07/10/2014 | By Sarah Borchersen-Keto
REIT returns doubled up the broader market during the first half of 2014, helped by low interest rates and muted supply, according to industry observers.
As of July 7, the FTSE NAREIT All REITs Index has had a total return of 16 percent, compared with 8.1 percent for the S&P 500 Index.
“The first half of the year has surprised us a little bit with how strong the REIT performance has been,” said Todd Lukasik, Morningstar senior analyst.
“We can’t help but notice that it also coincides with a meaningful drop in 10-year Treasury yields, which we think is a tailwind for REIT valuations that may or may not be sustainable,” Lukasik added. As of July 7, yields on 10-year Treasury notes were down 0.4 percent.
“REITs, as a defensive investment and a decent yield investment, did very well,” said James Sullivan, managing director at Cowen & Co. “It was a nice, safe place to be.”
Additionally, Lukasik explained that the slow pace of the economic recovery in the United States has kept development from overheating. Meanwhile, demand for existing real estate is growing incrementally, creating a “favorable environment for landlords,” according to Lukasik.
“At this point, other than a few markets and a few property types, people aren’t so bullish that oversupply is becoming a concern,” he said. “As long as that stays in balance, owners of existing assets are probably going to do reasonably well.”
Sullivan said REIT returns at mid-year have exceeded the expectations that many industry watchers set at the beginning of 2014. Sullivan noted that his firm’s forecast anticipated total REIT returns for the year of 10 to 12 percent, which was higher than a number of other forecasts.
He explained that REITs gained a boost during the first half of 2014 in part because the outperformance of the equity market in 2013 caused some investors to fall below their target allocations for REITs by the end of the year. This prompted investors to rotate into real estate and REITs in the first half, Sullivan said.
Apartment REITs Lead the Pack in First Half
Apartment REITs were the strongest performers during the first half. Total returns as of July 7 in the sector stood at 23.8 percent.
“There was increasing comfort in the market that fundamentals in the [apartment] sector were not decelerating as fast as many had feared,” Sullivan said.
Hotel REITs had the strongest second quarter, up 10.5 percent for the three-month period. Total returns in the lodging REIT sector were up 17.6 percent through July 7. Sullivan said the sector’s performance reflects the underlying strength in demand and pricing for the industry and limited supply growth.
“We think hotels are interesting and, from a valuation standpoint, relatively attractively priced, especially if the economy grows at a stronger pace in the second half,” Sullivan observed.
With regard to the second half of the year, Lukasik described current REIT valuations as looking “a little stretched.” He noted that health care REITs offer the best buying opportunity at this point, given that they have been hit the hardest since the Federal Reserve indicated a change in policy on quantitative easing.
Meanwhile, Sullivan said he expects economic data to put upward pressure on interest rates. In turn, this will cause the defensive appeal of REITs to soften, thereby narrowing the performance gap between REITs and the broader market, according to Sullivan.