From the April 2017 issue of Investment Advisor • Subscribe!

A Real Estate Play That Seeks ‘Sticky’ Tenants

Four criteria for evaluating REIT opportunities

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What's happening to the retail sector is more like Alzheimer's than death. What's happening to the retail sector is more like Alzheimer's than death.

Unnerved by Target's disappointing earnings report in February, we checked in with Burland East, a perspicacious 57-year-old who has spent more than 30 years investing in commercial real estate. East specializes in real estate investment trusts, or REITs.

We were worried. After all, the best-known index of REITs, a mouthful called the FTSE NAREIT All Equity Index, is about 20% invested in retail space. With Macy's, JCPenney and Sears closing hundreds of stores this year, that had to spell trouble for REITs.

Indeed, East gave a grim prognosis. “What's happening to retail is not instant death exactly. It's more like Alzheimer's. The core idea of a mall — driving to it, buying something and going home — is vanishing.”

(Related: Bull Market Not Over but ‘Broader Correction’ Coming: Bob Doll)

None of this bothers East. He has a secret sauce for real estate investing, and retail stores are not a big ingredient. As you probably know, REITs specialize in one property type only, such as shopping malls, timberland, data centers or self-storage facilities, giving investors like East a chance to design pure plays for his portfolio. For example, he invests only limited amounts in retail REITs, i.e., less than 10% of his overall assets.

His secret sauce? Simple. Invest in properties where you can charge the tenant higher rent. He's identified four conditions for when that's likely: Only a few companies have the know-how to build a facility; high barriers to entry exist for new developers; high barriers to exit exist for tenants; and tenants have a healthy underlying business. (Of course, there is no guarantee that any investment will achieve its objectives, generate profits or avoid losses.)

Think about the last time you sat in a dentist's chair. Millions of dollars of equipment surrounded you, from the autoclave that sterilizes surgical tools and dental instruments to the X-ray machine to the chair itself, bolted to the floor. Like many tenants of medical office buildings or research laboratories, dentists find moving an expensive hassle. East puts dentists and other medical office building tenants in the “high barriers to exit” category. He believes, given the choice, they’ll pay higher rent rather than move.

Or consider cell phone tower companies. The three largest that own, lease and operate these towers are all structured as REITs: American Tower (NYSE: AMT), Crown Castle International (NYSE: CCI) and SBA Communications (NASDAQ: SBAC). The tenant, which is a mobile phone company, has few options if it thinks its rent is too high. That's in stark contrast to, say, the more than 4,000 suppliers of apartment buildings. If rents get too high, there's no barrier to exit — the tenant moves.

Data center tenants meet East's high-barriers-to-entry requirement on his checklist. Like mobile phone companies, data center tenants have few options. Relatively few developers have the technical expertise of these citadels of information technology, with their requirements for CIA-caliber security, protection from electromagnetic blast pulses and air-cooled chillers.

East's fourth requirement is that the tenant has a healthy and growing underlying business, like data centers. Cisco estimates that data center IP traffic will grow at a compound annual growth rate (CAGR) of 27% in 2020.

“The general rule of thumb is that 90% of the world's data was created in the last two years. It could be the same next year and the year after that,” said East. The Internet of Things has convinced him that demand for data centers is in a secular trend, and that they will grow regardless of the economy.

Of course, past performance is not indicative of future results, and REITs in particular are affected by real estate conditions, changes in property value and interest rate risk.

What about his small, limited positions in retail REITs and the big retailers’ troubles? It turns out his REITs invest in the four “A-list” mall operators that don't rent space to Macy's or JCPenney or Sears. Taubman Centers (NYSE: TCO), Simon Property Group (NYSE: SPG), General Growth Properties, now called GGP Inc. (NYSE:GGP) and Macerich (NYSE:MAC) are anchored by high-end stores like Bloomingdale's and Nieman Marcus, stores that sell personal service along with Louis Vuitton luggage.

“The A-list malls will be able to hold out a little bit longer,” East said. It's not a ringing endorsement, but as he pointed out, e-commerce still accounts for only 10% of all retail sales.

--- Read 5 Trends in Commercial Real Estate for 2017: Pt. 2 on ThinkAdvisor. 

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