The REIT Stuff: How REIT Investors Have Benefited
from the Real Estate Recovery
By Steve Benyik
November 16, 2012
Recent trends in the residential and commercial real estate markets have provided some encouragement in a slow-growth economy. Case in point: real estate investment trusts (REITs),1 whose strong returns and yields have attracted considerable investment in recent years. Steve Benyik, Lord Abbett REIT analyst, provides perspective on the sector's key trends.
Q. How far has the REIT market come since the housing bubble burst?
A. Before talking about where we are, I think it's important to provide some historical perspective. The commercial real estate market and the REIT sector both essentially peaked in February 2007 with Blackstone's [a private equity firm] acquisition of Equity Office Properties at a relatively thin spread to the 10-year Treasury yield. Tremendous liquidity in the system drove real estate values to some of the highest levels ever, but when lenders pulled back during the financial crisis [of 2008–09], the companies with the highest leverage and development exposure were the hardest hit. This dynamic has contributed to greater volatility in the REIT space in recent years than we have generally witnessed in the past.
Q. When did things finally start to turn around?
A. The bottom of the REIT market was actually in March 2009; since then, you've seen a pretty tremendous rally in the REIT sector, led by some of the very companies that underperformed the most. For example, using rough numbers, the total return of the MSCI U.S. REIT Index2 was down 20% in 2007 and 42% in 2008, but has since rebounded by 21% in 2009, 24% in 2010, 5% in 2011, and 12% year to date [as of October 9, 2012]. Meanwhile, the FTSE NAREIT All Equity REITs Index3 is up more than 16% year to date, with an average dividend yield4 of 3.33%. [See Table 1.]
Table 1. REITs Have Been on a Roll in 2012
Source: National Association of Real Estate Investment Trusts; data as of October 9, 2012.
Note: The FTSE NAREIT Retail Index is a free float-adjusted, market capitalization-weighted index that includes all tax-qualified REITs listed in the NYSE, AMEX, and NASDAQ National Market. The FTSE NAREIT Equity Shopping Centers Index is a free floatadjusted, market capitalization-weighted index that includes all tax-qualified REITs listed in the NYSE, AMEX, and NASDAQ National Market. The FTSE NAREIT Equity Regional Malls Index is a free float-adjusted, market capitalization-weighted index that includes all tax-qualified REITs listed in the NYSE, AMEX, and NASDAQ National Market. The FTSE NAREIT Equity Free Standing Index is a free float-adjusted, market capitalization weighted index that includes all tax-qualified REITs listed in the NYSE, AMEX, and NASDAQ National Market.
Past performance is no guarantee of future results.
For illustrative purposes only and does not represent any Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect deduction of fees or expenses, and are not available for direct investment.
Q. Which REIT categories have done best?
A. U.S. apartment REITs have gained 246% since March 2009, continuing their streak of outperforming the broader REIT market and the S&P 500® [Index]5 by a substantial margin since the beginning of 1994. [See Chart 1.] More recently, shopping center REITs have shown a one-year total return of 38.5% [as of October 1, 2012], versus 33.7% for the SNL U.S. REIT Equity Index, according to SNL Financial.6
Chart 1. Apartment REITs Have Outperformed All REITs and the S&P 500 Over the Period December 1993–August 2012
Source: Marcus & Millichap, National Association of Real Estate Investment Trusts, and Standard & Poor's.
Note: The All REITs part of the chart is based on the FTSE All Equity REITs Index. The Apartment REITs part is based on the FTSE NAREIT Equity Apartment Index.
Q. What about companies that were highly leveraged when the financial crisis hit?
A. A number of the most highly leveraged REITs were forced to issue equity dilutively toward the bottom of the market, which meaningfully impacted their earnings growth rates and shareholder returns. Meanwhile, some of the better-managed and better-capitalized companies were able to weather that downturn and emerge better positioned on a relative basis. This emphasizes the importance of prudent balance sheet management for the REITs, particularly since the sector remains relatively highly leveraged at 7.0 times net debt to EBITDA.7
Q. How does Lord Abbett approach the REIT sector?
A. In a nutshell, we try to invest in solid, well-managed companies for the long term without taking disproportionate balance sheet or execution risk. In some instances, that means trying to find names that appear to be somewhat undervalued, but with good long-term growth prospects, decent asset quality, strong balance sheets, and potential catalysts in the near to intermediate term.
Q. How much has quantitative easing by the Federal Reserve helped the sector?
A. The current low-interest-rate environment has enabled some of the better-capitalized REITs to issue long-term debt at sub-4% interest rates, which has been a tailwind for earnings. However, REITs actually modestly underperformed following the most recent quantitative easing announcement, given that the sector often lags in a "risk-on" environment [where investors tend to feel more positive about conventional equities].
Q. Can you elaborate?
A. Part of the REIT business model is reliant on spread investing. In other words, REITs attempt to buy or develop assets with decent growth potential at a yield above their weighted average cost of capital. The low-interest-rate environment that is in part afforded by quantitative easing clearly helps in this regard. However, based on historical spreads, commercial real estate pricing should not be materially negatively impacted, unless the 10-year Treasury yield rises above 3%. The REITs could likely absorb some level of higher interest rates without materially underperforming the broader market, assuming that rent growth comes to fruition, but only if that rise in interest rates occurs in a relatively measured fashion.
Q. How does inflation factor into your outlook?
A. Modest inflation should, theoretically, help the REITs, given the historical relationship between inflation and rent trends. On the other hand, runaway inflation would add considerable uncertainty to the REIT sector, particularly if rent growth struggles to keep pace with higher interest rates. Overall, the probability of significant inflation in the near term appears to be relatively low.
Q. Which REIT subsectors are the most attractive at this point, in your opinion?
A. When you look at REITs from a long-term recovery perspective and take into account where we are in the cycle, the property types that likely have the most upside in terms of rent and occupancy would be industrial, office, and strip centers. However, we attempt to be relatively balanced in our investment strategy by maintaining some exposure to attractive names in more defensive categories, such as health care, malls, and, to some extent, apartments. It is important to keep in mind that management's capital allocation and balance sheet-related decisions can often be a more significant driver of long-term earnings growth than the company's specific property type focus. Said differently, management teams have a terrific ability to create or destroy shareholder value.
Q. Are banks much more willing to lend to REITs than individual homebuyers?
A. Corporations generally continue to have better access to capital than most individuals, and the REITs are no exception. The REITs have been active raising capital from both the secured and unsecured debt markets at very attractive rates, but have generally been more focused on replacing maturing secured debt with unsecured debt in order to improve their credit ratings. Overall, we will likely need to see increased bank lending to individual homebuyers at attractive terms to see a meaningful acceleration in the housing market recovery.
Q. Will low interest rates lead to more consolidation in the sector?
A. Mergers and acquisition trends are always difficult to predict. More often than not, public-to-public mergers are often influenced by the stock price of one company versus another. In the past, there have been instances where REITs have arguably overpaid in public-to-public transactions, but this was in part because those acquisitions were largely financed with well-priced equity capital. In addition, considering the number of publicly traded REITs that were taken out by private equity firms over the past five years, I suspect you'll see more of them coming public again if equity markets improve or remain relatively stable.
Q. Is international capital fueling some of the interest in U.S. REITs?
A. There has been a steady flow of capital from sovereign wealth funds into Class A property markets like New York City and Washington, D.C., which has kept yields relatively low. The expectation is that some of those investment dollars will eventually spread into secondary and tertiary markets as people try to achieve higher yields on their acquisitions, but we have not seen much evidence of this yet given that it often involves taking on more risk. Overall, I think that commercial real estate pricing in secondary markets will also be driven in part by the health of the commercial mortgage-backed securities market, since banks and life insurance companies are often less willing to lend in these markets.
Q. In your opinion, which regions are most attractive at this point? Or are they more national plays?
A. San Francisco has been a relatively strong market recently driven by the success of technology firms, but it is also a market that has shown dramatic volatility in prior cycles. Meanwhile, New York City and Washington, D.C., have been two of the stronger markets over the long term, despite their more recent struggles. The Sun Belt has the potential to benefit from favorable population demographics, but is also non-supply-constrained, so new development can become problematic relatively quickly. Overall, most of the large cap REITs own relatively well-diversified national portfolios.
Q. Hasn't nagging uncertainty about financial services and government spending raised concern about the near-term performance of the New York and Washington, D.C., office markets?
A. Yes, but these markets should continue to outperform the national averages over the long term, albeit perhaps by a smaller margin than they have in the past. For example, Washington, D.C., will likely be particularly challenged in the near to intermediate term, given the headwinds related to reduced government spending and the "fiscal cliff." However, private market valuations in Washington, D.C., will likely remain relatively strong, given the preference by institutional investors for major gateway cities.
Q. Do you see any potential for residential REITs buying up big chunks of distressed single-family housing?
A. Some private firms are attempting to amass large single-family housing portfolios in the Sun Belt and other regions, but I don't see the apartment REITs looking to diversify into the property type. The real challenge will be whether these private firms can garner the right amount of operational efficiencies across a geographically diversified portfolio, given myriad issues related to plumbing, electricity, maintenance, yard work, and the like. Their [private equity firms] ability to manage all of these challenges economically still needs to be demonstrated.
Q. Sales of new and existing homes have moved up in recent months, while the stocks of homebuilders and building supply companies have also rebounded. How encouraging is all that?
A. There has definitely been some improvement, and we are likely in the early innings of a housing recovery, which should positively impact the economy. However, I don't believe that the home ownership rate is likely to revert to its recent highs or that there will be a large-scale movement from multifamily homes back to single-family homes. Housing perceptions have changed on the margin, especially among people in their twenties and thirties. As a result, there will likely remain a sizable cohort that could afford to buy a home in the suburbs, but will delay that decision and choose to live more conveniently in an urban center for a longer period of time.
Q. How long do you think that urbanization trend will last, given current prices?
A. I think that the urbanization trend has legs, but the challenge for the apartment REITs is that occupancy is already relatively close to peak levels and rent growth is likely to slow in the coming years. Specifically, the apartment REITs are generating very strong internal growth, but that growth is likely to slow in 2013 and beyond as new supply is delivered into markets like Washington, D.C. Also, rents as a percentage of household incomes have risen meaningfully, and it remains to be seen how much more upside there is in the absence of wage growth.
REITs in a Nutshell
Why REITs' high dividends, plus the potential for moderate, long-term capital appreciation, continue to attract both individual and institutional investors.
In September 1960, President Dwight D. Eisenhower signed into law a bill that would give all investors the opportunity to invest in large-scale, diversified portfolios of income-producing real estate.
Since then, real estate investment trusts have provided investors with competitive long-term rates of return that can complement the returns from other stocks and from bonds. (See Chart 1.) One big reason for that is because REITs are required by law to distribute, each year, to their shareholders at least 90% of their taxable income.
Chart 1. REITs' Total Return Has Been Quite Resilient Over the Last 30 Years
FTSE NAREIT All Equity REITs Return Components
(Percent change, as of December 31, 2011)
Source: National Association of Real Estate Investment Trusts.
According to the National Association of Real Estate Investment Trusts (NAREIT), listed U.S. REITs today constitute an equity market of more than $300 billion, with an average daily trading volume of about $4 billion. Outside the United States, REITs and listed property companies constitute another $700 billion-plus, comprising a listed REIT and real estate investment universe of more than $1 trillion. Among the most popular REIT categories are regional malls, apartments, office buildings, and health care. (See Figure 1.)
Figure 1. Listed REITs Invest in All Property Types
Source: National Association of Real Estate Investment Trusts. Data based on the FTSE NAREIT All Equity REIT Index, as of October 9, 2012.
1 A real estate investment trust (REIT) is a company dedicated to owning and, in most cases, operating income-producing real estate, such as apartments, shopping centers, offices and warehouses. Some REITs also engage in financing real estate.
2 The MSCI U.S. REIT Index is a free float-adjusted market capitalization weighted index that comprises equity REITs that are included in the MSCI U.S. Investable Market 2500 Index, with the exception of specialty equity REITs that do not generate a majority of their revenue and income from real estate rental and leasing operations. The index represents approximately 85% of the U.S. REIT universe.
3 The FTSE NAREIT All Equity REITs Index is a free-float adjusted, market capitalization-weighted index of U.S. equity REITs. Constituents of the index include all tax-qualified REITs with more than 50% of total assets in qualifying real estate assets other than mortgages secured by real property.
4 Dividend yield is the percentage of income earned by the investor. The yield is calculated by dividing the amount of dividend per share by the current market price per share of stock. For example, if the stock market's price is $20 a share and the annual dividend is $1.00 per share, the dividend yield is 5%.
5 The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.
6 The SNL U.S. Equity REIT Index is a value-weighted index based on the market cap of a cross-section of America's largest REIT firms.
7 Net debt to EBITDA is a ratio that reflects a REIT's leverage that indicates how many years it would take a company to pay back its debt. It is typically calculated as a company's interest-bearing liabilities minus cash or cash equivalents, divided by its EBITDA. EBITDA stands for earnings before interest, taxes, depreciation, and amortization, and is sometimes referred to as net operating income.
Indexes are unmanaged, do not reflect deduction of fees or expenses, and are not available for direct investment.
Risks to Consider: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Investing in small and mid-sized companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations, and illiquidity. Real estate investing may be subject to a higher degree of market risk because of concentration in a specific industry, sector, or geographical sector. Real estate companies, including REITs or similar structures, tend to be small and mid cap companies, and their shares may be more volatile and less liquid. The value of investments in real-estate-related companies may be affected by the quality of management, the ability to repay loans, the utilization of leverage and financial covenants related thereto, whether the company carried adequate insurance, and environmental factors.
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