By Ralph Block

Most REITs fall under the category of equity REITs because they own, manage, acquire and develop commercial real estate. However, a significant number of them are mortgage REITs, which provide financing for real estate owners. About half of these lending REITs deal only in commercial real estate, while the other half focuses on residential lending.

In July, the subprime residential loan market virtually imploded, and the shock waves have impacted borrowers and lenders in every sector. Several residential lending REITs have filed for bankruptcy, and others survive only at the sufferance of their lenders. Even the stocks of the equity REITs have been hit hard, as many investors are shooting first and asking questions later.

Those who have invested in residential mortgage REITs have suffered horrendous losses. However, as all REIT investors are negatively affected by disruptions in the vast credit markets and increased risk aversion, let’s review some eternal verities about capital markets—which are often neglected during bull markets of the type we REIT investors enjoyed from 2000 through 2006.

1. When “OPM”—Other Peoples’ Money—is cheap, abundant and easily available, lending and investment discipline can quickly evaporate, sometimes becoming irrationally exuberant. This occurred in the venture capital industry in the late 1990s; it also happened in our industry in 1996 through 1997. More recently, shoddy underwriting was the order of the day in the residential lending business.

2. Required investment returns tend to decline substantially several years into bull markets, as lavish growth projections are often used to justify current prices and risk is ignored. Outside of the REIT industry, debt spreads on junk bonds have, until recently, narrowed into insignificance. With respect to commercial real estate, many of today’s cap rates are justified only by using very aggressive cash flow growth assumptions, and they may provide buyers with less-than-expected investment returns.

3. Complacent bulls often extrapolate past performance well into the future, and “black swans”—those “highly improbable” but very damaging capital market dislocations—are assumed to have become extinct. Condo converters have been guilty of this sin, assuming that the condo craze would last forever. Many office developers were guilty of assuming that space demand from start-up Internet companies would never cease during the hey-day of the dot-coms almost 10 years ago.

4. Real estate is among the most stable of asset classes. However, its acquisition is normally financed with debt. During most periods, debt leverage will goose investment returns, but excessive debt will be problematic when credit markets cease to function properly. Mortgage REIT investors now, sadly, understand this.

Having to re-learn old lessons is discouraging, especially when short-term investment losses abound. However, aside from a handful of mortgage REITs that, unfortunately, will never survive the mortgage market situation, the vast majority of today’s REITs will emerge from the current credit market dislocation much stronger. Long-term REIT investors will benefit accordingly.

REITs will make the wise deployment of precious capital a higher priority than ever, and shareholders will reward those REITs that allocate capital well. Management teams will demand that every new investment generate high risk-adjusted returns, even at the possible cost of disappointing near-term FFO growth. They will refrain from assuming that space markets will always provide a strong wind at our backs. More than ever, they will appreciate the importance of a strong balance sheet and very judicious use of debt leverage. In any event, an injection of humility is always beneficial.