How Does a Rising Cost of Capital Effect the Reit Market?

Sometimes in life, things get out of whack because of a mass reaction to new information. You are calmly enjoying your meal and your company when the fire alarm goes off. There is a rush out the door, some people get hurt, some who were planning on eating at that restaurant return to their cars and go elsewhere. But you…you were right in the middle of a meal. You don’t want to leave too quickly, because it may have been a test, or a false alarm.

So, thinking it was a false alarm, you decide you want to be one of the first to return - after all, you were enjoying your meal. What if you find, upon returning, that your meal is gone, the management will be happy to replace it, but you will have to pay for the replacement? Or, what if you return and someone else is sitting in your seat enjoying your meal, and if you want to finish you must eat what someone else orders?

The point to this strained analogy is that even if it is a false alarm or an over reaction, you may not be able to expect to just pick up where you left off. Even if it is a false alarm, things may not be the way they were before.

Case in point: Cost of capital. Many REITs that have nothing to do with sub-prime lending went down recently in sympathy with the mortgage REITs. You had a higher than anticipated default rate, then a credit squeeze, then downgrades, then equity downgrades, then another rush for the exits, then a repricing of risk, then another credit crunch, a couple of hedge funds busted, a couple more got rescued…exciting headlines, lots of fun for the talking heads, but nothing to do with my Shopping Center REIT or Industrial Property REIT, right?

Wrong.

Remember, stock and bond markets are CAPITAL MARKETS. You and I use them toward their secondary purpose…we buy and sell securities from other buyers and sellers in a secondary market. Primarily, though, capital markets are how firms raise capital. Especially important for REITs.

REITs, you will recall, pay out 90% of their net income (Funds from operations) as dividends to shareholders, leaving less than 10% for reinvestment. With so little retained earnings to invest in the business for growth, REITs are particularly dependent on the capital markets, because they must sell bonds or stocks to raise money for improvements, acquisitions, repairs, all those things they need to do to maintain and raise revenue.

In my analogy above, you may return to your meal of Shopping Center REIT, because it is not in the sub-prime residential sector, only to find that your Shopping Center REIT can’t raise money as cheaply as it could before… borrowing costs are higher, acquisition money may even be on hold. So in this instance, the stock should not be priced as it was before, when it had access to cheap capital. It should be priced lower, because it will be more expensive to grow revenue, which obviously reduces Net Income (FFO) and dividends paid to its investors.

Capital markets are dynamic and fluid markets, comprised of the individual decisions of millions of investors. In time, the market may discount the effects of increased cost of capital, or may absorb new sources of capital, or may weigh in some other factor to be of greater importance than the increased cost of capital, like immigration patterns or international trade agreements. Prices will once again rise to levels they were before the “sub-prime incident”. Just know that if you return to that market right away, you may not be able to pick up where you left off. Someone else may have eaten your lunch.