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Real Estate Investing : Hotels and REITs Last Updated: May 14th, 2012 - 22:24:01

Investing REITs through real estate cycles
Jerry Jones
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You can invest your money in nearly any kind of real estate imaginable: apartment buildings, manufactured-home communities, malls, neighborhood shopping centers, outlet centers, offices, industrial properties, hotels, self-storage facilities, hospitals, golf courses-even prisons.

Real Estate prices and profits move in cycles, usually predictable in type but not always in length or severity. If you¡¯re a long-term conservative REIT investor, you might choose to buy and hold your REITs even as their properties move through their inevitable ups and downs. Nevertheless, you should understand and be aware of these cycles since they can dramatically affect a REIT¡¯s funds from operations (FFO) and dividend growth. If you consider yourself more of a short-term market timer, you will want to plan your REIT investments either in accordance with a general real estate cycle or with the cycle of an individual property sector.

The phases of the real estate cycle are depression, recovery, boom, and overbuilding and downturn.

The Real Estate Cycles

Phase 1: The Depression. Vacancies are high, rents are low, and real estate prices are down. Many properties, particularly the highly leveraged ones, are being repossessed or are in foreclosure. There is virtually no new construction. Properties are selling at prices well below replacement cost. 

Phase 2: The Gradual Recovery. Occupancy rates rise, rents stabilize and gradually increase, and property prices stabilize. There is still little or no new building, but prices are firming up or rising slightly.

Phase 3: The Boom. After a while, most vacant space has been absorbed, allowing property owners to boost rents rapidly. With high occupancy and rising rents, landlords are getting excellent returns. Property prices are rising to the point that new construction makes sense again. Developers start flexing their muscles. Investors and lenders feel that they must join the party and provide all the necessary financing. During this phase, the medial begin to talk about why ¡°this time it¡¯s different¡± and why this property sector is ¡°no longer cyclical.¡±

Phase 4: Overbuilding and Downturn. After property prices have been rising rapidly, overbuilding frequently follows as everyone tries to get into the act. Vacancy rates rise, and rents soften. Eventually there is an economic recession. As the return on real estate investment declines, so do real estate prices. Eventually, this downturn phase may turn into a depression phase, depending upon the severity of overbuilding or the economic recession now the cycle is complete and begins anew.

Why do these cycles occur? Commercial real estate is tied closely not only to the national economy, but also to the local economy. Years ago, for example, when the steel mills in Pittsburgh or the rubber companies in Akron laid off workers, the local economy, from retail to real estate, became depressed. The part of the country known as ¡°Smokestack America¡± very quickly became ¡°Rust Belt America.¡± Families doubled up, with grown children moving in with parents. As the number of households declined, apartment vacancy rates rose.

Conversely, when the Olympic Committee decided to hold the summer games in Atlanta, or when Michelin Tires decided to build a plant in Greenville, South Carolina, the entire local economy picked up. Business improved for all the local residents, from dentists to dry cleaners, and job growth expanded.

Sometimes cycles become even more extreme than is justified by the local economy, however, and the boom phase becomes truly manic. Of course, it¡¯s not just real estate that¡¯s cyclical. You¡¯ve seen manic cyclically in the stock market. During bull market conditions, investors often throw caution to the winds. New York City¡¯s shoe-shine boys and taxi drivers hand out stock tips, and cocktail party chatter and Internet discussion groups are replete with details of the latest killing on Wall Street ¨C that is, until there¡¯s a change in the wind.

When real estate is booming, there is ¨C shall we say ¨C ¡°irrational exuberance,¡± but the exuberance isn¡¯t limited to investors. When real estate prices, rents, and operating income are rising rapidly, developers, syndicators, venture-fund managers, and even lenders want a piece of the action. The traditional debt leveragability on real estate investments only exacerbates the situation. This was the scenario that commenced in the mid-1980s. investors were buying up apartments at furious rates ¨C individually, through syndications, and through limited partnership. Developers were building everywhere. The banks and savings and loans were only too eager to provide the necessary liquidity to drive the boom over higher. Even Congress got into the act, passing legislation to encourage real estate investment by allowing property ownership to shelter income tax and allow faster depreciation write-offs.

Eventually and not surprisingly, apartments, office building, shopping centers, and other property types all over the nation became overbuilt, and property owners had to contend with depression-like conditions for several years thereafter.

While we can always hope that greater discipline and more accessible information will help to moderate these cycles, the bottom line is that some cyclicality is inevitable. In such times, investors must just repeat to themselves, ¡°This, too, shall pass.¡±





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