With U.S. property markets beginning to recover and access to unsecured debt improving, some are seeing investment opportunities in domestic and international REITs.
Indeed, REITs such as Vornado Realty Trust, Boston Properties and Tanger Outlet Centers are enjoying low vacancy rates and are trading near their 52-week highs, prompting TV personality Jim Cramer to ask why people are talking about a commercial real estate crash. "The action in these stocks screams triumph, not tragedy," he says.
Many advisors would consider Cramer's enthusiasm to be a flashing contrary indicator. It's unclear whether the commercial real estate cycle has bottomed out, but REITs, which invest in properties like office buildings, apartments, hotels and shopping malls, are in much better financial shape than they were a year ago. Capital-raising concerns have eased and REITs should have the cash to pick up property right now at very distressed prices. The sector is also a good hedge against inflation, which is expected to rise.
Over the last decade, REITs easily outperformed stocks. The economy was growing, employment was strong-generating high demand for office buildings-and people spent money, which helped the shopping mall and hotel REIT sector. Over the last ten years, the sector averaged annual returns of 10.31% while the S&P 500 returned negative 0.9%. But then REITs hit the skids three years ago when the financial downturn hit. The FTSE NAREIT All REIT Index fell 17.83% in 2007 and another 37.34% in 2008.
Things started to turn around in April of last year, when REITs returned almost 30%, their highest monthly gain since Morningstar began tracking them in 1985. They finished 2009 with a return of 27.45%.
How did real estate bounce back? REITs were once again able to raise capital to refinance their debts and, more important, to pick up some of the depressed assets becoming available. Many believe REITs are in the early stages of a new acquisition and formation cycle and that those with healthy balance sheets and strong management will do well.
"I think REITs will perform well, relative to stocks, but it will depend on the particular REIT's focus," says Gino Sabatini, a managing director at W.P. Carey. "Some are tied more to the economic recovery than others. If you're a REIT like Vornado, and you're focused on office space in big cities, and the economy continues to move in the right direction, you should do well. Same with a retail REIT like Simon. If consumers become more confident and spending goes up, I would expect them to do well."
The debt structure of the REIT is also critical, Sabatini says. How much debt does it have? When is it coming due? Is it a fixed or floating rate? Does it have cash to take advantage of today's buying opportunities?
"If they have a lot of debt coming due, they won't be able to take advantage of them," Sabatini says. "Those with less debt and more cash will obviously be in a better position."
Twelve months ago, it would have been hard to finance even a great deal. Today, not only is there cash available, but spreads have actually come in. Where REITs were paying about 8% last year, they can now find financing for less than 7%, Sabatini says.
And with real estate prices lower, initial cap rates-the rent divided by the purchase price-look better today. Two years ago, they were about 4% to 6%. Today, they're 6% to 8%. W.P. Carey recently acquired a supermarket portfolio in Spain for $104 million. Two years ago, the price would have been too high and the firm would have had a lot more competition for the assets, potentially driving up the price.
"We did not invest in those deals in '06 and '07. The price per foot was just too high," Sabatini says. "We have a terrific pipeline right now. We have tons of great deals we're looking at. We're very excited-both domestically and internationally."
Some of those projects involve developers using W.P. Carey to finance project construction. In the past, a bank would finance a project and only after it was done would a company like W.P. Carey step in and buy it. With bank lending scarce, REITs are stepping in earlier in the process. The advantage is that the REIT gets the premium associated with taking on the construction risk. That's a slice of the pie the developer used to get.
As an investment, REITs have two attractive characteristics: They pay high dividends and their share prices rise and fall with the commercial property market rather than the stock market. Investors need such uncorrelated assets to diversify their portfolios.
REITs are required to pay dividends. To retain their tax-advantaged status, they must pay at least 90% of their taxable income to shareholders annually in the form of dividends. In fact, REITs have for years been valued for their high dividends, stable cash flow and low volatility.
That's why it came as such a blow to the sector when REIT values plummeted in late 2008 and early 2009. But as commercial real estate values tumbled, liquidity dried up and refinancing became a concern, REITs began to hoard cash. Many slashed or nixed their dividends. Some 70% of Morningstar's REIT universe, for instance, cut or eliminated their dividends. But that should change shortly, as the economy and financing options improve. Morningstar believes REITs will increase cash payouts this year.
"Given the magnitude of dividend cuts over the past 18 months, we expect spectacular dividend growth from some REITs in 2010, particularly from those stocks that suffered the most severe cuts," Morningstar analysts wrote in a recent report.
Average dividend yields right now are about 4.75%, according to the National Association of Real Estate Investment Trusts (NAREIT). In the past, they've ranged from 6% to 8%.
Not all REITs are alike. There are traded or listed REITs, which are essentially revalued every day because they trade on an exchange. And then there are non-listed REITs, which don't trade on an exchange and raise capital and acquire assets over the course of several years. Some advisors, particularly now, prefer non-traded REITs because while they're more illiquid, their price is far less volatile.
"For the last couple of years, listed REITs were a bad place to be, from a return and volatility perspective," says Jeff Shafer, president of CNL Securities, which currently offers three non-traded REITs to advisors. "With a non-traded REIT, it doesn't matter whether Wall Street was having a good or bad day."
Shafer believes non-traded REITs are a far better investment right now because many of them hold newer, cheaper assets. "Non-traded are like a clean slate," Shafer says. "With a non-traded REIT, you don't have to worry about legacy assets purchased at the height of the market." Because some REITs have been able to invest in assets at very reasonable prices, the return on those investments will be higher, he added.
Dean Barber of Barber Financial Group in Lenexa, Kan., uses REITs for most of his clients, particularly REITs that invest in the health-care real estate sector. He thinks real estate offers more security than bonds and that a well-capitalized REIT right now can pick up assets at a 40% to 50% discount.
Barber prefers new, non-traded REITs such as Healthcare Trust of America Inc. because, like Shafer, he says if you buy a traded REIT, you don't know what you're getting. "The question is, do you want to go out and buy a property, know who the tenant is, know what the leases are and buy that property at today's prices, or do you want to go out and buy the stock of a traded REIT, which already has properties in it from who knows when and at what price?" Barber says.
Aside from health care, Barber likes multi-family housing and properties with corporate guarantees of 15 to 20 years on good corner locations-someplace where you might see a Walgreens pharmacy or a McDonald's fast-food restaurant. He says he wants buildings on the corner of "Main and Main."
"This is the perfect time to buy," Barber says. "It's like buying right after the stock market crash. You're buying at distressed prices. And with the commercial real estate debt issue looming overhead, prices are only going to be depressed further."
Not everyone is keen on REITs. Fitch Ratings, for one, put out a report in December that was negative on the sector for 2010. The firm cited weak property operating fundamentals across the U.S. equity REIT sector and uncertainty about when an economic recovery would happen.
Keven Lindemann, who heads up the real estate group at SNL Financial in Charlottesville, Va., is a little more optimistic, but he's still not letting loose the balloons. He expects modest returns this year-in the mid-single to low-double digits.
"The last nine and a half months have seen a terrific run," Lindemann says. "If there are modest expectations for this year, it's because REITs had such a terrific run through most of 2009 [and] there's a little bit of a concern that valuations have gotten ahead of themselves."
The REIT market is highly correlated with generic growth figures such as GDP and job growth. More positive signs on that front are needed to give people confidence that the commercial real estate market will recover, he says.
Lindemann speaks more positively about the prospects for international REITs. Like many others, he thinks they are a good play for investors who already hold U.S. REITs and want to diversify their real estate holdings. Japan and Australia have the most mature REIT markets, while the U.K. and Germany have passed REIT-enabling legislation over the last several years.
"There's definitely a perception that there are growth opportunities there and that some of these countries, as their public real estate markets grow, will be following in the footsteps of the U.S.," he says.
Growth opportunities are best in emerging economies and countries with favorable demographics, such India, Brazil, Russia and China-though the traded real estate companies in those countries tend to focus on residential rather than commercial properties.
"It's a little bit of a different animal, but it's still a real estate play," Lindemann says. "You don't find the same traditional REIT vehicles that you find in the U.S., in large part because there isn't necessarily the concentration of commercial properties in those countries as you find in the U.S."
The U.S. has a robust office space and shopping center market. You tend not to have that as much in emerging markets, he says.
"If you think about it, 70% of institutional-quality real estate is located outside of the U.S," Shafer says. Some of these other countries are projected to have GDP growth greater than that in the U.S., which bodes well for real estate in those markets, Shafer says.