To most outside observers, the nosebleed highs of REIT performance is starting to make them queasy. Since 2010, these names have been the top performers for several years. And when the Fed tamped down on its interest rate hawkery this year, the dividend-rich REIT class surged again.
How rich do you like it? How about year-to-date 50% share price gains for data center REITs like CoreSight and DuPont Fabros Technology by mid-July (followed by 44.5% for Digital Realty)? How about net-lease company Realty Income shares rising 37% for the year? In 2015, self-storage REITs as a group returned 40%.
With that success comes prices out of whack with consensus analysts’ estimates. Many of these same companies now face double-digit downsides if their consensus prices mean anything.
But REITs aren’t like ordinary small or midcap stocks, say analysts and portfolio managers who’ve been following them a long time. Seeing them as overvalued is a mistake, they insist.
Why does that matter now? Because REITs are about to get a big spotlight turned on them. On August 31, real estate crawls out from the throng of banks and insurance companies to get its own Global Industry Classification Standard (or GIC standard) in the Dow Jones and S&P indexes. When it does, portfolio managers that overlooked REITs will suddenly find themselves nakedly underweight in the freestanding sector.
The amount of money at stake as they play catchup is big, say analysts at Jefferies. “We estimate that the average manager is 3.3% underweight REITs and each 1% increase in weight represents $46.7 billion in buying pressure,” wrote Jefferies analysts Steven G. DeSanctis and Omotayo Okusanya in a late-April commentary. That pressure is different for different managers (large-cap managers have more ground to make up than small company investors) but the anticipated reallocation among managers, combined with REITs’ continued yield spread above Treasurys, will continue to push the asset class past even its current highs, say fans.
Buildings Already On Bedrock
The specific nature of the housing crisis meant that a lot of the property overbuilding that typically happens during tulip manias (think of the Empire State Building, which was going to serve as a symbol of the Roaring Twenties but instead served as its grave marker) hasn’t happened this time around. Seven years of GDP growth without a lot of new building has led to an undersupply of property at a time of growing demand. That’s the sweet spot for REITs, which like to raise rents organically and pass on that cash to investors (they must pass on 90% of taxable income to investors annually as dividends).
That’s given REITs room to run. J.P. Morgan Asset Management listed REITs as the top returning asset class every year from 2010 to 2014 except 2013. The FTSE NAREIT All Equity REITs Index returned almost 28% in 2010, about 8.25% in 2011, 19.7% in 2012 and 28% in 2014. By May 31 of this year, REITs had still topped most other classes in year-to-date performance with 6.32% (losing only to commodities, which are coming off of basso profondo lows).
“In U.S. equity REITs, you have a high 3’s dividend yield that’s going to grow by 6% or 7% each year,” says Jason Yablon, senior vice president and portfolio manager at Cohen & Steers in New York City. The healthy fundamentals for cash flow is being driven by demand for real estate “that’s greater than supply in most markets that we are invested in,” he says.
Derek Newcomer, a CFA at Beacon Pointe Financial in Newport Beach, Calif., says even markets like Nashville are seeing historically low levels of vacancy in office space where demand has outstripped supply.
Edward Mui, an analyst at Morningstar, agrees that the sector is fundamentally healthy: “Occupancies are high, rent growth is still pretty strong for many asset classes in many markets, and balance sheet strength leverage is down. People still have liquidity, access to capital, still, especially for the highest quality assets.”
The GIC reclassification is going to bring a lot of generalists into the REIT investing game. Longtime players in this space say these portfolio managers are going to have to really look closely at the asset class and learn how to properly evaluate—not just see overvalued stocks, says Michael Underhill, the CIO at Capital Innovations in Pewaukee, Wis.
“In place of traditional valuation metrics like earnings per share, price to earnings and price-to-book value, REITs utilize factors such as funds from operations (FFO), net asset value (NAV), capitalization rates and internal rates of return (IRR),” Underhill says. “These terms are simply not understood by most generalist investors.” REIT specialists, on the other hand, will better understand industry valuation methods; do on-site property inspections; and go meet with property managers, tenants and leasing agents, he says.
Over the last 10 years, the dispersion between the best and worst performing REITs is 35%, says Yablon. That creates room for active managers.
Wheat and Chaff
Because even in REITs, there are current winners and losers. Take the mall business. Owners of high-quality malls and shopping centers (the types of properties owned by Simon Property Group) are doing well and seeing good demand fundamentals while low-quality mall owners (think CBL & Associates and WP Glimcher) struggle in the e-commerce era. “If it’s not a pleasant shopping experience, customers aren’t going to show up and they will choose to purchase online instead,” Yablon says. “B quality” malls are suffering as retailers like Pacific Sunware, Aeropostale and Sports Authority declare bankruptcy and anchor stores like Sears and Macy’s face declining earnings and thus close many stores.
Not only that, this comes at a time when many mall REITs are going to be facing maturing debt and refinancing problems over the next two years. Malls in general have been more willing to tap the CMBS market for loans, a lender of last resort, says Chris Lucas, a managing director and sell-side analyst at Capital One Securities, and these sources now have greater capital retention requirements.
That’s a horror story waiting to happen as some $56 billion in conduit loans backed by retail properties are going to mature by 2017, says industry publication the Commercial Observer.
Nor are all apartment REITs continuing to surge. New York, which has seen rents in the nosebleed highs for apartments, has finally started to see a glut of properties, so much so that one REIT, Equity Residential, which derives 17.3% of its net operating income from the Big Apple, has been forced to lower its earnings expectations. Markets tied to the energy market, like the Houston and New Orleans office markets, have also been hurt. Houston’s office vacancy rate has been at about 15%.
Underhill says that office space is coming online in the tech corridor in Silicon Valley and Southern California as well— as tech unicorns die off and less space is absorbed. It’s hard to see the downward pressure on rents there yet, according to industry reports. But observers say something must give.
All this means managers must break down REITs by geography and net operating income. “There are some REITs that generate more than 50% of their net operating income from San Francisco and Los Angeles,” Underhill says. “That’s a big net operating income concentration. So we need to be cognizant of that.”
As the e-commerce trend puts pressure on bricks and mortar businesses, Underhill says that things like industrial REITs and especially data center REITs are going to continue to be areas of opportunity. He and Yablon call data centers—which host giant processors for digital storage and must be close to users and clusters of hosts—a great money maker in the age of the cloud.
“Whether it be Digital Realty, DuPont Fabros or CoreSite, we’ve been investing in those data center REITs for years cause it’s a great way to buy into technology without taking the technology risk,” Underhill says. This is a leaseback strategy, he says: With long-term leases of three years or so, not monthly leases, there’s dependable, durable cash flow and there’s lower volatility. “So you look at [them] growing, good cash flow, adjusted funds from operations look solid, and you can buy them with exposure from California all the way through to Connecticut, from Minneapolis, Minnesota, all the way down to Texas.”
Self-storage REITs have also been shredding it—earning back returns of almost 40% for 2015 on the backs of a younger migratory workforce that is moving more, renting more and using multifamily housing more in urban areas. U.S. News & World Report, citing census data, reported in October that multifamily building increased at 43% from 2012 to 2014, while single-family home construction grew only 20%. These units are also getting smaller, and younger people holding off house purchases need storage as they change cities and jobs (or get divorced). This is not to mention the contribution of hoarders. As demand for self-storage increases, there has not been a great supply come online, in part because cities don’t particularly like approving unattractive properties that don’t employ many people or pay back a lot in taxes. That supply/demand imbalance offer perfect weather for rent increases.
Health-care REITs are benefitting from the baby boomer generation hitting their senior years. Morninstar’s Mui says that the baby boomers have only started hitting the Medicare age for the past five years: “Another 15 years of this 80 million person population about to hit that part of their lifetime where they are going to drive demand for senior living, assisted living, independent living, skilled nursing, health-care spending—just because historically senior citizens have spent three to three-and-a-half times the health-care spending per capita than the rest of the population. So these health-care REITs are really going to benefiting from this demographic shift driving demand for their properties.”
As data centers and self-storage thrive, other types of property have been softening. One type is hotels, because of the excess supply in certain markets. Cities such as New York have too much space, at the same time tourism has been hit by the stronger dollar. Hotels also suffer the fate of reduced corporate profits in the U.S. economy (which squeezes business travel). Yablon says he’s underweight in hotels for these reasons.
The Numbers Are Good. Why Not?
“Since the bottom in 2009, the NAREIT index has gained 364% versus 228% for the overall market,” says the Jefferies report.
So why have regular managers been underweight? Several reasons, says Jefferies. One is that portfolio managers like companies that reinvest their earnings for growth, and REITs are payers not reinvestors. They ladle out the cash. REITs also have less liquidity, which spooks managers. But most important, Jefferies suggests managers will value them the wrong way. In theory, buildings depreciate on the books. In actuality, they don’t.
“REITs are a unique animal with the sector having its own unique lexicon and valuation methodologies that require time to understand and appreciate,” write DeSanctis and Omotayo Okusanya. Using standard valuation tools like price to book, they say, “REITs will always look expensive given the heavy depreciation of the asset base.”