09/22/97 THE NEW WORLD OF REAL ESTATE
09/22/97 THE NEW WORLD OF REAL ESTATE Historical DEvelopment of the REIT A MAMMOTH WAVE. But if an audacious new breed of real estate tycoons has its way, this time it will be different. 0ver the past few years, the world of commercial real estate has dramatically transformed itself in a way that could temper those cycles. The reason: what Sam Zell, the biggest owner of office buildings, apartments, and manufactured housing in the country, calls ''a massive revolution in how the real estate industry is viewed, financed, and valued, and in its long-term role in the U.S. economy.'' That revolution will not abolish real estate cycles. But Zell and other real estate experts argue that it will lead to more stability. That should mean a healthier industry more hospitable to investors. By far the most crucial changes in the business involve the financing and management of real estate. Until the early 1990s, most real estate was owned by private, family-owned companies that relied entirely on borrowed money and generated returns by flipping properties. The 1990s bust, though, caused private financing to evaporate. The mortgage-backed security market emerged to provide debt financing. And as industrial corporations had done decades earlier, real estate firms started tapping the public market, via initial public offerings, for equity capital. The vehicle was the real estate investment trust, or REIT, which was created by Congress in 1960 but that had never attracted much interest. Now REITs are proliferating rapidly. ''We are watching what could be the biggest asset class in the country--bigger than the Treasury or bond market--begin to go public,'' says Andrew Davis, manager of the top-performing Davis Real Estate Fund. ''Ultimately, REITs are the way real estate should be owned.'' REITs are companies that own, manage, and develop pools of properties, from apartments and office buildings to self-storage facilities and now, even prisons. In exchange for following rigid guidelines, such as paying out at least 95% of taxable income in dividends and earning that income primarily from leasing buildings, REITs are exempt from corporate taxation. Now, a mammoth consolidation wave is creating dozens of huge, far-flung REITs with billions of dollars in portfolios that stretch from coast to coast. The market capitalization of the REIT industry has soared from $8 billion in 1990 to $120 billion today. The total capital of REITs and the handful of real estate operating companies that exist is $200 billion. The commercial mortgage-backed securities market has grown to $144 billion. In the ways that they function, these new mega-REITs are light-years away from the old family-owned empires. REIT execs argue that their companies should weather industry cycles much more handily than the old firms. They offer these advantages: -- permanent public financing -- modest leverage, with debt levels of roughly 30% of equity, vs. the 70% or higher levels prevailing in the 1980s -- large, diversified portfolios and economies of scale -- active management, vs. the passive approach of the old REITs, and professional, corporate-style management -- accountability to shareholders, including abundant disclosure of information -- one of the highest percentages of management ownership of any industry in the U.S.
