By Christopher M. Wright

It wasn't so long ago that large institutional investors were reluctant to invest in REITs because the overall REIT market was too small, and large orders could easily move the market against the trade.

The pension fund managers at General Motors (GM) were typical of those who grappled with the issue. "At the time of our original allocation [1992], the total equity market cap of the REIT market was approximately $13 billion, and the average daily trading volume for many of the REIT securities at that time was low compared to that of larger cap equity securities," Jamie Behar, portfolio manager at GM Asset Management (GMAM), says.

Daily Trading Volume for the SNL Financial — Equity REIT Index All equity REITs, including hotel and health care REITs
Year	Number of Shares Traded
1994*	5,134,805
1995	5,557,577
1996	8,247,712
1997	11,384,329
1998	14,017,247
1999	14,621,661
2000	15,203,950
2001	20,428,780
2002	24,547,598
2003	26,044,088
2004**	35,206,765
* last 6 months ** first 6 months Source: SNL Financial

That was then; this is now. Today, the REIT market is nearly 20 times larger and GMAM has over $2 billion invested in REIT shares. "Our expectation that the market would grow substantially over time has been realized," Behar says. Put another way, REIT liquidity is significantly better than it was just five years ago, says Matt Gilman, senior portfolio manager at ABP Investments.

ABP is one of the largest institutional holders of REIT shares, with some 4 percent of the market. Gilman gauges liquidity by the size of the REIT market and the number of players, both of which have increased significantly since the early 1990s and the start of the modern REIT era. The equity market capitalization of listed U.S. public REITs has steadily risen, reaching $275 billion (187 companies) as of Sept. 30, 2004, according to NAREIT data. The top six REITs all have equity market caps on the order of $6 billion to $10 billion.

Not only are companies larger now, but also an increasing number of institutions are trading in the space, joining the dedicated real estate securities managers who had the sector pretty much to themselves in former years. There were only five or six big managers trading five to seven years ago, but now most major mutual funds have REIT analysts and products, Gilman says.

Goldman Sachs Asset Management (GSAM) also finds ample liquidity in REIT shares. "We measure liquidity by how long it takes to establish a meaningful position in a security or portfolio without moving the market," Mark Howard-Johnson, senior portfolio manager for GSAM's Real Estate Securities Strategy Group, says.

GSAM tested REIT liquidity using a proprietary model looking at float and other factors. GSAM found it could invest $100 million in the kind of REIT shares it wants in three to four days without meaningfully moving the market.

"Clearly, if you've got patience and $1 billion to invest, you can acquire REIT shares with liquidity being far less of an issue than it ever has been," Howard-Johnson says.

Price Impact

Price impact is where REIT liquidity has improved the most, ABP's Gilman agrees. "The bid-asked spread is fairly useless to me. I don't care if the spread is 2 cents or 5 cents. Because of our size, I couldn't do a large sale at either price," he says.

Average Daily Trader Volume of the NAREIT Composite Index March 1990–September 2004 In Millions of Dollars

Source: NAREIT

Specialists set the prices but they are only good for a limited number of shares. Gilman often goes to block desk traders who know the recent sales and where the buyers are.

REITs have good liquidity now because "there are lots of buyers and sellers within 25 cents of the market," he says. "I could easily buy or sell $500 million of REITs in three to six months with very little impact on the market. Liquidity should not be an issue for any institution that wants to get in or out of REIT shares."

Increased trading volume reinforces Howard-Johnson's conclusion that REIT liquidity is no longer an issue for most investors. There has been a nearly 10-fold increase in dollar volume traded in REIT shares in the last 10 years—$124 million a day in 1994, growing to $318 million a day by 1999 and $1.2 billion a day in September 2004, he says.

"Also, there is a vibrant secondary market where large blocks of REIT shares are available and this provides extra liquidity to the market," Howard-Johnson says.

Total secondary REIT equity offerings were $5.5 billion in all of 2003, but $3.5 billion in the first quarter of 2004 alone; so the trend is up, he says.

The result of all this is that REIT liquidity has become a "far less meaningful issue" for most investors, he says. However, perhaps a dozen of the very largest funds still have to be careful about how they implement their strategy.

"It can be difficult for large investors to take a position in any small-cap stock whether in REITs or some other sector," Howard-Johnson says. When he canvassed Goldman Sachs traders on the subject, they said that "there is more liquidity in REITs than in small-cap value names."

Performance Earns Mainstream Acceptance

REIT liquidity has improved as REIT shares have gained acceptance among institutional investors. Part of this acceptance is due to how well REITs have performed in recent years.

"They've beaten the S&P 500, beaten bonds, beaten everything," ABP's Gilman says. "Real estate stocks did well in the recession and are completely accepted by institutional investors. It's been a huge transformation," he says.

"Without a doubt, REITs are now accepted as a mainstream investment vehicle," Gilman says. "One place you see this is in the growth of the number of 401(k) plans that offer a REIT option."

GSAM's Howard-Johnson agrees that REITs have gained traction as a mainstream investment alternative because they have performed so well.

"There's more capital in the space and that capital has improved REIT liquidity," he says. One indication of the mainstream acceptance of REITs, he says, is that the largest pension funds now invest in REIT shares, citing IBM, General Motors, TIAA-CREF and CalPERS as examples.

ABP's Gilman no longer hears other institutional investors talk about REIT liquidity as an issue, he says. REIT liquidity is comparable to other sectors of the market at this point, he says. Ordinary price impact remains, he says, but it's no different from what large traders experience generally or what small cap stocks occasion in other industries. Moreover, REIT liquidity is "infinitely better" than buying or selling individual buildings, Gilman says. Plus, it's easier to diversify with REITs than with direct real estate, he says.

"The REIT market is relatively deep now," ABP's Gilman says. There may still be lagging perceptions about REIT liquidity, but it's like the words to the old song, ‘but that was yesterday and yesterday's gone.'"