June 19, 2011

Three REITs for an Uncertain Environment: Portfolio Fix

Some REITs should be able to maintain historical average dividend growth of 5%

The financial markets are focusing on the implications of a possible Greek default and the prospect of slower economic growth. Given that less-than-positive outlook, it could be time to reconsider real estate investment trusts (REITs) if you’re not using them already in client portfolios.

Philip J. Martin, a REIT strategist with Morningstar Inc., in Chicago, says REITs have outperformed other asset classes in previous slowdowns and he believes they are poised to repeat that performance.

“Right now equity REIT FFO (funds from operations) dividend-payout ratios are averaging about 69%,” said Martin, in an interview. “That’s near the historical low of 66%. So even in a slow economic growth environment, they have enough cushion in their cash flows to provide some pretty significant dividend growth.

"We believe they have the ability to maintain their historical average dividend growth of 5% even in a slow economic environment. There are some good things here about REITs where they’re well positioned fundamentally from a cash flow and balance sheet standpoint," the strategist explained. "We’re seeing some fundamental improvement, as well, so they should be pretty competitive investments over the next several years.”

Martin believes that investors concerned with a slowing economy or other headwinds such as rising interest rates and inflation should focus on REIT-sectors that are less cyclical and “cater to need-driven industries.”

He cites retail shopping centers anchored by stores that serve everyday consumer needs as an example. Examples of these anchors include Publix supermarkets and mid-sized tenants, such as a T.J. Maxx, Marshalls and Target.

The retail REITs Martin suggests focusing on include Realty Income (O) and Federal Realty Trust (FRT). “Many of FRT’s shopping centers are anchored by either the leading grocer in a market or a value retailer,” he said. “That, again, is serving everyday consumer needs and focused on value. They benefit from some very, very strong locations in urban infill markets. So, there’s very little competition from new development projects.”

REITs with health-care companies and labs as tenants are another defensive sector, because health care is less tied to the economic cycle. Health-care and lab-space REITs cater to the large biotech and pharma companies like GlaxoSmithKline, Novartis and Johnson & Johnson.

Alexandria Real Estate Equities Inc. (ARE) is an example of a health-care REIT that Martin likes. “Alexandria is our favorite in that sector,” says Martin. “Alexandria has key life-science clusters in, for example, South San Francisco, La Jolla, and Cambridge.

"Internationally they have a first-mover advantage in India, and they really align themselves with not only the local universities such as Stanford and San Francisco. But they’re also full integrated with the health-care systems, the venture capital, other biotech firms," he explains. "They are the go-to landlord, developer, and owner of those assets.”

Martin also favors multi-family REITs. Although share prices have increased significantly over the past several years and valuations are “a bit stretched from a fundamental standpoint,” the sector still makes sense, he believes: “We’re seeing a significant amount of (housing) demand for a number of reasons.

"Number one, it’s a very cost-efficient housing alternative, especially in an environment in which there’s a lot of uncertainly around home ownership where evaluation is settling out and there’s a lot of supply. It’s been very, very difficult to get a mortgage, so mortgage financing is very difficult," Martin explains.

"That leads to a tremendous amount of uncertainty. On top of that you have a levered balance sheet from the average consumer," he notes. "All of that is creating significant demand, and I would call it outsized demand for multifamily at a time when we don’t have a significant oversupply of multifamilies. It has driven valuations so we’re seeing very good rent growth in the 5% to 10% annual basis for the multi-family REITs.”

The REIT’s management team is another key factor in a slow-growth environment. Martin says. In particular, he wants to see what he calls a “full-service real estate skill set,” which he defines as the ability to acquire, develop, redevelop and manage property.

These businesses, he says, “are able to grow or have flexibility through a cycle, whether that’s an economic cycle, slow growth or high growth or whether that’s an inflation cycle or whether that’s just a real estate or financial cycle.”

Another factor to consider if interest rates rise: the REIT’s finances. “We want to focus on those companies with strong balance sheets where leverage isn’t too high, where interest coverage ratios are in good shape, where debt maturity levels on an annual basis are at a manageable level,” he says. 

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