Amid macroeconomic headwinds fueled by the continued concerns about sovereign debt issues, rising energy costs, and fears of a double-dip recession, the U.S. Real Estate Investment Trust (REIT) industry continues to outperform the market. The REIT market has been driven by an increased inflow of funds as institutional investors allocated more capital to the industry.
Investors looking for high dividend yields have favored the REIT sector. Solid dividend payouts are arguably the biggest enticement for REIT investors, as U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends to shareholders. The dividend yield for the FTSE NAREIT All REIT Index by the end of second quarter 2011 was 4.3%, compared to 3.2% for the 10-year U.S. Treasury Note.
The FTSE NAREIT Equity REIT Index had total returns of 3.6% in the second quarter of 2011 vs. -0.6% and -0.9% for the NASDAQ Composite and the S&P 500 Index, respectively. This performance has largely carried into the third quarter as well, though some of the sub-groups within the broader REIT universe really standout.
The standout performance in the REIT industry (year to date as of September 9, 2011) was that of the self-storage REITs (a total return of 19.18% as measured by the FTSE NAREIT Equity REIT Index), followed by apartments (16.54%) and regional malls (6.60%). The relatively underperforming sectors were lodging/resorts (-34.89%) and industrial REITs (-17.09%).
A combination of factors has helped the REIT industry stand out. During the crest-to-trough period of 2007 to 2009, REITs took on far less debt than private real estate investors, and many were able to sell at the top of the market when private equity investors were still buying.
Importantly, during the downturn, REITs were able to acquire properties from highly leveraged investors at deeply discounted prices. This enabled them to add premium high-return assets to their portfolios. Furthermore, REITs have been able to raise capital to pay off debt, making them an increasingly attractive investment proposition.
Moving forward, limited supply of new construction, coupled with the increasing demand for high-quality properties, bodes well for future earnings prospects of REITs, especially those which have assets in high barriers-to-entry markets. In terms of earnings, approximately 75% of REITs have reported in line or exceeded expectations during second quarter 2011. For full year 2011, funds from operations (FFO) for the industry are now expected to rise by 14%, up from 12% at the beginning of the year.
OPPORTUNITIES
As “echo boomers” (the children of the Baby Boomer generation) opt to move out on their own and more renters decide to part ways with family and roommates, single-family homeownership rate across the U.S. has witnessed a continuous decline and demand for multifamily rental apartments have surged. With new supply remaining muted until late 2013 or 2014, we expect the multifamily sector to remain comparatively stable in the coming quarters, as renting has emerged as the only viable option for customers who could not get mortgage loans or are unwilling to buy a house at present.
In this environment, we remain bullish on AvalonBay Communities, Inc. (AVB), one of the best-positioned apartment REITs, primarily focused on developing multi-family apartment communities for higher-income clients in high barrier-to-entry regions of the U.S. AvalonBay has Class A assets located in premium markets, such as Washington DC, New York City and San Francisco, where the spread between renting and owning is still high despite home price declines.
In addition, AvalonBay has a reasonably strong balance sheet with moderate near-term debt maturities and adequate liquidity. Consequently, the company can capitalize on potential acquisition opportunities due to distressed selling from owners and developers who cannot refinance their properties, which augurs well for its top-line growth.
We are also bullish on Public Storage (PSA), the largest owner and operator of storage facilities in the U.S. The company has significantly increased the scale and scope of its operations through the acquisition of Shurgard Storage Centers that had a considerable presence in the European markets. Although Public Storage currently owns a 49% stake in Shurgard, the size and scope of its operations have enabled it to achieve economies of scale, thereby generating high operating margins and managerial efficiencies.
The “Public Storage” brand is the most recognized and established name in the self-storage industry with a presence in all the major markets across 38 states in the U.S. In addition, the storage facilities of the company have a high visibility and are usually located in heavily populated areas that improve the local awareness of the brand. This provides a significant upside potential for the company.
Another stock worth mentioning is Taubman Centers Inc. (TCO), which owns, develops and operates regional and super-regional shopping centers throughout the U.S. and Asia. Retail shopping centers spanning over 400,000 square feet of gross leaseable area (GLA) are generally referred to as “regional” shopping centers, while those centers having in excess of 800,000 square feet of GLA are generally referred to as “super-regional” shopping centers.
Taubman focuses on dominant retail malls that command the highest average sales productivity in the U.S., measured in terms of mall tenants’ average sales per square foot. On a trailing 12-month basis, mall tenant sales were $600 per square foot during second quarter 2011 — a unique record for the company as well as the U.S. public regional mall portfolios.
In addition, a large number of these shopping centers are strategically located in the most affluent regions of the country, which include Los Angeles, San Francisco, Denver, Detroit, Phoenix, Miami, Dallas, Tampa, Orlando and Washington DC. This in turn enables the retailers to target high-end upscale customers and maximize their profitability.
WEAKNESSES
A significant chunk of REITs are raising capital through property level debt and equity offerings. Although both debt and equity financings provide the much-needed cash infusion, they could potentially burden an already leveraged balance sheet and dilute earnings. Property level debt is also harder to obtain and more expensive as commercial real estate prices remain under pressure.
We are bearish on Host Hotels & Resorts, Inc. (HST), the largest lodging REIT and one of the largest owners of luxury and upper-upscale hotels. The majority of Host Hotels’ properties are concentrated in the luxury and upper-upscale segments, which had been the weakest performing segments during the economic downturn. While the outlook for these markets has improved, the pace of the improvement remains quite uneven and unsteady.
We also remain skeptical about Prologis Inc. (PLD) — the erstwhile AMB Property Corp. that acquires, develops, operates and manages industrial real estate space in North America, Asia and Europe. Although the quarterly results were in line with the company’s expectations and signified a gradual improvement in market fundamentals, macroeconomic issues have contributed to a slower pace of recovery.
The credit crunch has also widened the bid-ask spread between buyers and sellers of commercial real estate, which has caused deal volumes to fall comparatively. In addition, market vacancy increases will mitigate Prologis’ ability to push through rental rate increases. This has significantly affected the long-term growth of the company.
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