By Michele Lerner

Strong performances among Asian REITs, contraction in the North American market and the sluggish showing of U.K. REITs are among the most significant findings of the second annual Ernst & Young "2007 Global REIT Report."

The global study encompassed 15 real estate markets around the world: Australia, Belgium, Canada, France, Hong Kong, Japan, Malaysia, the Netherlands, New Zealand, Singapore, South Africa, South Korea, Turkey, the U.K. and the U.S.

Following positive feedback from the company's "2006 Global REIT Report," Ernst & Young expanded the report with additional analysis comparing the past two years of REIT performance. The study also includes a lengthy comparison of tax and regulations in the 15 countries, disclosure of property subsector splits in each country and region and an in-depth analysis of each country's risk-free rates and other key debt measures compared to REIT returns.

"Over the 12 months between June 2006 and June 2007, Asia produced the top three REIT countries in terms of one-year total return," says Ed Psaltis, a REIT-focused partner for Ernst & Young Australia. "Asian REITs grew in size from $46 billion to $82 billion between June 2005 and June 2006. The depth of the Asian market was equally impressive last year, with $34 billion traded from June 2005 to June 2006, compared to $62 billion for the same time frame a year later."

Strong Asian Performance

The report notes that the Asian REIT market grew fastest in the first half of 2007, with 41 percent more listed REITs than in 2006 and an increase in total market capitalization of 76 percent.

With Asia, Singapore's attractive regulatory environment provided the platform with outstanding growth and total returns of 73 percent. The South Korean REIT market achieved a 43 percent return, due to increasing office rentals and rising debt leverage. Additionally, J-REITs' 42 percent return stemmed from continued foreign investor interest in real estate, and a strengthening property market.

Psaltis found a surprising trend in the data with respect to the spread between dividend to cost-of-debt-yield. "Japan has been a hot market over the past year due to a high spread with its cost of debt being low, but other Association of Southeast Asian Nations (ASEAN) countries actually had higher positive yield spreads than Japan," Psaltis says.

He added that South Korea's positive yield spread was 4.18 percent, Malaysia's was 2.99 percent and Japan's was 2.33 percent.

Ernst & Young's Global Report predicts another positive year in Asia for 2008, with the market ready to experience more cross-border investment.

Steady Outlook for U.K. REITs

The U.K. REIT market, included for the first time in the global report, was off to a slow start, with the lowest total return of 11 percent for all 15 countries covered. However, the report predicts improved performance in 2008.

"There are signs that there is plenty of upside to be enjoyed in this market," Psaltis says. "This will be a big REIT market. A very high volume of trade took place this year, with an average of $8.8 billion traded per U.K. REIT."

Peter Beckett, tax director for real estate at Ernst & Young LLP, says the main concern for U.K. REITs is that they were introduced at the wrong time in the real estate cycle. "There is a downward movement on prices, partly because of the credit crunch and partly because there was too much excitement about the REIT introduction. Prices rose too quickly before they were introduced," Beckett says. "There was froth in the market in 2005 and 2006 as it became clear that REITs would start in January 2007. This reflected an increase in share prices based on the anticipation of conversion to REITs."

Beckett expects more U.K. REITs to be introduced in 2008, particularly in sectors such as hospitality, because the current REITs are primarily in the commercial and retail sectors. He anticipates some consolidation among existing REITs, because share prices are low and large diversified REITs may become more sector-specific.

Pressure on U.S. REITs

Michael Frankel, the global director of REITs for Ernst & Young LLP's Global Real Estate Center, says that the inclusion of U.K. REITs and growth in the Asian market have offset the contraction in the U.S. REIT market. The global REIT market has grown in total market capitalization by more than $150 billion in the past year.

According to the study, private equity deals have taken REITs out of the listed markets in both the U.S. and Canada, contributing to the decline in size of the U.S. market from $394 billion in June 2006 to $382 billion in June 2007.

The recent turmoil in debt markets resulting from problems in the U.S. subprime mortgage market has been felt around the globe, but Psaltis says that it is not clear yet how this change in market conditions will impact global REIT markets.

"Credit margins on corporate debt have increased and new financings are now likely to be subject to tighter covenants and increased financing costs, with negative implications for real estate values and REIT returns," Psaltis says. "Further, low historic interest rate environments have led to increased debt levels in the global REIT market. As REITs seek to refinance, they will, therefore, be disadvantaged by these new debt market conditions."

Frankel says that the short-term outlook for the U.S. REIT market looks generally subdued. "The pace of the merger and acquisition activity that has supported the U.S. REIT public market prices may not continue. With the tightening in the debt markets, there is likely to be increased downward pressure on the U.S. REIT market," he says.

Looking Long-term

Older REIT markets—the U.S., Australia and the Netherlands—each had a higher one-year rate of return in June 2007 compared with June 2006, according to Psaltis, who says that all three had unimpressive results compared with the rest of the world.

Looking at the longer-term three-year rate of return on a regional basis, the European REIT market has the highest return of the four world regions with a return of 29 percent over three years. The Global REIT Report expects the European market to become a world force to rival North America in scale and activity, particularly with the introduction of Germany and Italy REIT markets.

In analyzing the 2007 REIT data, the Ernst & Young report concludes that next year will likely show slower merger and acquisition activity in the U.S., continued growth in the Asia-Pacific market, improved performance in the U.K. and growth in the European market overall due to the introduction of German and Italian REITs.