Analysts offer their assessments of Equity REITs at the start of a new year.
2/1/2016 | By Charles Keenan
REIT magazine: January/February 2016
Building on a year in which REITs outpaced the S&P 500, albeit with a modest total return, things are looking fairly sanguine for the industry in 2016, according to recent interviews with analysts.
Supply remains tight in most sectors, while rent growth will be buoyed by steady demand. Meanwhile, new capital remains poised to flow into publicly-traded real estate, with the debut of a headline Global Industry Classification Standard (GICS) sector for real estate in August 2016 that will be made up primarily of stock exchange-listed Equity REITs.
That said, there are some worries, as questions abound with respect to interest rates on 10-year Treasury bonds may continue the marketand how their gyrations may effect REIT stock prices. Property valuations might peak, too. There’s also concern about the world’s economy and a tech-industry retrenchment, both of which would have a ripple effect for real estate.
Among asset classes, multifamily, storage and industrial REITs look strongest. More privatizations are likely, fueled by plentiful capital and REITs trading at a discount to net asset value (NAV).
REIT: What’s your general outlook for 2016 and why?
Haendel St. Juste: We see an economy that is steadily improving: We have GDP growth, household formations, a number of favorable tailwinds that are supportive to real estate broadly and you see it in the fundamentals.
You have a significant amount of capital pursuing real estate assets in a world thirsty for yield. There are really not a lot of compelling alternatives. People are attracted to the U.S. real estate market and the implied safety of it.
Jeff Donnelly: We’re optimistic on 2016 performance. Earnings growth will likely remain fairly resilient. It seems that there is more concern about rates and money flows than there actually is.
Since the underlying real estate doesn’t seem like it’s eroding, it seems like [REITs] could be positioned to outperform the S&P 500 once again.
Ross Smotrich: It’s mixed. On the fundamental side, you are seeing relatively disciplined supply and growing demand across all property types as the economy continues to grow, albeit modestly. The capital markets are wide open.
Yet, on the technical side, we have concerns about interest rates and a global macroeconomic slowdown that will continue to overhang the group as we go into next year. You also need the generalist investors—those who don’t have to own REITs—to come back in order for the group to perform well.
Cedrik Lachance: From an operating perspective, most property sectors are in the favorable part of the cycle, although we seem to be in the sixth inning. Near-term supply is close to demand—and in some cases well below it—fostering a positive environment that should result in modest occupancy gains in 2016.
More importantly, market rents should experience continued solid growth, but 2016 could be the peak in growth rates for this cycle.
When you talk about cash flow net operating income (NOI) growth, you are going to see about 4 percent on average in 2016, in line with what we had last year.
Steve Sakwa: I think it’s mixed. Fundamentals are good. Rates are a headwind to the space right now. That tug of war is a challenging one.
The picture of business and job growth are supportive of NOI growth still being healthy for many companies in 2016. It’s really a question of what kind of P/E do you put on the “E” of the companies. It’s less about the earnings and more about the right multiple and cap rate as debt costs begin to go up.
REIT: What are your thoughts on interest rates?
Donnelly: The question is whether interest rates will rise as much as everyone thinks. We are hard pressed to see how you are going to see these really pronounced increases in the 10-year Treasury. Inflation is what historically drives rates higher, coming from increased demand. You are not seeing it from emerging markets, or in the U.S.
Low rates and tepid economic growth rates make for kind of a sweet spot for REITs.
Sakwa: With short-term rates, the question is how many hikes will the Fed have in 2016. To the extent the data continues down a reasonable path of improvement, there could be several more hikes.
For our models on the 10-year, we use 3.25 percent when looking at discounted cash flows. It’s not always where the number goes, but where people think the number will go. That’s probably more important than the actual result.
St. Juste: Rate fears have weighed unfairly on REIT valuations and performance. The stocks have traded at times near double-digit discounts to NAV, versus a 5 percent historical premium. Yet, our analysis shows a correlation of 82 percent between 12-month forward-looking REIT returns and same-store NOI growth, compared with a correlation in the low single digits between forward returns and rate movements.
Smotrich: I’m not convinced rates will move materially, but a 50 to 100 basis-point increase in rates is already priced into asset values and into stocks. The reality is that rising rates won’t hurt earnings that much.
What I worry about more than a rise in rates is a flatter yield curve, which historically has been a predictor of muted real estate returns.
REIT: What sectors look best?
Sakwa: Storage and multifamily are well positioned. Storage still has limited supply, and improving house and job markets, which are all positive drivers, so storage should still have very good pricing power.
Same thing for apartments. You’ve got a housing market that is improving, but not nearly as robust as it was, with people still generally wanting to rent.
St. Juste: Apartments and industrials, where there is very favorable landlord pricing power.
With apartments, you have very favorable renter tailwinds, declining homeownership rate, demographic shifts, the economic improvement, household formations—things that are working in favor for apartment landlords—against what is still a manageable supply level.
On the industrial side, the growing economy, e-commerce tailwinds and an improving housing market mean more goods flowing through warehouses. There’s a favorable mark-to-market embedded rent growth in leases and a limited supply backdrop.
Lachance: Sector picking is a tough task. We prefer to think about sectors that can outperform in the long run, such as self-storage, manufactured housing, apartments and high-end malls, rather than handicapping the short run. All four of them tend to have low to reasonable capital expenditure burdens, something which is also underappreciated by the public markets. That results in outperformance of the sectors in the long term.
Donnelly: The fundamentals continue to look very good for apartments. The U.S. is moving more toward a renter society. That trend will persist.
We also like shopping centers and malls. As a contrarian pick, health care might attract interest at the fringes as something that would be more resilient in a downturn.
Smotrich: Our top sector now is industrial. It’s driven by global trade and supply-chain logistics, and the sector has a very healthy supply-and-demand balance. We also like the class-A mall space. Both sectors will be very sustainable into 2016.
REIT: What sectors look vulnerable?
Lachance: Hotels have had challenging operating results, as they have been faced with localized oversupply and a real reduction in tourism arrivals. But the pricing of hotel REIT stocks is reasonable.
Smotrich: We’re mixed on office, but it’s market specific, city by city. We prefer urban over suburban and class-A over class-B. In the mall space, class-B also concerns us a little.
Sakwa: Health care REITs are certainly vulnerable. They have too much supply in the assisted-living parts of their business. They are more dependent on external acquisitions for their growth. With their stock prices coming down, it’s a little bit harder for them to find deals. They don’t really develop, and it’s harder for them to sell assets than it is for other REITs such as multifamily.
REIT: What are you most excited about for REITs in 2016?
Smotrich: You are going to see some social and demographic trends impact how we look and value commercial real estate. There is a very clear trend toward urbanization, a clear demographic shift among the millennials in how they want to live and work.
All of that is really just in the early stages of being recognized. People talk about it a lot, but you are going to start to see it manifest itself in 2016.
St. Juste: We see the inflow of capital providing a good supportive backdrop for asset values and NAVs. The wildcard tailwinds include having above-average trend growth, the likelihood of M&A activity and stock exchange-listed Equity REITs getting their own headline GICS designation in August.
REIT: What concerns do you have?
Lachance: It is now a good betting line that property prices will decline slightly over the next 12 months. Since 2009, real estate values have looked attractive when compared with corporate bonds. But that relationship reversed in 2015, with the ballooning spreads of corporate bonds over comparable Treasuries.
Given the clear relationship of bond and real estate prices, the value of real estate relative to the rest of the capital markets will eventually return to historical norms, which could result in lower commercial real estate values.
Sakwa: REITs may put up good rent growth, NOI growth, and good yields, but their stocks don’t go up. There’s a disconnect, where performance and stock prices don’t always align.
St. Juste: Exogenous factors, such as geopolitical ones. What knucklehead with an arsenal of weapons is going to start a dispute in a far outpost of the world? We also have concerns around tech in San Francisco, if that were to derail the uber-growth story we have seen the last couple of years.
Donnelly: A stronger than expected decline in the technology industry, the impact that can have on job formation. Not just San Francisco, but all the other markets, such as Denver, [Northern Virginia] and Austin.
REIT: What are your expectations for M&A?
Smotrich: There is a huge amount of capital looking for deals, but it is not going to be the wave that people predict. If the past is any guide, transactions are more often driven by cultural, rather than pure corporate finance, considerations.
Lachance: We expect a healthy pace of go-private transactions since REIT share prices remain below the private valuation of assets in most sectors.
Sakwa: There will be more deals if there’s a disconnect between property valuations and stock prices. You’ll need management to agree to it, but I think there are companies that will sell, and you will see more privatizations than public-to-public deals.
St. Juste: The setup is almost too good. Stocks are trading at a discount to NAV, and there’s a ton of capital out there, low borrowing rates, good cash flow growth, and good, fundamental organic growth.
Donnelly: You really have the ingredients for privatization. REIT valuations have been choppy, and capital flows into private equity continue to be robust. All the major providers of debt such as banks, insurance companies and pensions are looking for yield, and it’s very hard to find it in a low-interest environment.
REIT: What would you want to see more of from management in 2016?
Donnelly: Ensure they keep their compensation reasonable in people’s eyes, thinking about it not just relative to themselves, but to other like real estate enterprises.
Sakwa: There are corporate governance measures that some companies could adopt, such as eliminating staggered boards, opting out of the MUTA (Maryland Unsolicited Takeover Act) and having more alignment of executive compensation to performance.
St. Juste: More stock buybacks. A lot of companies complain about how cheap their stock prices are, but they don’t do anything about it. Also, more clarity on succession plans at companies with seasoned management teams.
Smotrich: We like to see acute focus on excellence in whatever a REIT’s core competency is, whether it’s urban development, acquisitions or redevelopment.
The management [teams] we like are the ones that have developed a competitive advantage, a core competency in some way that creates incremental growth.
Lachance: With REITs trading at a discount to NAV, most companies would be better off being net sellers. Management teams that have the best ability to recognize that their cost of capital has changed—and to take advantage of the new dynamics—will be rewarded in 2016.
A simple look at the 2015 returns for Equity Commonwealth (NYSE: EQC), which dramatically shrunk its portfolio, should push others to follow suit.
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