Published March/April 2012
2011 proved to be yet another profitable year for REIT investors. The FTSE NAREIT All Equity REITs Index returned 8.28 percent for the year, approximately four times the total returns of the S&P 500. It marked the third-consecutive year that REITs have outpaced the broader markets.
However, many actively managed REIT funds failed to beat the REIT index on the year. Hoping to harness some of their insight, REIT magazine assembled a group of leading fund managers for a roundtable discussion on investing in a choppy economic climate and the keys to staying on top of the market in 2012.
REIT: When all is said and done in 2012, will we look at the year as one where stock pickers ruled? Or, will we view it as a case where REIT investors would have had to work to actually not earn positive returns?
Steve Brown: We continue to believe that there will be material differences in property sector returns and individual stock returns in 2012. Fundamental research and active management will continue to generate hundreds of basis points of alpha for investors. Stock pickers should rule in 2012.
Al Otero: We are confident that stock selection will once again be a primary differentiator of performance for active managers in 2012. Following three years of strong absolute performance and very strong relative performance versus broader equity markets, managers will certainly have to earn their fees in the coming year. Macroeconomic and geopolitical factors will continue to have an impact on the short-term trading of REITs, but in the final analysis, it will be the operating performance of the companies and their success in executing on capital allocation, balance sheet management and operations that will ultimately drive intermediate to longer-term results.
The three-year outperformance of the REIT sector will also cause investors to approach valuation with a much more critical eye than in prior years.
REIT: Fundamental shifts in the housing market have made multifamily REITs one of the industry’s top-performing sectors in recent years. Do you think apartment REITs still have room to run?
Amos Rogers: We don’t expect single-family housing to improve any time soon, so we believe that apartments will continue to benefit from the housing-apartment tradeoff. However, in 2012, apartments will face some stiff competition from other property sectors based primarily on valuation and from a slowing rate of earnings growth. Over the long run, we think the sector can benefit from external growth, including development.
Jay Leupp: There is still room to run in many of the U.S. markets simply due to lack of construction.
Getting back to your first question, by year end, portfolio managers are going to have to be good stock pickers among the multifamily REITs, though. They will have to lighten their exposure where new supply is coming online and overweight their exposure to areas where new supply has yet to come.
Tim Pire: I think multifamily will continue to have good returns. However, I do not think they will dramatically outperform the broader index.
Fundamentals are still strong in this sector, but I think the momentum is changing a bit. A number of factors have driven the sector’s performance in the last two years in a positive way. However, some of the issues which have helped multifamily, such as below historical levels of construction, have started to move off the bottom, causing a little bit of a more of a drag on the growth rate. I see more of a stabilization, not an acceleration, in the growth rate of revenues.
REIT: What are some of the sectors that you’re particularly high on at the moment?
Ritson Ferguson: In the United States, in addition to apartments, we like malls, particularly A-quality property owners, and landlords with high-quality portfolios in select central business district office markets. We also think industrial property owners will do well in 2012.
Globally, we also like Australia and Hong Kong. The high-quality mall owners are a global theme, too.
Leupp: We like the hotel sector right now. We think most of the hotel REITs are trading at meaningful discounts.
Pire: I also think lodging is going to do pretty well. As long as the economy continues to hold up and business people are traveling, I think lodging is going to have another good year in terms of earnings growth. It helps that there’s no new construction in the sector.
I think self storage will continue to do well. The listed companies operating in the storage sector are taking market share. Ten years ago, everybody focused on the yellow pages when they were looking for storage sites. I don’t even know if we have a yellow pages at home today. The public companies can be much more forceful than smaller competitors when someone gets on the Internet and does a search for storage.
Otero: Consensus expectations for the shopping center and office sectors are pretty low going into the new year, and we believe they both have the potential for an upside surprise during 2012. In shopping centers, we would expect retailers to continue a process of selectively opening new units in established, high-quality locations with improving demographics, while closing stores in deteriorating markets. This process will bode well for many of the shopping center REITs we invest with.
The office sector has been suffering from a crisis of confidence on the part of the business community for the better part of three years, even though corporate profits have been strong. With signs that unemployment may be slowly abating and permanent hiring picking up, our high national vacancy rates in the sector may start to dissipate.
Brown: The continued improvement of the U.S. economy bodes well for the lodging sector and the industrial sector. Continued improving demand coupled with historically modest hotel supply growth give this sector an attractive tailwind.
Industrial REITs appear to be in the early stages of a leasing recovery. Continued confidence in the U.S. recovery should allow for increased confidence in industrial REITs meeting or exceeding their leasing goals.
Rogers: We continue to like data center and storage REITs based on both current and long-term growth prospects, particularly in a recovering economy. We also look favorably on hotels despite low GDP forecasts, since we believe that corporate travel will continue to expand, fueled by ongoing business development activity.
REIT: In talking with investors, what attributes of REIT investment do they find most appealing in the current market?
Rogers: Clearly, income is a major factor in investors’ positive attitude toward REITs in the current environment. On a longer-term basis, investors see REITs’ diversification, core orientation and liquidity as a way to play the recovery cycle.
Ferguson: In today’s market, investors are looking for transparency and the prospect of solid returns. In the “new normal,” investors understand that return potential of 8 to 12 percent is attractive, especially if a good bit of it is delivered via dividends. So the growing dividends are also part of the attraction too.
Otero: With memories of the global financial crisis forever engrained in investor psyche, REIT liquidity and access to capital are key attributes which have made “believers” out of a new generation of investors.
Brown: Investors continue to be fixated on current income. Dividends yields of 4 percent or better are an easy conversation starter. We believe as the year progresses and evidence mounts as to the strength of commercial real estate fundamentals, investors will get excited about total return potential.
REIT: Do you think the latest market cycle has changed their attitudes about REIT investment, good or bad?
Leupp: If you look back to the market activity in 2008 and 2009, the REIT sector took a bit of a punch in the face, given the level of leverage that was being used and that there was meaningful refinancing risk. Most REITs got religion quickly and raised equity to fix their balance sheets.
Now, they’re considered the premium owners, investors and borrowers in commercial real estate.
Pire: On the good side, I think REIT liquidity continues to be important. You can always sell your shares. You may not have liked the price, but at the end of the day, you could figure out what those shares were worth.
On the bad side, there was too much leverage in general and definitely too much leverage for some strategies. Some strategies were too complicated and too risky. Several REITs have simplified their story and delivered.
Rogers: On the negative side, some investors were spooked by the volatility in the REIT market, particularly more traditional private investors. However, to the positive, the vast majority of our investors believe that real estate is an important component of their overall portfolio construction. They have welcomed the transparency, diversification and income that REITs provide and are now much more appreciative of REITs’ liquidity, but more sensitive to leverage issues in the sector.
It is clear that REITs still have an important and growing place in institutional portfolios.
REIT: What’s one story or trend in the REIT market that isn’t getting enough attention?
Pire: Dividend growth. REITs grew their dividends by greater than 10 percent in 2011, and 2012 is going to be another strong year. Investors are going to be really surprised by the dividend growth they’re going to get, and it will continue into 2013 if fundamentals hold up.
Brown: We believe the market has not fully acknowledged the full impact of the credit crunch of 2008 to 2010 and its positive implications for commercial real estate fundamentals. With property supply growth expected to be less than 1 percent for most major property sectors, REITs are in an excellent position to deliver rising earnings with modest external activity.
Otero: REIT execution in the debt markets has been very strong over the past year and may be underappreciated by investors.
REIT: Lastly, I’m sure you’ve heard, but there’s a big election coming up in November. In general, how does the political and regulatory climate tend to affect your assessment of REITs? Is it difficult to account for these factors in your investment decisions?
Leupp: It’s difficult to do. What we try to do as investors is scenario analysis as to what the economic outlook is going to be based on which party is in power.
Polling data are very inconclusive today, but I think the one thing we can conclude is that a growth platform is going to be required for candidates for the presidency and the open seats in Congress. A lot of promises will be made this year, and that should translate into bullish sentiment on the part of investors.
Rogers: The elections are certainly entertaining, but we will not give too much consideration to them in our investment process. Regardless of the outcome we are looking, and hoping, for a favorable business climate and initiatives to stimulate job growth and help stabilize capital markets. If we get even a little bit of that, we think the sector will enjoy a tailwind and we can focus on which REITs will benefit the most and when.
Otero: Regardless of which political party controls the White House in 2013, the challenges relating to healthcare reform, bank reform, housing and the budget deficit—to name a few—will remain as real threats to the overall economy for years to come and will continue to have an impact on the trajectory of the recovery in commercial real estate. We try to factor these impediments into our overall thought process, but there is not a direct impact on our stock selection.
Ferguson: All eyes are on the election. In my extensive global travels, it is the favorite topic of conversation, so the audience is global for the November presidential race.
Our focus is on whether the election results are likely to create an environment more conducive to growth of the economy and of jobs. I think it is also critical that Washington demonstrate some resolve to deal with the issues necessary to reduce the deficit and restore debt issues to sustainable levels. The latter is critical to maintaining the fragile investor confidence and market stability.
Allen Kenney is REIT’s managing editor.