01/09/2015 | by
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Although unlikely to match the returns of 2014, positive fundamentals have REITs in position to sustain a solid performance in 2015, according to market observers.

The FTSE NAREIT All REITs Index had a total return of 27.2 percent for 2014, compared to a return of 13.7 percent for the S&P 500 Index.

“It was a pretty sensational year for REITs,” said Rich Moore, managing director at RBC Capital Markets. “Going forward, you’re going to have a positive year on the fundamentals side, no question about it.”

Morningstar senior analyst Todd Lukasik said the slow and steady economic recovery has been positive for commercial real estate. “Demand is slowly building for commercial space without the overconfidence that leads to excessive supply,” he said.

Michael Bilerman, managing director at Citi Research, noted that he expects REIT returns in 2015 to be supported by strong capital flows to United States’ real estate from investors around the world. Other factors supporting REITs in 2015, according to Bilerman, include low interest rates, strong corporate balance sheets and attractive dividend yields.

Matt Werner, portfolio manager at Chilton Capital Management, echoed Bilerman's sentiments about demand from overseas investors. Additionally, increased allocations to real estate and public REITs by pension funds put downward pressure on capitalization rates in 2014, according to Werner. “We see this trend continuing in 2015 and providing an anchor to cap rates, even in the face of rising interest rates.”

High Valuations

While analysts anticipate continued buoyancy for the REIT market in 2015, some also expressed unease with the current level of REIT share prices. Additionally, even though interest rates should remain relatively low, valuations could exacerbate the negative impact of an interest rate hike on the REIT market.

Current REIT share prices are about 15 percent above fair-value estimates, according to Lukasik.

“Last year, we thought things were a little bit pricey. Now we think they are a bit more pricey,” he said. “Even though the stocks had a great run last year, our expectation is that they’re probably not going to be doing as well this year.”

If interest rates head higher in 2015, REIT valuations will suffer, Lukasik said.

“If rates rise, we would view that as a valuation headwind, and I think it would be a really tough year for REITs in terms of total shareholder returns if that’s the case,” Lukasik observed.

Brad Case, senior vice president at NAREIT, countered that improvements in rent growth and occupancy might counter any effect of rising interest rates.  “What we’ve seen historically is that REITs have more often had strong positive returns than weak or negative returns when interest rates are going up,” Case noted.  “That’s because interest rates normally increase in response to strength in macro fundamentals, which drives increased net operating income, higher property values, and dividend growth.”

Case also pointed out that according to the latest estimate from real estate research firm Green Street Advisors, the industry-average REIT stock price premium to net asset value stands at just 3 percent, only slightly above the 2.2 percent long-run average.

Development Momentum in 2015

Meanwhile, analysts expect REITs to continue to find external growth opportunities through development and redevelopment.

“Going forward, you have a much greater emphasis on taking the core property and making it better. Development is really starting to pick up, and most REIT balance sheets are strong enough to allow them to do redevelopment,” Moore said.

And while high price tags have made acquisitions a challenge for most REITs, Moore said he believes opportunities will emerge in 2015 as a result of the large number of maturing commercial mortgage-backed securities (CMBS).

“There’s so much stuff coming due that I think REITs will be able to find some nuggets within the CMBS debt maturity pool, and they’ll be able to make some good acquisitions,” Moore said. “I don’t think acquisitions are the next wave, but they have been left for dead because they are too pricey. I think the CMBS maturities will keep that alive.”

Oil Prices Declining

As analysts formulate their 2015 forecasts, a new factor in the mix is the change in oil prices.

“Oil’s freefall has left commercial real estate investors scrambling to identify which sectors and geographies will be ‘winners’ and which will be ‘losers,’” Green Street wrote in a recent report. The firm noted that Houston has already seen higher cap rates and lower prices across all property sectors compared with a month ago.

Bilerman pointed out that while lower oil prices may boost disposable income, the energy sector, in general, has been a boon for employment.

Green Street noted that the impact to property values could expand beyond energy markets if sovereign wealth funds, many of which are funded by oil revenues, begin to dial back their U.S. real estate investment.