01/08/2014 | by
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Further strengthening of the economy is expected to boost REIT earnings over the coming year,  while strong balance sheets will allow companies to react if attractive buying opportunities arise, according to industry observers.

The FTSE NAREIT All REIT Index posted a 3.2 percent total return in 2013, compared with a 32.4 percent return for the S&P 500 Index.  Interest rate concerns, the federal government shutdown and budget cuts imposed by sequestration were among the major factors offsetting improving real estate fundamentals.

“We continue to see good news about the economy,” said Calvin Schnure, NAREIT’s vice president of research and industry information.  Schnure pointed to four main influences currently bolstering the economy: a stronger consumer, a reduced role for government, a firmer housing market and steady job growth.

“Consumers are much more ready to go than they were three years ago, when a few small bumps were able to derail the recovery for another year or two,” Schnure said. Furthermore, the economy will not suffer the huge negative impact from budget cuts, Schnure noted, which “clears the way for a good private sector-led recovery going forward.”

The housing market, he added, has not only stabilized, but shown solid signs of improvement.

“We’re seeing a lot more demand for housing, which is going to have ramifications for the overall economy,” Schnure said.

The Federal Reserve, meanwhile, is unlikely to raise policy rates in the near future, Schnure noted.

“That means we have a very favorable interest rate environment for the overall economy,” he said. “This is still stimulus—it’s going from massive stimulus to normal stimulus.”

Brad Case, NAREIT’s senior vice president for research and industry information, added that while the Fed is unlikely to raise policy rates anytime soon, it will allow market rates to rise. However, that’s not necessarily a bad prospect for REITs in his view.

“I believe interest rates are going to increase, but they’re going to increase because the economy continues to strengthen,” Case said. In turn, earnings will head higher, he noted, with strong growth in funds from operations (FFO) likely.

Optimism for Apartment, Retail Sectors

Which sectors are most likely to benefit from the operating environment? Case pointed out that apartment and retail mall REITs have been among the weakest performers recently; both segments could see improvement.

“There’s a lot of unmet demand for rental housing,” Case said. At the same time, “we’re seeing signs of increasing consumer spending,” he noted.

Schnure offered similar sentiments regarding the market for rental housing.

“The really fundamental driver here is that there’s huge unmet demand,” he said. “There are several million potential households that didn’t form. As the job market improves, there’s no reason why you can’t have stronger rental and stronger housing markets.”

Schnure and Case both said they expect to see gains in traditional REIT sectors, which are tightly tied to the economy and job growth, as well as some of the newer REIT segments. They explained that the newer REIT sectors, such as data centers and health care,  are driven more by structural and demographic shifts, rather than economic cycles.

Positive Credit Environment to Continue

REITs will also continue to benefit from a positive credit environment, according to Case. The industry raised substantial  amounts of capital in 2013. According to SNL Real Estate, U.S. equity REITs raised $65.5 billion in 2013.

However, Case did question the idea that REITs would be as active in the capital markets this year. He explained that REITs were the most active acquirers when property values were low, but prices have now started to recover.

“Going forward, there are going to be other investors and investment managers more active in property markets, so that may cool down REIT demand for capital, both debt and equity,” Case said. Likewise, initial public offering (IPO) activity may not be as lively in 2014 compared to last year.

“If the acquisitions market isn’t as favorable, there may be fewer IPOs going forward,” Case said.

In the meantime, REIT balance sheets look solid to Case.

“REITs have brought down their leverage dramatically,” he said. “To the extent that there are good acquisitions to be made, they are able to raise the capital for that.”

Schnure added that the success of the REIT approach to commercial real estate investment relies in large part on companies having conservative balance sheets so that they can access public capital when opportunities arise. “Right now, they do have the solid balance sheets,” he emphasized.