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Catch You on the Upside

03/28/2014 | By Charles Keenan

Published March/April 2014

When it comes to outlook for REITs, recent interviews with analysts revealed an optimistic regarding 2014. While job growth and gross domestic product numbers could be better, tight supply in most sectors means the economy need not be going gangbusters to offer reasonable total returns in REIT stocks.

That said, worries persist about the potential for the Federal Reserve’s tapering of its easy monetary policy, which would likely lead to a rise in interest rates and cost of capital. Analysts interviewed by REIT magazine also cited political gridlock as a concern.

At the sector level, all agreed that industrial REITs would benefit from a continued economic recovery, but opinions were more mixed for groups like multifamily, malls, and self-storage. Suburban office was mentioned most often as an asset class to potentially underweight.

The year 2013 was a mixed bag for REITs.
 
Total returns for the FTSE NAREIT All REIT Index rose for a fifth straight year. Yet, the index’s fall from record highs in May showed that even a hint of Fed “tapering” and rising interest rates could spook the markets.
 
How should investors navigate the current environment?
 
REIT magazine recently talked with portfolio managers of top-performing funds of 2013 for some insight. How did these managers outperform peers in a rocky year, and what looks promising in 2014? Chief among their concerns is how investors will respond to changes in the level of long-term interest rates in 2014. In addition , the managers said the direction of the economy and core real estate fundamentals will have an impact on the pricing of real estate securities.

REIT: How would you describe your investment philosophy and strategy?

THOMAS BOHJALIAN: We have a core portfolio that makes up a majority of the fund, and we make opportunistic investments in
real estate-related securities and fixed income. We also in some cases use overlays of covered-call options on the stocks we hold, where we think we can generate extra income.
 
MARK SNYDERMAN: I’m looking to provide a combination of a good income and total return to the shareholders. We don’t hold more than 50 percent common stock, and also significantly invest in securities such as preferred (stocks), bonds, commercial mort- gage-backed securities and convertibles.
 
JOEL BEAM: We’ve always been value oriented across our REIT and infrastructure investments. Lately I’ve tried to capture Select Income Fund’s modus operandi with the phrase “income in the context of total return.”
 
JAMES MURRAY: We are looking to invest in the best REITs with the best management teams. We invest in core names such as Simon Property Group Inc. (NYSE: SPG) and Boston Properties Inc. (NYSE: BXP). We will vary the amount based on where they trade to net asset value. We like companies with a track record, not only in running the company, but also in the public markets.
 
EDWARD  TURVILLE: Our focus is trying to buy really good real estate at a value that is usually below what we think private market values are for that portfolio. Every day we look for mispricing and there is not a particular focus on sector or property type. We also look for mispriced securities up the capital stack such as preferreds, and we buy debt through mortgage REITs.

REIT: What  were  some of the underlying  factors of your fund’s solid performance in 2013?

TURVILLE: The groundwork was laid after the big decline of REIT stocks in 2011. We built up positions over 2012 of mispriced stocks of companies below the top tier of public real estate. A lot of that mispricing got corrected in 2013. Mid-year we saw some elevated pricing, with internal rates of return shrinking, so we built up cash.
 
BEAM: We were disciplined about backing away from the table when yields on preferred stocks and bonds got too low. We were also disci- plined with our strategic goal of raising common stock exposure in
the portfolio. Earlier in the year, we had a very cautious attitude about our incremental investment opportunities. But when the right pricing came into our sights, we didn’t hesitate to put capital to work.
 
BOHJALIAN: We owned assets that benefited from a strengthening of the economy; they tended to be more growth-oriented companies. Hotels were a big positive.
 
SNYDERMAN: In each asset category, we outperformed the indexes. While interest rates went up, we kept the duration of our bond-like investments short. We also took intelligent credit risk, so we didn’t have a lot of long bonds trading tight to the curve where there isn’t the potential for capital appreciation. We also invested in floating-rate instruments: commercial-mortgage backed securities and bonds that pay based on LIBOR.

REIT: What  does the rest of 2014 and beyond look like  for REITs and publicly traded real estate companies?

SNYDERMAN: REITs will do better relative to the S&P 500 than they did in 2013. We are not creating too much supply, so cash flows to owners will continue to grow modestly. The harder part is predicting what multiple the market will want to pay for those cash flows.
 
TURVILLE: We do focus a lot on where we are in a longer-term real estate cycle. We think we’re in the early to mid-cycle where you have passed the recovery period. The low-hanging fruit that’s available during that type of period is pretty much gone.
 
MURRAY: This is the first time in a while that a good number of REITs are trading at an attractive valuation, even below NAV. We should see a 5 percent to 10 percent total return for REITs this year.
 
BOHJALIAN: We see external growth by acquisitions more muted this year, either because the opportunity set has diminished or because companies’ equity has rebased from 2013 highs that we saw last May. There will be more focus on internal growth, particularly with larger companies. The recovery is in full force across all prop- erty types, but the velocity and degree to which they are recovering varies quite dramatically.
 
BEAM: Property in general retains its character as a brilliant long- term investment. I think we have to brace ourselves, though, in case the sector becomes a source of funds for clients who want to take more risk somewhere else.
 

REIT: What sectors look the most promising?

BOHJALIAN: We like office—more urban and coastal markets, where there is powerful job growth. We like what we are seeing in the retail space, shopping centers in particular—where supply is low, retailer demand is high, and consumers are better off in 2014.
 
SNYDERMAN: I have always liked the net lease businesses because they have low capital expenditures—the tenant pays almost every- thing. Health care REITs are mostly net lease, so those are worth watching, especially since they have gotten a lot cheaper.
 
BEAM: We are emphasizing short lease duration—hotels and apart- ments especially. But we’re also taking some risk in the suburban office space. Many people have a pretty forlorn view of this sector, and the prevalence of that view is worth noting.

REIT: What concerns do you have about the real estate investment market?

MURRAY: What concerns me is how bad an overreaction with the selloff to interest rates would be. What excites me is the opportunity to benefit from that. If we are in the right position, we can hope- fully ride the wave up and outperform in the long term.
 
TURVILLE: My concerns over fundamentals are relatively low. I think that across all property types the economically driven cyclical factors are all quite positive. Market concerns relate more to the level of interest rates and periodic risk off trades.
 
SNYDERMAN: I worry that some companies are excessively focused on getting larger and are issuing stock and other securities too much. I would prefer a focus on creating more value per share rather than pure size of the company.

REIT: What  attributes  do you look for in a company to open a position?

BEAM: We look for companies whose property assets have enduring value and whose management teams provide great protection and enhancement of that value.
 
BOHJALIAN: We look at a company’s NAV relative to its stock price and its going-concern value, which is the value of the real estate and business operations. Then we look for earnings that are accelerating or decelerating and whether there is a positive earnings revision coming. We rank the stocks every night based on those metrics.
 
MURRAY: We use a three-pronged model that calculates price-to- NAV, price-to-AFFO, and discounted cash flow to rank all the companies. It also comes down to a strong management team with a strong balance sheet.
 
TURVILLE: At the very top of an enterprise, we try to make sure that the managers are people we want to be partners with in real estate for a long time. We look at how well they lease, develop and redevelop. Are they very efficient managers? How do they allocate capital, and how flexible is the capital structure?

REIT: What type of an exit strategy do you use?

TURVILLE: We screen the universe into four quartiles, from most attractive to least. When the securities move into the fourth quartile, they are candidates for reducing ownership. Usually the (internal rate of return)—based on the current price—shrinks down to something below 5 percent or even negative. We unwind gradually unless a roach starts crawling out from under the door.
 
MURRAY: If the stock reaches our target price, we either sell it com- pletely or reduce the position and find a better valuation elsewhere. Another reason to sell is from a fundamental perspective, if we believed management changed its focus or strategy.
 
SNYDERMAN: I sell if a stock goes so far above fundamental value that I think it is going to return to some norm, or if a bond has credit tightened all the way to where I thought it would and future return doesn’t look great.
 
BOHJALIAN: If the absolute valuation no longer looks attractive and we think that the shares fully reflect the valuation, then we are going to move on and reallocate that capital to a different opportunity.
 
BEAM: For us to completely exit an investment, it has to be pricing in a return that is too low for us. Or, we might also exit if something has gone wrong with the business or if strategy pivots in a direction we don’t believe in.
 

REIT: What  are your thoughts on interest  rates and how has the uncertainty affected your investing?

TURVILLE: There may now be less uncertainty as to the direction of interest rates as it appears they are normalizing upward. We are trying to underwrite our investments as if the 10-year Treasury ends up in the 3.5-percent to 4-percent range.
 
MURRAY: If interest rates rise slowly for the right reason—due to a strengthening economy—REITs should do relatively well. To gauge the risk of rising rates at the company level, our detailed valuation model takes into account the balance sheet and financial strength.

 

Column/Department: 

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