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.