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.