From a small northwestern observatory…

On June 28, Fitch Rating Services issued a report on the REIT development pipeline that has generated a bit of discussion in the real estate community.  Fitch’s emphasis was on the lack of development — with some noteworthy exceptions — and how this has “not a meaningful” implication for REIT credit risk.  However, the topic is important from a fundamental perspective, and deserves a bit more discussion.

Historically, REITs weren’t in the development business.  REITs are a tax vehicle, and to maintain that status, they’re supposed to collect rents and pay 95% of those rents out to shareholders (well, that’s a gross oversimplification, but let’s go with it).  As such, REITs enjoy preferential tax status, and have usually enjoyed excellent leverage.  REITs have some significant limitations on the proportion of profits which are supposed to come from business enterprises, capital gains, and such, and can lose their preferential tax status if these other items exceed a certain threshold.

During hot and heavy times (let’s say, pre-2007), REITs are hit with a triple-whammy.  First, they depreciate existing properties, and need that depreciation to shelter income (and thus exceed the 95% threshold, which they usually do and which investors expect).  Second, they were loathe to sell fully depreciated properties in order to buy new ones, because the huge capital gains from sales would impact the preferential tax status.  Finally, developers were demanding large premiums — income producing buildings were selling for amazing multiples which barely made sense (that’s called a “bubble”, folks).

The good news for a REIT was that if they developed their own properties, the development profits could be kept in-house, and there would be no fatal tax recognitions.  Depreciation expenses stayed high, and they could thus pay-out higher and higher funds from operations to shareholders.  It was a win-win.  The only downside, of course, was that development activities were considered risky, and so the credit rating agencies kept a close eye on these practices.  However, REITs were typically less leveraged than other ownership vehicles, to the riskiness was usually minimal.

A tthe peak, in 2007, the REIT universe had an aggregate investment of 7.6% of undepreciated assets in the development pipeline, or a total of $34 Billion.  By March 31, 2012 (the cut-off for data in the Fitch report) that had collapsed to 2.7%., and indeed over a third of that is in the fundamentally sound apartment market.

Fitch summarizes the market as “fairly muted”, and says that “By and large, companies have not ramped up development pipelines,” according to Steven Marks, managing director at Fitch in a follow-up interview to Globe Street.  “It is really growth via acquisitions and organic cash flows from existing portfolios.”

The report also noted that over the past 10 years, REIT development activities have had a high correlation with U.S. GDP changes.  Thus, improvements in U.S. GDP would signal development opportunities for REITs, but continued stagnation in the U.S. GDP suggests that REITs will continue to remain quiet on the development front.