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Study Doubts Big REITs Will Rule Rental Market

SPECIAL TO THE TIMES

Contrary to a popular theory, a handful of giant REITs will not soon dominate ownership of the nation’s income-producing residential real estate, according to a just-released report that examined the economies of scale associated with the ever-rising concentration of ownership among America’s commercial properties.

The report, titled “Strategic Management of the Apartment Business in a ‘Big REIT’ World,” was prepared by Kerry D. Vandell, director of the Center for Urban Land Economics Research at the University of Wisconsin at Madison. It doesn’t dispute that the biggest publicly traded real estate investment trusts keep getting bigger as they buy more apartment communities, office buildings, malls, hotels, warehouses and the like.

Contrary to a REIT-domination theory working its way into the conventional wisdom among industry forecasters, however, the report concludes that ownership of the nation’s apartment stock isn’t likely to be concentrated among a select group of giant REITs.

That conclusion is based primarily on evidence disputing a major tenet of the “swallow the world” theory, which suggests that scale economies make apartment ownership and operation much more cost-efficient (read: profitable) for huge REITs than for private investors or even moderately sized REITs.

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While Vandell acknowledges that the “definitive word has not been provided yet,” his report seems to side more with the “limited consolidation” theory. That school of thought acknowledges the ongoing concentration in income-producing real estate but questions the extent to which it will proceed into the 21st century--primarily because the supposed economies of scale to be exploited by large public companies are at best overstated, and at worst nonexistent.

Generally, the three most noteworthy studies Vandell cites “suggest that the evidence on strong economies of scale among REITs is mixed,” his report notes. The cost components displaying strong economies of scale seem relatively small in actual impact, while the larger components of operating and especially interest and capital costs “present weaker evidence of scale economies and even possible diseconomies beyond a certain point,” he says.

In other words, with the possible exceptions of the biggest regional malls, office complexes and hotels, bigger property portfolios don’t necessarily mean lower costs per square foot and higher profitability--as the REIT-domination theory holds.

Some recent studies indeed found that general and administrative expenses represent a lower portion of overall costs for bigger REITs than smaller ones, and that the fees the REITs pay to the entities managing the apartment communities also tend to decrease as REITs get bigger. There’s also some indication that interest and capital costs can be cheaper for the larger REITs--although “the shape of this relationship to size has yet to be established with confidence,” Vandell says.

There’s also evidence to suggest that these better efficiencies associated with scale are limited.

REITs generally achieve optimal cost-of-debt economies when they reach the $500-million-to-$1-billion market-capitalization range--when they are typically able to replace unsecured credit lines with rated corporate bond debt (at an average interest savings of about 40 basis points). As the Vandell report notes, even the biggest REITs, with $4 billion or more in capitalization, can’t drop debt costs much below that rate.

And the Vandell report notes that costs associated with operating apartment communities on a day-to-day basis don’t appear to coincide with REIT size--and in fact appear to occasionally increase with some REITs when they grow beyond the industry’s average size.


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