From the August 2011 issue of Investment Advisor • Subscribe!

July 28, 2011

Making the Case for Equity REITs

Several factors make equity REITs an important part of your long-term strategy

We believe equity REITs should be part of a long-term investment strategy based on diversification, yield, inflation protection, improving fundamentals and strong corporate governance. We are mindful that the economy faces several potential challenges, including slow economic growth and the threat of either rising inflation or interest rates. However, equity REITs have historically outperformed the broader market when faced with these headwinds. We believe similar long-term future outperformance may be possible based on a number of factors.

Equity REITs increase return, reduce risk—According to a Morningstar study, since 1972, a diversified portfolio with 20% allocated to equity REITs reduced portfolio risk and experienced an average annualized total return of 10.5%. This compared to a 10% return for the portfolio with no allocation to equity REITs and a higher risk profile.

Dividend growth and yield sustainability with interest rate and inflation protection—An improving economy benefits equity REIT operating fundamentals. This should improve cash flow and dividend growth, maintaining the current 3.4% sector dividend yield. Presently, the average equity REIT FFO dividend payout ratio is 69%, near its historic low of 66%. We feel the 69% level allows equity REITs a sufficient cash flow cushion to increase annual dividends at the historic 5% growth rate, even amid slower economic growth. The 5% growth rate would, as in the past, likely exceed inflation and allow equity REIT dividend yields to also keep pace with market interest rates.

Better liquidity, transparency and corporate governance—Publicly traded equity REITs provide investors with a cost- and risk-efficient vehicle to invest in commercial real estate, an asset class where it can be difficult to achieve appropriate diversification, liquidity and transparency. Compared with alternatives, such as direct/private commercial real estate investment and public non-traded REITs, publicly traded equity REITs generally offer:

  • Meaningful operating expertise
  • Daily liquidity
  • Better transparency (detailed public filings, quarterly conference calls)
  • Financial flexibility and access to affordable investment and financing capital through public markets
  • Strong corporate governance and structure (de-staggered boards, few conflicts of interests, incentivized compensation and disciplined cost structures)

Total return performance has also been consistently strong as equity REITs have achieved an average annualized 10- and 20-year total return, through June 2011, of 10.7% and 11.6%, ahead of the 2.7% and 8.7% delivered by the S&P 500, respectively.

Diversification within the asset class—Equity REITs offer exposure to many different real estate sectors, such as office, industrial, retail, multifamily, health care, lab/R&D space, self storage, lodging, data centers, cell towers, timber and land. Equity REITs also provide geographic diversification potential, whether locally, regionally or internationally. This potential allows investment portfolios the ability to better manage risk and adjust strategy throughout economic growth and investment cycles.

Healthy CRE supply—Unlike past cycles, excess commercial real estate (CRE) supply/expansion didn't cause or precede this downturn, and CRE has maintained a healthy balance. This should allow underlying CRE rents, cash flows and valuations to rebound more quickly than past recoveries.

Equity REIT valuations ahead of fundamentals; recommending a defensive approach—We estimate equity REITs are trading at a 15% premium to our fair value estimate and ahead of improving economic and the associated portfolio fundamentals. However, equity REITs continue to trade 30% below peak valuations, which they reached in February 2007.

Based on current valuations, we recommend equity REIT portfolios be weighted more defensively, focusing on business models positioned for more sustainable long-term growth through commercial real estate and economic cycles. We suggest equity REITs with:

  • A history of incremental increases in both portfolio net asset value and business model fair value
  • A full-service real estate skill set (acquisition, development, property management), which more appropriately positions the equity REIT to exploit growth opportunities and manage risk and cash flows throughout the real estate cycle
  • Lower FFO dividend payout ratios (top 20% of industry)
  • Debt/EBITDA below 6 times (current industry average is 6.4x)
  • Fixed-charge coverage ratios above 2.5 times (current industry average is 2.1x)
  • Niche, competitively advantaged operating strategies
  • Operating strategies and portfolios focused on less cyclical consumer services, such as health care or necessity retail
  • Operating strategies not overly dependent on strong economic and employment growth and consumer discretionary spending

Based on the above criteria we currently recommend investors consider Alexandria Real Estate Equities (ARE), Ventas (VTR), Realty Income (O) and Corporate Office Properties Trust (OFC).

Read our Point/Counterpoint articles about non-traded REITs role in portfolios from the June issue of Investment Advisor.

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