Figure 3.1

      Source: Nareit.

The 21st Century (So Far)

      Every bear market leads to a bull market eventually, and every bull market leads to a bear market. Moreover, one sector suffering will often lead to another's rise and vice versa. So it's not surprising that the highly speculative dot‐com bubble bursting would send despondent investors back into safer stocks like REITs. That renewed interest in value investing brought REITs to levels they had never experienced before … right up until the next bubble burst. And that one was directly tied to housing.

      The MSCI U.S. REIT Index reached a closing high of 1233.66 on February 7, 2007. Yet 25 months later, it bottomed out at 287.87. It took REITs the next two years to recover most of what they'd lost.

Sometimes stocks and sectors suffer from their own foolishness. Other times, they're the victims of outside sources beyond their control. And, in this case, it was much more the latter. A volatile cocktail of government policies, a lack of banking integrity (or intelligence), and public enthusiasm – among other factors – sent property prices skyrocketing. And when the housing market proved to be less than perfect, those bank bets came crashing down, leading to the collapse of Bear Stearns and Lehman Brothers, Merrill Lynch selling itself to Bank of America, Wachovia selling itself to Wells Fargo, and AIG almost collapsing under its own weight.

      While national leaders and legislators decided to bail big banks and car companies out, REITs weren't anywhere as lucky. They were left to deal with the fallout on their own, including vacancy rates as high as 17.5% in certain subsectors. They also had to handle overall debt leverage levels that shouldn't have been unmanageable but were anyway due to the circumstances.

      Like most property owners, REITs have always used debt to finance their purchases. Heading into the 2007 downturn, leverage ratios of about 45% were consistent with recent norms. With that said, ratios of debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) had risen. Combine that with the perfect storm that erupted, and you have intense problems indeed.

      Fortunately, most REITs rose to the occasion. While most did have to cut their dividends – 35 in 2008, 56 in 2009, and another seven in 2010 – they worked hard to reduce their debt leverage by raising equity, selling some properties, forming joint ventures for others (a trend that developed specifically to handle the depressed conditions), and preserving cash however else they reasonably could. As a result, they were able to rebound sharply in 2009 and 2010. In fact, by the end of that second year, they were much healthier than their private real estate counterparts.

      The sector went on to grow for much of the next decade, including by adding new subsectors such as prisons, farms, and gaming – all of which we'll discuss in greater depth in subsequent chapters. New REITs went public, some of which through C‐corp spinoffs where already publicly traded companies turned their real estate into separate businesses altogether.

      On that last note, President Obama did sign an omnibus appropriations bill on December 18, 2015, which contains significant changes to U.S. taxation of REITs. It limits the use of the spinoff transaction in two ways according to the Proskauer Law Firm:

“First, the Act disallows tax‐free treatment in a spinoff if either the distributing corporation or controlled corporation is a REIT. Second, the Act prohibits a taxable corporation that is a party to a tax‐free spinoff from making a REIT election for a ten‐year period beginning on the date of the distribution.”

      The Act does not, however, impact the ability of a REIT to spin off another REIT, such as the spinoff of DDR Corporation into Retail Value Trust or Spirit Realty into Spirit MTA REIT.

      There was also merger and acquisition (M&A) activity during this time, such as Prologis Inc. taking over DCT Industrial for $8.5 billion in 2018, Omega Healthcare purchasing MedEquities Realty for $600 million in 2019, Healthcare Trust of America acquiring Duke Realty's medical office building portfolio for $2.75 billion in 2017, and Mid‐America Apartment buying up Post Properties for $3.9 billion. Then there was the “mega‐mall” marriage between Simon Properties and Taubman Centers that was first agreed on in February 2020. Due to the shutdowns that soon followed, the deal was later closed at $2.6 billion and involved Simon acquiring an 80% stake in Taubman Realty Group, the operating partnership through which Taubman Centers conducts its operations.

      2016 in particular was a big year considering how the S&P, Dow Jones, and MSCI gave equity REITs and similar companies their own separate and distinct designation on the Global Industry Classification Standard (GICS). Before that, they were listed under the financials sector. To understand the importance of this decision, you have to know what Nareit does: that “GICS is the industry classification methodology that both companies rely on for their proprietary stock market indexes. And it serves as one of the primary classification systems for equities for investors around the world.”

      Another enormous year was 2020, though on the downside in many ways. As Covid‐19 spread from China out into the West, governments around the world began shutting down group gatherings, including those held in office buildings, hotels, malls, shopping centers, and so many other REIT‐held properties. Some of them literally couldn't open for months on end, forcing dozens and dozens of dividend cuts and other measures taken to prevent total collapse.

      Through October 2020, 65 equity REITs either cut or suspended their dividends because of this, with most of the volatility seen in the lodging, retail, office, and healthcare spaces. We'll explore how that global pandemic impacted REITs on a subsector level over the course of the next several chapters.

Lending REITs Versus Ownership REITs

If you recall, REITs don't have to own real properties. They're also allowed to originate, acquire, hold, and even securitize real estate mortgages – such as those backed by residential or commercial properties – and related loans. As of July 31, 2020, there were 35 mortgage REITs, with 21 focusing on the residential side and 14 on the commercial. Hybrid REITs, which both own properties and hold mortgages on others, were popular some years ago. But they're not widely prevalent today.

      In the late 1960s and early 1970s, lending REITs were exceptionally popular since many large regional and “money‐center” banks and mortgage brokers formed their own real estate–specific institutions. Almost 60 came to life back then, most of them lending funds to property developers. That worked well enough until interest rates rose substantially in 1973, causing a crash in demand for new developments. Nonperforming loans then spiked to fearsome levels, and most of these entities crashed and burned, leaving investors in the lurch.

      A decade later, a new round sprang up to invest in collateralized mortgage obligations (CMOs), only to suffer a similar end.

      A number of mREITs – particularly the residential kind – also performed very poorly in the Great Recession, though that didn't stop many new ones from forming. As hundreds of traditional bank failures ballooned, big private equity companies seized the opportunity to lend to property owners. And several other players with more specialized lending platforms also emerged in the wake.

      Today, I'm happy to say that the quality of mREITs has improved substantially. However, they still present several challenges, starting with their tendency to be more highly leveraged with debt than