The U.S. Real Estate Investment Trust (REIT) industry gained its momentum back in the fiscal 2010 third quarter, after lackluster results in the second quarter that was preceded by two strong back-to-back performances in first quarter 2010 and fourth quarter 2009.
The FTSE NAREIT Equity REIT Index reported total returns of 10.9% in the third quarter (as of September 23, 2010), vs. returns of 9.6% and a 9.5% for the Dow Jones Industrials and the S&P 500, respectively. In the second quarter 2010, this Equity REIT Index had produced negative total returns of 3.1%, vs. losses of 12.5% and 10.6% for the S&P 500 and the Dow Jones Industrials, respectively, owing to broader stock-market concerns fueled by the European debt crisis that prompted investors to cut back their holdings.
The upsurge in third quarter results was primarily due to the stabilization of market fundamentals, as well as from low interest rates and government policies, including subsidized mortgage rates, tax credits, increased FHA (Federal Housing Administration) lending and a government-sponsored slow down in distressed liquidations. Investors looking for high dividend yields also favored the REIT sector. The current dividend yield for the FTSE NAREIT Equity REIT Index is 3.8% compared to 2.6% for the 10-year U.S. Treasury Note.
Struggling financial institutions have further contributed to the strong performance of the REIT sector. REITs are comparatively better equipped to raise capital to pay off debt, making them an increasingly attractive investment proposition. In 2009, REITs and REOCs (Real Estate Operating Companies) raised nearly $38 billion in an industry-wide push to recapitalize balance sheets, and over 90 secondary equity offerings were issued in addition to 37 unsecured debt offerings. With gradual stability in the overall industry, sector dynamics and individual companies’ strategies are currently receiving greater attention to capitalize on the future growth potential.
The standout performance in the REIT industry during the third quarter was that of the diversified REITs (a total return of 14.9% as measured by the FTSE NAREIT Equity REIT Index), followed by regional malls (14.4%), apartment REITs (12.8%), residential (12.8%), shopping-center REITs (12.6%), self-storage (12.2%), office (10.8%) and healthcare REITs (10.5%). The relatively underperforming sectors were lodging/resorts (3.6%), specialty (4.6%), and mixed-use REITs (6.0%).
OPPORTUNITIES
Many REITs are still trading at discounts to NAVs (net asset values), traditionally a good “buy” signal. Over the past 7 or so years, REITs had traded near or in excess of NAV. Continued issues in the availability of credit is expected to have a positive effect on commercial real estate down the road, as new office, apartment and retail construction has slowed considerably, which will benefit owners in a couple of years. Many companies that we cover have stopped all-new construction.
With plummeting home prices and reduced access to credit, apartment REITs continue to perform strongly. We expect this sector to remain comparatively stable in the coming quarters, as renting has emerged as the only viable option for customers who could not avail 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 focusing 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 currently bullish on Simon Property Group Inc. (SPG), the largest publicly traded retail real estate company in North America, with assets in almost all retail distribution channels. The geographic and product diversity of the company insulates it from market volatility to a great extent and provides a steady source of income. Furthermore, Simon Property’s international presence gives it a more sustainable long-term growth story than its domestically focused peers.
Another stock worth mentioning is Public Storage (PSA), the largest owner and operator of storage facilities in the U.S. Public Storage 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.
In addition, 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. The storage facilities of the company have 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.
WEAKNESSES
REITs still depend on access to capital to fund growth, and with the credit markets still not fully back to normal, it is difficult to raise money for new developments/acquisitions. In this scenario, most REITs are raising capital through property level debt, dividend reductions 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.
Fundamentals are declining in many suburban office markets as corporate expansion continues to slow. More and more corporations are putting off leasing decisions until the economy recovers fully. Recent employment trends are also not encouraging as the U.S. economy continues to shed jobs.
Given the market uncertainties, we are bearish on AMB Property Corp. (AMB), an industrial REIT that leases industrial facilities to manufacturers, retailers, transportation companies, third-party logistics providers and other enterprises with large-scale distribution needs. The continued troubles in the residential sector are weighing on commercial property operations.
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 dramatically. In addition, market vacancy increases will mitigate AMB’s ability to push through rental rate increases. This has significantly affected the top-line growth of the company.
We would also avoid Host Hotels & Resorts Inc. (HST), the largest lodging real estate investment trust (REIT) in the U.S. The majority of Host Hotels’ properties are concentrated in the luxury and upper-upscale segments, which have been the weakest performing segments during the economic downturn. This has affected the bottom line of the company and has reduced operating margins. The hotel industry is also cyclical in nature, and is heavily dependent on the overall health of the U.S. economy, as well as room supply and demand.
Unfavorable macroeconomic conditions has compelled customers to cut back on discretionary spending, and now prefer lower priced brands over premium ones. Consequently, demand for Host Hotels has reduced comparatively, and the company is under severe stress to maintain profitability. The continuous acquisition spree of Host Hotels also involves significant upfront operating expenses with limited near-term profitability. New hotels usually take time to generate revenues, and will continue to drag down margins until they get established.
AMB PROPERTY CP (AMB): Free Stock Analysis Report
AVALONBAY CMMTY (AVB): Free Stock Analysis Report
HOST HOTEL&RSRT (HST): Free Stock Analysis Report
PUBLIC STORAGE (PSA): Free Stock Analysis Report
SIMON PROPERTY (SPG): Free Stock Analysis Report
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