cashed out and moved on to the dot‐com craze.
There were also too many REITs entering the market and/or raising money all at the same time. In fact, the total raised between 1997 and mostly early 1998 was $54.2 billion. That amounted to 69% of the equity market cap of all equity REITs as of the end of 1996. Not to mention that the entire industry's value in this regard was less than that of Microsoft.
In addition, many REITs pursued aggressive acquisition strategies from 1995 to 1997, often relying heavily on short‐term debt and what Ralph Block called “exotic hedging techniques.” As should have been expected, they overextended themselves, helping lead to what became known as the Great REIT Pie‐Eating Contest. That wasn't a compliment.
Still, the decade didn't end on a bad note, thanks to the REIT Modernization Act (RMA) signed by President Clinton in December 1999. This enables every REIT organization to form and own a taxable REIT subsidiary, or TRS. By owning up to 100% of one, a REIT can develop and quickly sell properties while providing substantial services to its property tenants without jeopardizing its legal standing – a major issue in the past.
