Real Estate Fund Managers Assess the Outlook for 2016

REIT magazine: March/April 2016

Healthy fundamentals in the REIT sector during 2015 offset concerns about the economy and rising interest rates, and enabled REIT returns to outpace the broader market. The FTSE NAREIT All REITs Index had a total return of 2.3 percent for 2015, compared with 1.4 percent for the S&P 500 Index. 

REIT magazine recently spoke with the portfolio managers of some of 2015’s top-performing real estate mutual funds to discover the opportunities and challenges they see for 2016.

REIT: What factors were you most attuned to as you invested in real estate in 2015?

Thomas Bohjalian: Our focus was on asset classes where the supply-demand imbalance was the greatest and on companies that could still deliver above-average growth in an environment where growth is decelerating to a more moderate level, but one that’s still above the long-term average. 

Steve Buller: It really was bottom-up, individually based stock picking more than anything, and that did lead to some overweight positions in specific sectors such as self-storage and multifamily. To a lesser extent, it was about taking advantage of some of the corporate events that occured, such as privatizations, companies selling off real estate, buying shares back or converting to a REIT. 

Dean Frankel: We were looking closely at risk-taking and leverage. One of the biggest factors at a thematic level that we were very focused on was the impact of technology on real estate. Another important factor was new index entrants, many of which represented different investment models, and we spent a lot of our time understanding their business drivers.

J. Scott Craig: For our fund, which has a high-quality bias, it was a year when everything went right. The stocks of high-quality REITs significantly outperformed in 2015, and we were overweight in the apartment sector and underweight in the hotel sector, both of which worked very well. I’ve been watching for signs of late-cycle frothiness, such as properties trading above replacement cost, undisciplined supply growth and aggressive debt financing. I didn’t see a lot of that in 2015, but I’m starting to see some early signs to worry about in those areas, and that’s something I’ll remain highly focused on in 2016.

Matt Richmond: We favored companies we believed were in the sweet spot of improving employment trends, most notably apartment owners. We also believed the strong pricing power that self-storage owners were enjoying would continue throughout the year.

REIT: How do you see the REIT market performing in 2016?

Richmond: On a relative basis, the group could continue to outperform other asset classes given their more durable near-term earnings growth, attractive dividend profile and discounted valuation levels. We see the current yields on REITs as attractive and safe, with the prospect of another year of dividend growth.

Bohjalian: REITs have performed better than the broader equity market in large part because of the predictable nature of the cash flows. Assuming we’re not going into a recession, which is our view, they should hold up relatively well. 

Frankel: Our outlook calls for moderate growth and moderate rates, and we think this is good for REITs. The U.S. economy is slowing right now, and investors appear concerned about a recession. If the economy picks up steam in the latter part of the year, we could see a nice recovery in some of the core sectors. Lower oil prices should be a tailwind, but have been a headwind so far. China is kind of a wild card right now.

Craig: Commercial real estate prices may be a bit ahead of themselves, and we could see some downside risk in 2016. If that happens, the likelihood of REIT share price underperformance is also relatively high.

REIT: Is interest rate uncertainty still an issue?

Craig: The forward yield curve implies that five years from now, the 10-year rate will still be below 3 percent. That’s a very benign backdrop for real estate. The pace at which the Fed increases short-term interest rates in 2016 should not be a significant driver of REITs one way or another, as long-term rates are much more important for REITs.

Buller: As real estate is a long-term asset class, the cost of long-term funding is paramount. I still think that’s going to be relatively benign, notwithstanding what the Fed does on the short end of the curve.

Richmond: We’re much more focused on the pace of economic and employment growth as the primary driver of real estate returns than we are any modest rise in interest rates from here.

Bohjalian: With the Treasury 10-year back at 2 percent, maybe we can take some of the interest rate hike questions off the table. We think the Fed’s going to take a measured approach.

Frankel: The interest rate environment feels less uncertain right now and we don’t feel that we have to “defend” against rate hikes and higher long-term interest rates. It’sreally hard to imagine what could cause the 10-year to move above 3 percent over the next several years. 

REIT: How is the continued inflow of foreign capital impacting the real estate investment landscape?

Frankel: Recent legislation is a big positive to promote increasing foreign capital. I’d be surprised if we don’t see significant foreign inflows continuing into real estate. 

Craig: Foreign capital continues to be highly focused on a small number of markets, predominantly big markets on the coast. I believe there’s generally a rational relationship between asset pricing in those markets and the rest of the United States, which would imply to me that foreign capital is not significantly distorting asset values.

Bohjalian: We continue to hear that there is more foreign capital that wants U.S. real estate in order to diversify the long-term income stream away from oil. Sovereign wealth funds like the qualities of the real estate asset class. We think there will be a continued bid for high-quality real estate, particularly gateway cities.

Richmond: There is plenty of capital seeking a home in U.S. real estate, not only because the market is relatively stable compared to other parts of the globe, but because it presents a potential safe-haven currency trade with income growth.

Buller: It will still be positive. Recent changes in the Foreign Investment in Real Property Tax Act (FIRPTA) will have a short-, medium- and longer-term impact on capital flows out of foreign entities. At the same time, slightly less will come from the sovereign wealth funds of oil-producing nations, which have been very large purchasers, so there is some offsetting in that.

REIT: What are your views on REIT valuations – are more privatizations likely?

Buller: Generally speaking, I think that REITs still trade at a discount to their real estate value. I do think you’ll continue to see some privatizations in the REIT space. There’s still capital on the sidelines that wants to invest in real estate. One of the ways they can easily put large amounts of capital to work is by privatizing some REITs that trade at a discount.

Bohjalian: Assuming there continues to be a disconnect between public and private market values, we’ll see more mergers and acquisitions (M&A). There are some really, really cheap stocks out there. If you have a longer-term view, there are some great opportunities for private capital to come in and generate a good return for their investors.

Craig: On the merits, we should see a significant number of privatizations in 2016 because many REITs are trading at significant discounts of 10 to 15 percent or more to net asset value (NAV). There’s tons of equity capital on the sidelines, and the debt markets are relatively accommodative. Unfortunately, we won’t see as many deals as we should because most CEOs and boards are not willing sellers.

Frankel: REITs are cheap right now on spot pricing. Foreign capital would be a big potential part of increased privatizations.

Richmond: The steep discounts present today will continue to foster privatization discussions. Hotels certainly seem to be some of the most likely candidates, as do some in the shopping center sector. I doubt we will see privatizations pick up to the level that we saw in 2006 and 2007, but I’m sure there will be more to come in 2016.

REIT: What should REIT management be most focused on in 2016?

Richmond: Continue to focus on creating rock-solid balance sheets to weather the next downturn, whether it’s one or three years away. That, to me, means walking away from the acquisitions table, turning off the development spigot and paying down high-coupon debt. 

Bohjalian: Management needs to ensure their balance sheets remain in great shape. Focus on credit, focus on the management of liabilities, make sure development is properly scaled for the size of the company and where we are in the economic and real estate cycles, and be disciplined about managing external growth.

Buller: If you have traded for an extended period of time at more than a 10 percent discount to net asset value, the board and the management should be potentially exploring ways to maximize shareholder value. That could involve privatizing or selling assets and buying back shares. 

Frankel: Maintaining balance sheet integrity. Continue to sell assets and mind their cost of capital, while paying attention to the markets’ red and green lights. Increase share buybacks if the discounts are excessive. Boards should really be focused on how to create value and not be concerned so much with growth.

Craig: REITs should be building significant balance sheet capacity now, so they can aggressively deploy capital when the next downturn hits. Unfortunately, very few are now doing this. This will end up being a huge missed opportunity for the sector.

REIT: Are you planning to watch any property sectors particularly closely in 2016?

Bohjalian: We’re looking at the hotel stocks that continue to underperform dramatically and at some of the health care names that have underperformed. We like data centers; there’s a very strong secular story occurring there where demand will outstrip supply in the near to medium term. We think there’s still an opportunity in some of the consumer-orientated property types like shopping centers, and we do like the apartment sector. 

Buller: Lodging, given the de-acceleration we saw late last year in the fundamentals and the large discount that it trades at. I think by far that is the one that needs to be watched more closely than others.

Frankel: We think that the impact of technology on real estate is going to be a major influence, and from that perspective, we’re particularly focused on malls, hotels, data centers, industrial, and self-storage. 

Richmond: Rather than specific sectors, we are looking for companies with defensive cash-flow characteristics that also enjoy cost of capital advantages. As a group, data centers have the wind at their back as they benefit from increased adoption of the cloud and the “Internet of Things.”

REIT: Do you see any off-the-radar trends or issues becoming more important for REITs in 2016?

Bohjalian: We’re most focused on are the macro issues and whether there’s a knock-on effect to the U.S. economy or the securities themselves. Credit is extremely important, and so far we haven’t had any real credit issues. But if the cost of capital for REITs moves, that will impact how REITs finance themselves and how investors think about value, so we are focused on that. 

Craig: I believe that new construction in the self-storage segment could end up being higher than many expect, leading to disappointing same-store results for existing properties. Though I understand there are significant barriers to entry, including reluctance of municipalities to grant zoning approvals for self-storage development, I believe that development profits are large enough that developers will find ways to get beyond these barriers.

Buller: Corporate governance. I do think there have been many companies and boards that haven’t always been acting in shareholders’ best interests. That is, if they have traded for an extended time at a discount to their real estate value or have been very much an underperformer versus their peer group, then it’s incumbent upon them to examine that. 

Richmond: Any material decline in availability, or higher pricing of commercial mortgage-backed securities debt, may derail certain companies’ non-core disposition plans. In addition, while on the surface it seems like a long-term positive for the sector, REITs becoming their own GICs sector could introduce periods of instability, as the interest of generalist investment managers waxes and wanes. 

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