Although real estate investment trusts are once again the darlings of Wall Street, it's time to raise a caution flag.

Unfortunately, if the real estate underlying a REIT is not selected, analyzed, and managed by real estate specialists with in-depth local market knowledge, it is likely that some REITs will fail to deliver on their promise to investors, damaging future opportunities for portfolio securitization.

As an alternative for recapitalization of real estate portfolios, REITs have been spectacularly successful in the past few years. Since 1986, assets controlled by the trusts have more than doubled to $49.3 billion in 1992.

A $10 Billion Market

Last year, 58 REIT offerings raised $6.6 billion, and currently the value of the public offerings planned for this year totals more than $10 billion.

However, the continued success of REITs is not assured. For the REIT market to continue to grow, owners and underwriters must insist that the REIT vehicle be applied to portfolios of truly investment-grade properties, be properly and thoroughly underwritten, and be managed by commercial real estate specialists.

Considerable segments of the real estate industry will be unable to access REIT equity capital since the trusts are best suited for portfolios of income-producing, investment-grade assets.

Limits on Securitization

Land and other non-income-producing assets are very difficult to securitize, and REITs are usually unsuitable for routine property trading, since minimum ownership rules require that most assets be held for a minimum of five years.

REITs that promise, attractive returns investing in land or speculative, lower-quality assets will find it difficult to fulfill the expectations of investors.

Even with a portfolio of investment-grade properties, proper underwriting must evaluate REITs based on the specific underlying real estate assets rather than on cash flow of the property, physical condition of the property, and the qualifications of the property manager.

Ensuring Asset Quality

To help ensure the success of a REIT offering, underwriters and sponsors need to be confident that the real estate assets have been thoroughly analyzed by qualified professionals with experience in local markets.

Concerns such as toxic contamination, local zoning restrictions, and property leasing trends may be overlooked by inexperienced managers, and sloppy underwriting will lead to marketplace failures.

Professional management, whether internal or retained externally, is also vital. Well-designed and well-located real estate can quickly be turned into a liability by poor management, whereas mediocre real estate can be made profitable by experienced managers.

Fortunately, some of the best real estate specialists have been attracted to the REIT trade, though unfortunately, good management is not a hallmark of all REITs.

Quality Control

Underwriters of REITs must not allow management to be subject to the whims of the market or be misled by the attractiveness of an internalized function, but must insist that REITs be staffed by credible, competent, experienced management or that qualified outside consultants and real estate managers are employed.

The market fundamentals of REITs remain strong, since the trusts provide portfolio owners with a proven conduit for accessing attractively priced equity sources.

The selection of the appropriate portfolios, combined with a thorough analysis of the assets and qualified real estate management, will help the REIT market continue to grow as an equity source for real estate.

Proper utilization of the REIT as a real estate equity tool will ensure that the industry can minimize the boom-and-bust cycle of the past and look forward to sustained growth beyond 1993.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.