The FTSE NAREIT All-Equity REITs Index has produced total returns of 8.30% through July 31, and its components have been sharing 4%-plus dividends with investors. Those impressive returns have some advisors and their clients wondering about the direction of future results.
We asked five REIT experts for their thoughts on the market’s current condition and longer-term outlook. The panel includes Steve Buller, vice-president and manager of the Fidelity Real Estate Investment Portfolio (FRESX); John Guinee, III, managing director, Stifel Nicolaus Equity Research-REITs; Brian Jones, CFA, co-portfolio manager, Real Estate Securities Group, Neuberger Berman; Todd Lukasik, CFA, senior analyst-real estate, Morningstar, Inc.; and Anthony Paolone, CFA, senior equity research analyst, J.P. Morgan.
What trends favor REITs today?
Buller: I view it as a three-legged stool. The legs of the stool are fundamentals, access to and cost of capital, and valuation. For fundamentals, generally speaking in commercial real estate, we live in a world with increasing occupancies and the ability to push rental rates higher. Even with this slow economic growth, there’s a high correlation between GDP growth and job creation and the demand for most forms of commercial real estate.
But commercial real estate is also about supply. After many years of almost non-existent new competitive supply, we’re still fairly below historical trends in the building of new competitive supply. So, even with sluggish economic recovery, that fundamental picture is slightly positive or above positive.
The second leg of the stool is access and cost of capital. Obviously we’ve had fairly sizeable movements in long-term U.S. interest rates since May 22 of this year. But putting it in a broader context, the cost of debt capital and the spread that most of the listed REIT sector is paying are still fairly advantageous from a debt perspective versus the long-term historical cost.
Also, REITS have a distinct competitive advantage with their access and their cost of capital. They exploit that competitive advantage by issuing new capital and acquiring new buildings. That has been, and even today can be, accretive to earnings and to net asset value.
The third leg of the stool is valuation, and REIT stocks have done fairly well. If we had this conversation in early May, I would have told you that the valuation of REIT stocks, whether it was versus private real estate or on a multiple basis, was generally a weaker leg of the stool. We had a pretty sizeable correction within the REIT market.
Guinee: The clear trend for investors in the current environment is yield and modest growth without taking undue risk. As long as interest rates do not increase significantly, we think REITs offer this combination.
We expect earnings and dividend growth to both be roughly 8% for 2013, which is a good growth profile when combined with a 3.5% dividend yield. Overall, REITs are not trading in excess of net asset value or replacement costs, so the downside is manageable.
Jones: Over the last few years, REITs have generated strong total returns relative to other equity and fixed income securities. We believe there are a few investment trends that have supported strong relative REIT performance, the most important of which is the search for yield among individual and institutional investors.
However, we believe the most important factor driving strong REIT returns has been the recovery in underlying real estate fundamentals. Since the second half of 2010, commercial real estate fundamentals have improved meaningfully, as evidenced by rising occupancy rates and improving rent growth across most sectors and in most regions of the United States. Modest economic growth and very low levels of new commercial real estate construction have supported the recovery.
Although timing precise entry and exit points is never easy, I believe that currently REITs represent an attractive investment opportunity for investors with medium- to long-term investment horizons. I expect the strong cash flow growth (9% in 2012) that REITs have generated recently is likely to continue. Tenant demand for space continues to improve, and new construction volumes remain subdued. I expect the current recovery cycle for commercial real estate to continue for at least a few more years.
Lukasik: The macro backdrop of the past few years couldn’t have been much better for REITs, in our opinion. Slow and steady economic and job growth has translated into incremental demand for commercial real estate, yet the macro economy has not improved enough for developers to aggressively add incremental supply to commercial real estate stock.
As such, existing landlords have experienced improved occupancy rates, greater bargaining power relative to tenants, and nice increases in same-store net operating income. Similarly, the low interest rate environment has allowed REITs to refinance debt and preferred equity at very favorable rates, saving hundreds of millions—if not billions—of dollars in aggregate industry financing costs.
Also, we think investors were drawn to the attractive dividend yields of REITs as interest rates fell, driving up asset prices. Our view is that the generally favorable backdrop REITs have faced over the past few years will change, although the timing remains uncertain.
In April, our REIT coverage looked roughly 15% to 20% overvalued. With the recent rise in rates and drop in REIT prices, our REIT coverage looks slightly overvalued today relative to our expectations, and we think investors should be very selective when considering what REITs to own in their portfolios.
Paolone: What’s been important for the group, as it relates to the stocks, is that we’ve been in a fairly modest-growth economic environment. We’ve also been in an environment in which interest rates have been low and investors have sought out some income as an investment strategy. Those things all play into REITs quite well.
You’ve seen a good amount of capital flowing into the space, as well as into direct real estate for that matter as this asset class, broadly speaking, delivers good risk-adjusted returns. I think that was the big driver to the performance over the last few years.
Looking ahead, I would say a couple of things. One is that fundamentally the business looks like it continues to improve slowly as job growth continues to move ahead in the country. At the margin, landlords are gaining a bit more pricing power, occupancies are rising, and there’s not a whole lot in the way of new supply of commercial real estate generally speaking. As a result, cash flows at the companies are growing.
The second item, though, relates to interest rates and just how this group of stocks may or may not fit in to the broader market. If we are going to have an environment in which rates move rapidly higher, these are going to be stocks that face headwinds, because they were beneficiaries of the search for yield and because they offered some relative safety in a fundamentally mediocre period of time.
But presuming that if rates are going up and you have more robust economic activity as your backdrop, the risk is that you see a flight of capital out of REITs into other areas of the market, perhaps into more cyclical sectors. You saw some of that in the very end of May and into June, when you saw the move in the 10-year Treasury and the market sentiment shifted from being more income-oriented and to being out of sort of bonds and yield instruments. REITs bore the brunt of that.
How can REIT investors adapt to likely higher interest rates?
Guinee: We think the best way to hedge against rising interest rates is to focus on REITs which have higher-quality portfolios, have internally generated earnings growth and are valued by investors more on net asset value than on dividend yield.
Jones: Our historical correlation work and analysis suggests that over the medium and long term, REIT total returns have not been closely correlated to changes in interest rates. However, over the short term, significant changes in the interest rate environment can lead to volatility in REIT returns.
Investing in REITs with above-average cash flow growth prospects should be a way to protect against higher interest rates. REITs with above average growth can increase their dividends to potentially keep pace with higher interest rates. We also believe that real estate and REITs with above-average growth should maintain or improve their asset values compared to the sector overall.
Paolone: A couple of broader thoughts are: Number one, move to property types with shorter lease durations, which are things like apartments and industrial perhaps; and, two, focus on companies that over the last few years, as you came out of a downturn, really built up pipelines of developments by repositioning properties.