How REITs Could Bail Out the Housing Market

by JT McGee

REITs are the solution to American Housing CrisisWe might as well make this real estate week on MoneyMamba.

I spent a few hours playing with the real estate valuation spreadsheet Brad sent me, and if there’s anything that I’ve realized, it’s that REITs are the solution to the housing crisis.

The housing crisis is more than just depressed property values.

Here are just some of the problems we need to solve:

1. Market Overhang – There is simply too much overhang in the real estate market. In a BusinessWeek article properly titled, “Uncle Sam Owns 248,000 Homes” it becomes clear that the glut in housing is bigger than just a few single family homes here and there; the problem is institutional—it’s engrained in the US government’s balance sheet.

2. Construction employment – Building homes is big business…well, it was big business. Now, with real estate prices depressed, home builders find it difficult to compete with homes on the market. Additionally, homeowners are passing up repairs and improvements to their properties because prices are so low, and so unpredictable. Only very recently have remodeling projects rebounded, due mostly to the realization that moving isn’t an option for those who are underwater. It’s still too soon to call this a trend, however.

3. Retirement plight – Retirees are getting burned in this low interest rate environment. I feel bad for the people I’ve labeled as the “four percenters”—the people who thought that they could reasonably withdraw 4% annually from their retirement accounts each year without drawing down their principal investment. Let’s give them an avenue to generate yield WHILE putting the economy on track.

The Great REIT Bailout

REITs are real estate investment trusts, essentially collections of revenue-generating real estate which are bought and sold on the open market. Investors buy REITs for cash flow, and their organizational structure allows for the trust to avoid taxes if 90% of profits are returned to investors in the form of disbursements, or dividends.

You’ve been missing out on the insanity of property investments if you haven’t kept up with REIT yields. Currently, REITs yield ~4% per year, well below the historical norms. The decline in yields is not due to vacancies, but to rising valuations for real estate investment trusts. As the REIT prices rise, the yields drop relative to the price.

This is a natural function of a market where money is practically free. When investors can borrow for 2% per year through a brokerage account, REITs become incredibly attractive. One would have to be completely insane not to see how much money can be made borrowing at 2% and investing at 6-8%, or more.

Fundamental Problems with REITs

There is a very fundamental problem with most REITs on the market, and it is the reason why so many investors (including myself) shun the idea of purchasing shares of a REIT—real estate investment trusts are rarely pure-plays. For the most part, REITs hold a combination of commercial real estate (which is unattractive given the economic climate) and residential real estate.

Investors have long been craving exposure to residential units only. Residential units experience far less pricing pressure in recession, and quickly find tenants, keeping vacancies low. Additionally, the market for residential units, especially single family homes, is far better than the market for commercial property. Investors would rather own a home spewing cash flow than an office building spewing similar yields.

Investors are so happy to chase yields in residential real estate investments that they’re going after overseas property investments. Australia, for example, has a benchmark rate of 4.75% on the Australian Dollar, which, in terms of capital flows, incites plenty of “hot money” in real estate. Consider the advantage that US-based real estate investors have in financing Aussie real estate—the US Dollar has a benchmark rate of only .25% per year. The current rate environment supports overseas real estate purchases. It’s basically a subsidy by the Fed to every country around the world.

The REIT Doctor is in!

Because investors are bidding up the prices for REITS, and bidding down the yields they’re willing to receive on investments in real property, the time for Uncle Sam to act on housing is right now. Investor appetite for yield is strong; and the WSJ recently reported that hedge funds, the buyer of last resort for many speculative investments, are coming into the market with both hands. In the same article, an investor is quoted saying REITs for single-family homes would find plenty of appetite.

I can’t help but to think this is true. The goal, of course, would be to dump as much of Uncle Sam’s real estate holdings WITHOUT creating a large supply of below market value properties. Naturally, any solution would have to come in “waves;” we still can’t dump a quarter-million properties on the market tomorrow.

Structuring Sensibly

Investors who buy REITs don’t care about the color of the kitchen in each property, or the distance to or from one school district to another. REIT investors buy cash flow, not happy thoughts and the nonsense that is the “American dream.” Basically, REIT investors aren’t picky.

So here’s how I’d implement this:

1. Tranches – From the image at the top of this article, we see that the majority of foreclosures are in the areas hardest hit by plummeting real estate values. That’s only natural, but to avoid complete fallout in market prices, available properties would have to be auctioned off in pieces. One-third here, one-third there, and then one-third later.

2. Geographic specificity – If we’re going to engage in a complete overhaul in the way real estate is bought and sold, we need to at least cater to the buyer. Investors want geographic plays as much as they want plays on specific types of real estate. There are enough homes in Nevada and California to create state-specific REITs in these areas. In less populated areas where foreclosures are few, we can settle for regional REITs. Besides, there’s a marked benefit to such a structure in that the REIT becomes the new “index” for real estate valuations in specific markets. Two birds, one stone—full stomach.

3. Proportional comps – The government is keeping properties off the market to stop what would be a precipitous decline in “comps,” or comparative sales. Assuming that the properties are sold in blocks to prospective REIT administrators, the comparative sales price made public should be equal to the proportional value of the home relative to homes in the REIT. So, if the REIT IPOs at $25 per share, and a single home makes up 1/500th of the income, it should get a valuation equal to 1/500th of the REIT value, or $.05 per share. Simple enough—problem solved.

There’s just one fundamental problem to the above post: no politician would ever let Wall Street bail out Main Street!

Photo by: Pink Sherbet Photography

{ 9 comments… read them below or add one }

krantcents October 26, 2011 at 14:48

Interesting idea, although the REITs would create a pricing pressure on the foreclosure(banks) marrket. They generally pay all cash and have greater flexibility and sophistication vs. the average home buyer. They could easily take thousands of foreclosures out of the market at onece.

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JT McGee October 27, 2011 at 09:50

The demand side is there, in my view. People want to rent/buy a home, but there are structural issues that persist. I don’t think it’d put _that_ much pricing pressure into the market.

The game comes down to who dumps first–the US government, or the banking system?

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Financial Samurai October 27, 2011 at 16:10

All it takes is liquidity, and if REITs can gather a ton of extra liquidity that will then be injected into buying more property, awesome!

Wall St. already bailed out Main St. Main St. just doesn’t know it yet.

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JT McGee October 30, 2011 at 20:46

Liquidity? No problemo!

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LaTisha @YoungAdultFinances October 27, 2011 at 18:06

I like this idea also. I already like reits right now. I’m actually very bullish commercial real estate, especially global real estate so I think a residential reit could be a good option.

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JT McGee October 30, 2011 at 20:46

You got balls, girl.

(Always wanted to say that. It was appropriate here. 😛 )

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LaTisha October 31, 2011 at 18:06

haha! Especially when my portfolio took a nosedive last month. But in the last week it’s up 21%. Bow!

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Evan October 28, 2011 at 12:52

It is a great idea but the whole post assumes a viable rental market in the homes the REIT owns.

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JT McGee October 28, 2011 at 13:32

Which is probably the safest assumption in real estate. Occupancy reached 94.8% in the 3Q of 2011. Rental prices rose 4.2% in the year-over-year period to the quarter.

SoCal is one of the areas with the most excess real estate yet

“Demand for more than 15,000 apartments in Los Angeles during the third quarter pushed the metro’s occupancy rate up 1.5 percentage points to 96.4 percent. Effective rents rose 2.1 percent during the past three months, taking the annual increase to 4.8 percent.”

http://www.multihousingnews.com/news/national/mpf-research-confirms-strong-occupancy-rental-growth-for-u-s-apartment-sector/1004041834.html

There’s a viable rental market BECAUSE so many homes are in foreclosure/holding periods between the sale.

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