Published in the January/February 2014 issue of REIT magazine.
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.
Meanwhile, expectations for initial public offerings (IPOs) were sanguine, thanks in part to high-profile deals last year such as Brixmor Property Group Inc. (NYSE: BRX) and Empire State Realty Trust (NYSE: ESRT). With mergers and acquisitions, volume should be steady, but perhaps more active in the triple net lease sector thanks to the agreement by American Realty Capital Properties Inc. (NYSE: ARCP) to acquire Cole Real Estate Investments Inc. (NYSE: COLE).
To wrap the roundtable, analysts commented what they want to see more of from management.
REIT: What are some macroeconomic factors that you watch with regard to property valuations and REIT prices?
Smotrich: Economic growth is far and away the most critical macro driver, in particular job growth. It also depends on the property type. For example, in multifamily, we are looking at demographics and employment growth, and the tradeoff between for-sale and rental housing. In the mall space, it’s consumer spending and retail sales.
Adornato: Private sector job growth. A pickup in job growth would have the largest positive impact on many different sectors of real estate demand. On the industrial side, we look for imports and exports into the U.S. That tends to be a driver as well as GDP.
Sakwa: Job growth is the main driver. At the end of the day, you need either wage growth or more people working.
REIT: What economic factors point to a favorable outlook for REITs?
McGrath: Certainly the supply-and-demand dynamics. Supply has remained more in check, and certainly as a percent of inventory. Over the next three-plus years, if you have a recovering economy with the backdrop of very controlled supply, there are markets where you can see rental growth be much stronger.
“Over the next three-plus years, if you have a recovering economy with the backdrop of very controlled supply, there are markets where you can see rental growth be much stronger.”
Moore: Supply is extremely good. New supply is not an issue for the most part, with the exception of a couple of sectors. So you don’t need the kind of robust economy that you might in a more typical environment where there’s a lot of building going on.
REIT: On a macroeconomic scale, what worries you?
McGrath: Volatility and gridlock in Washington have certainly been a negative on growth. Also, if the outlook for jobs moves downward, that would worry us.
Smotrich: The biggest concern is the extent the economy begins to slow down and the potential for job growth to turn negative. Also, in the short term, it’s the political divisiveness on all levels of government – it feels like the policymaking apparatus is really frozen by virtue of partisan politics.
Moore: There is not much positive data among the numbers we look at, which include GDP, employment, travel statistics and consumer spending. There is a bit of pause in consumers’ and business leaders’ minds as to where they head next, and that plays somewhat negatively for commercial real estate.
Sakwa: We have had very easy and accommodative monetary policy for several years. It would appear the Fed is at the end of the rope on quantitative easing. The timing is uncertain. A sharp back-up in rates would cast a pall over the REIT space.
Adornato: The capital markets are a little bit less certain than they have been, at least in terms of cost of capital. For REITs, cost of capital is increasing in both debt and equity. So we are worried about companies that need to access the capital markets extensively in order to carry out their business plans.
REIT: What REIT sectors do you favor for 2014?
Smotrich: We like multifamily and the retail space, particularly malls. These sectors will put up the best earnings growth consistently over the next couple of years. Their performance has been driven by a basic misperception on the part of broader investor constituencies.
Moore: Retail looks very good, with malls and community centers continuing to show very good organic growth. Triple net lease has a lot of acquisition activity and a lot more product that can be bought. The office space has begun to pick up, though central business districts are better than suburban. And with any kind of economic improvement, the industrial space will also be pretty strong.
Adornato: We expect continued strong operating fundamentals in self-storage, although at a slower growth rate. Industrial is another positive: We have seen steadily increasing occupancies, but have had minimal or negative rent growth. We expect that to turn positive in 2014. Regional malls might also be at an inflection point.
Sakwa: Despite some headwinds, the mall business still looks very strong, given the demand for space from high-quality retailers, with operators gaining pricing power. There’s very little space available. The industrial sector clearly has turned the corner and should continue to improve. Strip centers still have another year of recovery under their belt. Apartments are still good, but slowing.
McGrath: Rather than an overweight-underweight sector strategy, we view it more as stock picking within the sectors. There are still opportunities to outperform in the mid- and small-cap REITs. That was the story last year. We think market conditions for industrial are still generally pretty positive. The secondary markets in the industrial sector are probably poised to have better rental rate growth because they don’t have a lot of construction.
REIT: What sectors are you underweighting or might look to underweight?
Sakwa: Storage will be good, but the stocks at this point seem to be more on the expensive side. We are cautious on the apartment space until we see more stabilization of the net operating income (NOI) streams into next year. Another sector is one we don’t follow: the freestanding triple net lease retail owners.
Moore: Storage is one of the fast growers that may have had its day. Apartments have had a tough period, although I think their fundamentals will continue to lag a bit. In the retail space, the malls still continue to be the weakest from a stock standpoint.
McGrath: Self-storage might be poised for a breather after four years of outperformance. Not that things are going to slow down any, but trees don’t grow to the sky.
Adornato: It’s hard to get too excited about suburban office. It has had trouble showing any sort of growth. On the plus side, there has been virtually no new construction. For contrarian value investors, it might make sense to start sniffing around.
“REITs have done a very good job over the last few years taking advantage of restructuring their balance sheets.”
Smotrich: We remain concerned about some of the office markets around the country, particularly in the suburban markets, which is not necessarily new news. But relative to some of the other property types, that is one we would be shying away from.
What considerations should investors keep in mind, given the long-term interest rate volatility of 2013?
REIT: What considerations should investors keep in mind, given the long-term interest rate volatility of 2013?
McGrath: Those property sectors where you can mark the rents up more quickly give you better protection in a rising rate environment. It’s no surprise that hotels have done well. Industrial has also done well. Its leases are not as short term, but they are definitely a sector more leveraged to an economic recovery.
Adornato: Sectors most likely to be exposed to interest rates are net lease and health care. Both of these sectors have structures that remove a lot of the real estate operating risk from the equation and, therefore, tend to be more sensitive to rates.
Sakwa: Look for companies with very good strong organic internal growth. These are maybe less sensitive to movement in rates since they don’t have to rely on acquisitions for growth.
Smotrich: You are seeing historically low levels of supply, so on the REIT level the dividends might be worth a little bit less when rates rise, but I do believe you will be able to make it up on a total-return basis through better earnings growth.
REIT: What’s your outlook for mergers and acquisitions?
Adornato: We expect to see some activity as always. In the shopping-center space, there is a long list of smaller companies, with only a few larger companies. This could set the stage for some additional M&A activity. The net lease sector also has some momentum.
McGrath: While the ARCP-Cole deal is only one transaction, I do think it sets the stage for a modest pickup in M&A. Net lease is well set up for that because it is an acquisition-driven sector. I don’t think bigger is necessarily better, but there are instances where it can lower the cost of capital. So the spread investing sector of net lease having a lower cost of capital is a positive.
Moore: I don’t think you will see many REITs being purchased. Most REITs have made it through the tough times, so the current management is less likely to want to sell.
Sakwa: I don’t see a big rash of M&A taking place this year. M&A hasn’t made a tremendous amount of economic sense, in that most of the costs of the companies are probably property-level expenditures. Merging two companies doesn’t really save a lot at that level. You are still paying insurance, taxes, salaries and utilities.
REIT: And IPOs?
Sakwa: The IPOs will come. We had deals such as Brixmor and Empire State. Some conversions could happen. But I can’t imagine that there are too many companies that are so compelling that the market can’t already get those assets today.
Moore: IPOs had a period where they became much less frequent after the recession, and I think that will get back to a more normalized state where you see a good number of them. There is still a lot of real estate that is not in the public domain.
McGrath: IPOs traded pretty well last year, and you have had these non-listed REITs start trading and then get taken out. It shines a light on opportunities, those that might not be the big bellwether names.
REIT: How does the debt picture look with respect to leverage and maturity schedules?
Smotrich: On average, REITs are relatively well positioned. Leverage levels have come down and maturity schedules have been pushed out. Companies are in good shape.
Adornato: REITs have done a very good job over the last few years taking advantage of restructuring their balance sheets. This is definitely a lesson learned coming out of the recession.
Moore: The price REITs are paying for the debt has gotten a lot cheaper than it has been. Many have taken the steps to go for an investment-grade rating and do unsecured bonds.
Sakwa: We’ll probably see further deleveraging from some companies due to organic growth. Companies are also willing to take a little bit more pain now and do seven- to 10-year bonds for an extra three to five years of term in order to extend the maturity.
REIT: What is something you would like to see more of from management in 2014?
Moore: At this point, it is how they define and articulate their growth platform. The balance sheets have been cleaned up. You have to have a platform of acquisition, development or redevelopment, something that says “I am going to grow faster than my peers.”
McGrath: Focus on the extension of debt maturities. We’ll see many REIT management teams try to do 10-year debt. Beyond 2015, if we are going to be in a place of economic recovery, rates have to go higher.
Smotrich: In this kind of environment where fundamentals are good and stocks have not performed all that incredibly well, a real tendency is to hunker down and ride it out. I think, though, that the better-quality management teams will try to look forward in a prescient way, anticipate how the world is changing and take the appropriate risks for future growth.
Adornato: There are still some improvements that can be made in terms of disclosure. Almost every REIT now has a supplemental package, but in some cases it is getting to 50 to 70 pages in length. When it gets to be that much, we need more intelligent supplemental information.