Real estate investment trusts (REITs) continue to produce solid returns for investors. According to the National Association of Real Estate Trusts (NAREIT), the FTSE/NAREIT All Equity REITs Index was up 16.11% in 2012 through the end of June. Furthermore, the component stocks of the index pay a combined dividend of 3.25%, providing investors with a solid total-return combination.
Will REITs continue to deliver? We asked four REIT experts for their outlook on the sector. The panel includes Scott Craig, vice-president and portfolio manager with Eaton Vance Real Estate Fund (EAREX); Paul Curbo, CFA, senior director and portfolio manager, Invesco Real Estate Fund (REINX); Brian Jones, senior vice president and portfolio manager, Neuberger Berman Real Estate Fund (NREAX); and R. J. Milligan, a REITs research analyst with Raymond James.
What is the argument for REITs as an investment class?
Craig: I think there are four good arguments for any diversified portfolio to have exposure to equity REITs. The first is dividend income. This is an environment where it’s not easy to get good yields, and REITs provide reasonable dividend yields. Second is diversification; REITs demonstrate low correlation to other asset classes and thus provide portfolio benefits. Third is that commercial real estate is an inflation hedge and if we have inflation over the medium- to longer-term, which I think is likely, REITs can provide a hedge against some of that inflation. And, then finally, commercial real estate is a $5 trillion asset class in the U.S., and it’s very difficult for individual investors to access that asset class through any vehicle other than equity REITs.
Curbo: Investors are attracted to REITs because of their income-generation characteristics and lower correlation to other asset classes. Since REITs own assets with income generated from underlying leases, they are able to provide relatively consistent income to shareholders. This income generation, coupled with the ownership of real assets, tends to provide a unique investment offering compared to other alternatives. As a result, REITs’ correlation to other major assets classes has tended to be low historically.
In addition, REITs are also able to benefit from periods of economic growth as this leads to increased tenant demand and higher rents, as long as new construction remains under control. Moreover, unlike fixed income investments, REITs are hard assets and possess some inflation-hedging characteristics over long-term periods. With these characteristics, REITs have been able to produce favorable long-term results, handily outperforming other equity indices over nearly all long-term time periods.
Jones: We believe REITs are an attractive way for both individual investors and institutions to invest in commercial real estate. Importantly, REITs provide investors with daily pricing and liquidity characteristics that are often uncommon in many other real estate investment vehicles. Investors can access the cash flows of large and diversified commercial real estate portfolios through investments in REIT securities. REITs tend to also have above average dividend distributions compared to other equity investments, and investors can also benefit from capital appreciation if cash flow growth trends improve and/or if real estate asset values rise.
Milligan: While we all know past performance doesn’t guarantee future results, it is tough to ignore the fact that the REITs have outperformed the S&P (500 Index) over the past 1-, 3-, 5-, 10-, 15- and 20-year periods on a total-return basis. We continually tell generalist investors they should at least marketweight the REIT sector and believe now is no different.
Hard assets serve as an attractive inflation hedge, and growing REIT dividends provide investors with an attractive, well-covered income stream in this low yield environment. We are in the midst of a multi-year fundamental recovery and while some investors lament that they may have already “missed it,” we think there is additional upside from here.
Where are we in the REIT investment cycle?
Craig: I think we’re in the middle innings of the cycle. I think there are a couple of strong positives. Importantly, there’s very little construction in the U.S. In most markets, and most property types, there’s little to nothing being built. Therefore, incremental demand is flowing to the benefit of existing assets.
Second, fundamentals are clearly recovering. In most property types in most markets, occupancy rates are rising and rental rates are rising. On the negative side, yields are low relative to historical levels. That would argue we’re deeper into the cycle, but I think that’s mitigated to some degree by the fact that yields are low for other income generating investments. So on a relative basis, REITs are more attractive.
Curbo: REITs remain in an extended, yet slow recovery phase. While economic growth remains lackluster, it is sufficient to allow for modest improvement in commercial real estate fundamentals. Given the low rate of economic growth, developers have not been active in adding new projects. Moreover, in many cases, rents do not justify new supply. As a result, new construction remains close to historical lows.
As long as economic growth remains positive, tenant demand should outpace new supply in most markets and property sectors, resulting in increasing occupancy rates and rents. This fundamental backdrop serves to boost cash flows and, in many cases, dividends for REITs. The downside risk remains an outright decline in the economy, which would serve to delay the steady recovery that the market has experienced over the last couple of years.
Jones: We believe we’re in roughly the third year of what we anticipate to be a multi-year recovery in commercial real estate fundamentals. Typically, commercial real estate recovery cycles have been seven to 10 years in length. And so, in our opinion, being in the third year of what is likely to be a multi-year recovery in commercial real estate fundamentals is an attractive place to be.
Occupancies have risen in most REIT sectors and we’re beginning to see rent growth in many of the better markets. Most REITs have improved their balance sheets and are well positioned to acquire properties from private owners of real estate or in certain sectors to selectively expand their development pipelines. Although REITs performed well in 2011 and have posted further gains year to date in 2012, we believe that the positive industry fundamentals should continue to support REIT share prices in the future.
Milligan: We are in the fourth year of the third major REIT up-cycle since the modern REIT era began. Typically these up-cycles last seven years and have historically retuned an average 20-22% compound annual total return. However, given sluggish economic growth and increasing construction costs, we think the runway for commercial property fundamental improvement is only getting longer as supply growth is almost nonexistent, save for a few sectors (such as apartments and data centers). Thus, we believe this up-cycle could last well beyond seven years.
Where are the investment opportunities to be found today, and why do you like these sectors?
Craig: Two property types that I’ve been favorable on are apartments and self-storage. Those are both property types where occupancies are high and fundamentals are strong.
Curbo: While we do not necessarily have a bullish view on the pace of future economic growth, the lack of new construction suggests that commercial real estate fundamentals should continue to improve. As such, we like sectors that can benefit from demand outpacing supply.
The apartment sector offers the potential for more consistent cash flow growth than other sectors. The sector has experienced an improvement for some time given the decline in the home ownership rate, as individuals continue to favor renting over owning at the margin.
While new construction is beginning to pick up in several markets, the levels are relatively low compared to history. Most markets still favor the landlord and rent increases should continue as long as the economy does not experience a downturn. Given these factors, the improvement in apartment fundamentals should prove to be more sustained than in prior cycles.
Jones: One sector we are positively biased towards is the regional mall sector, because we’ve seen continued growth in retail sales. Also, we’ve seen growing store opening plans for many of the mall tenants. In particular, many foreign retail firms, including H&M, Zara, Uniqlo and Lego, are expanding their U.S. presence helping to improve occupancy levels in U.S. malls.
We are particularly attracted to malls serving upper-income communities. The unemployment rate of individuals with a college degree is 4.3% currently, which is roughly half of the overall unemployment rate.
We think upper-income consumers in the U.S. will continue to increase their spending, because their employment levels are strong, and also they’ve seen better income growth than lower-income consumers. So, we remain focused on the mall sector and in particular malls that target high-income communities.
Another sector that we overweight is the technology-related sectors of data centers and cell towers. The growing utilization of smart phones and tablets has created strong demand for real estate that houses data-storage equipment, as well as data-transmission equipment.
Estimates suggest that mobile data traffic will quintuple between 2010 and 2013, driving strong demand for data centers and cellular-transmission towers. There are a number of REITs that focus on owning either data centers that house servers and storage equipment or cellular towers that house data-transmission equipment for cellular-telephone companies.
Milligan: We prefer sectors with visible and meaningful earnings growth (apartments, self-storage, malls, and data centers), though it is tough to make overarching sector recommendations given valuation metrics. We consider the mall REITs to be a good place for investors to weather the economic uncertainty, as sales growth has continued to surprise to the upside across the REIT portfolios over the past year. We believe the malls will post strong same-store net operating income (or NOI) growth going forward, given the relative health of the luxury consumer, fewer local shop tenants and exposure to outlet centers, which have outperformed.
We also continue to overweight the multifamily sector as we believe the rental market remains in the sweet spot of the housing continuum, benefitting from: 1) a significant lack of new rental apartment supply; 2) strong growth in renter household formation; 3) low resident turnover; and 4) the relative affordability of apartments vs. Federal Housing Administration (FHA) mortgage financing in many of the markets where apartment REITs operate. We also like a few of the specialty REITs, such as Digital Realty (data centers), BioMed Realty (life science buildings), Rayonier (timber/specialty fibers), and American Tower (cell towers).
Are you avoiding any sectors — and, if so, why?
Craig: I generally don’t avoid sectors outright, but I have been underweight in my exposure to the health care REITs. There are a couple of reasons for that. First, I think that a significant portion of the cash flow those REITs generate comes from Medicare and Medicaid, and I think there’s risk of reduction in payments in both of those areas. Second, I think the risks of the triple-net lease restructures are not well understood. Therefore, I think the properties are too dearly valued in the public markets.
Curbo: The suburban office sector is dependent upon job growth in order to generate a sustained level of improvement. Given the macro environment, employers remain cautious in new hiring and planning for expansions.
Furthermore, there is anecdotal evidence to suggest that some companies increasingly prefer an urban location. As such, tenant demand in many suburban locations remains quite subdued, and prospects for sustained rent growth are likely to be delayed until job growth accelerates.
Jones: In terms of sectors that we’re avoiding, we currently underweight the health care sector, because we’re concerned that federal and state budget pressures may lead to spending cuts within the Medicare and Medicaid health care programs.
These potential spending cuts could impact both the skilled nursing sector and the hospital property type that are both within the health care REIT sector. We’re also somewhat concerned, because many of the health care REITs trade at material premiums to our net asset value estimates limiting the potential upside to their share prices.
Milligan: We have recently lowered our suggested weighting on the broader office REIT sector to underweight from marketweight following solid first-half 2012 share price performance, few obvious fundamental catalysts and the likelihood that continued deleveraging will weigh on stocks near term. Weak employment growth and an ongoing trend of reduced office space per employee continue to hurt demand. Financial services layoffs, government contraction/paralysis and global economic weaknesses may further delay a recovery in office demand.
Has the economy’s slow recovery changed your investment universe?
Craig: It really has had no impact at all. My investment philosophy is very consistent, whatever the economy looks like. I always emphasize high quality properties, good management teams and strong balance sheets. And, over medium to longer periods of time, those criteria tend to generate above average performance. It’s so difficult to predict what the economy is going to do, so I just focus on quality, regardless of what the economy is doing.
Curbo: Given the slow nature of the economic recovery, we tend to favor those sectors and companies that can generate growth without reliance upon strong economic growth. Given the lack of new construction during this recovery, the commercial real estate market can still record improvement in rents as long as market conditions are reasonably tight (e.g., the market was not severely overbuilt during the last cycle). Those sectors such as apartments, life sciences/lab office, and several property markets across the West Coast seem to favor the pricing power of landlords despite the slow pace of economic growth.
Jones: The slow recovery within the U.S. economy particularly in terms of job growth throughout our nation is a significant concern within our investment group, and we think it is a concern in regards to the direction of the overall U.S. economy. However, we do expect economic growth in the U.S. to remain positive for the remainder of 2012, and we’re cautiously optimistic that the U.S. economy will not suffer a double-dip recession.
Relative to the slow recovery in the U.S. economy, we underweight a few of the more economically sensitive sectors. We currently underweight the hotel sector due to the sector’s close correlation to short-term economic fluctuations. Additionally, many of the hotel REITs and hotel C-corps have exposure to European markets, where the near-term economic outlook is even more uncertain.
Another factor we consider in relation to the U.S. economic recovery is that we’re focusing on regions of the United States that are experiencing above-average economic growth. Two regions where we expect economic growth to continue to be above average are the Texas markets, as well as Northern California. In Northern California, they’re benefiting from the growth of technology, social media and Internet companies. And, in the Texas markets, job growth has been strong within the energy sector, particularly related to the emergence of onshore shale, oil and gas fields. So, we are overweight companies with material exposures to Texas markets, as well as REITs that own high concentrations of properties in Northern California.
Milligan: If anything, it has supported our REIT thesis. We don’t anticipate much new supply in the near to intermediate-term, which will only help to ultimately drive rents higher as demand improves. The REIT sector provides an attractive risk-return proposition in this yield-hungry environment, especially in light of its increasing dividends, low payout ratios and significantly improved balance sheets.