Capital Market View from Top Analyst

REIT magazine: March/April 2020

Editor's note: This interview took place in January, before COVID-19 began to impact the U.S. markets. 

With well over two decades of experience in real estate research and investment banking, Citi’s Michael Bilerman has had a front row seat for the REIT sector’s growth in size and scope.

An active member of several real estate associations including The Real Estate Roundtable, where he is co-chairman of the Research Committee and is a cabinet member of Nareit’s Real Estate Investment Advisory Council. Bilerman also sits on the FTSE Nareit U.S. Real Estate Index Series Advisory Committee. He recently spoke with REIT magazine on issues ranging from real estate cap rates and valuations, to the importance of asking difficult questions.

Q: With the stock market on a near-record decade long bull run, how do you feel the REIT sector is positioned today?

REITs will ultimately take their cue from how the economy performs from here as we enter the 11th year of economic expansion. While cycles don’t simply die of old age, there is some heightened risk in 2020 with the U.S. presidential election, unicorn valuations and their growth, further trade negotiations, and the overall geopolitical environment.

These unknown outcomes could lead to potential hesitancy by tenants and different equity market, economic, and interest rate trends. However, outside of these macro factors, REITs are very well-positioned and we see continued positive returns in 2020.

Q: Against those factors, how do REIT valuations look at this point?

The REIT sector’s overall valuation is not extended relative to the broad market or to corporate bonds—positioning the sector well. In fact, given the broad market rally, REITs trade at a discount on a multiple basis. In addition, while REIT implied cap rates are down over the past year, corporate bond yields have actually fallen more than REIT implied cap rates, which makes REITs look more attractive to start 2020 than they did at the start of 2019.

However, there is wide valuation dispersion on a property sector basis with significant “crowding” in a number of sectors and stocks, which could increase volatility. Lastly, while REIT operating fundamentals remain positive today, they will undoubtedly be tied to the overall macro environment and notably have turned negative during recessions.

Q: Which REIT sectors have outperformed according to your analysis, and will they continue on that trajectory?

We are not anticipating a significant reversal in the out and under performers in 2020. In fact, a lot of the fundamental and capital trends that existed to drive the outperformers in 2019 continue to exist today. Within Citi’s REIT model portfolio, we continue to like the industrial, single-family rental, urban/CBD office, data center, and gaming REITs. Out of those sectors, only CBD/urban office was relatively in-line with REITs last year, with the other sectors largely outperforming.

In terms of the rationale, for industrial, there are very strong secular demand trends and private capital has an insatiable desire to put capital to work. For single family rentals, there is a strong demand backdrop with tighter expense controls. For data centers, the stocks offer growth with positive secular trends. Within office, we continue to favor the CBD/urban landlords over suburban, where valuations and growth are less compelling. For the urban/CBD landlords, demand is solid, and while the West Coast has been outperforming, we think New York can continue to catch up.

The gaming REITs benefit from relatively attractive valuations, accretive growth opportunities, and well-covered dividends with premium yields to the REIT group overall. Lastly, while the multifamily sector was broadly in-line with REITs last year, we remain underweight in the group as we see elevated supply and potential deceleration of same store growth against full valuations.

Q: Conversely, which REIT sectors have underperformed recently that could potentially make them a good buy this year?

A lot of the underperforming sectors from last year continue to face secular challenges or supply issues, and we have been reluctant to “call the bottom” simply on valuation. As such, we remain underweight on the malls, self-storage and lodging REITs—which all underperformed last year.

Mall fundamentals remain under pressure from store closings and bankruptcies while there is limited private market activity and companies are needing to invest a lot of capital into assets. Most mall REITs, outside of Simon Property Group (NYSE: SPG), also have higher leverage. Self-storage has challenging fundamentals and the sector will likely face the impact of continued supply. While we believe the lodging REITs could underperform on weak revenue growth and rising expenses, we do favor the lodging c-corps (i.e. - the managers), which have good global growth prospects even in a low RevPAR environment.

The health care REITs also underperformed last year, and while we like the demographic backdrop and trends, we continue to be concerned over senior housing supply and operating margins and are underweight in the sector overall in our model portfolio. That said, we do prefer the medical office building REITs, which have a cost of capital to acquire and grow and also offer some defensive characteristics.

Lastly, the shopping center and net lease REITs sectors were modestly ahead of REIT returns last year, and we moved to a neutral position on both sectors in our model portfolio. The shopping centers should benefit from an occupancy tailwind, which should help to drive continued healthy same store NOI growth for at least the next few quarters. While we continue to see risk in box tenant fallout, we expect the pace to remain manageable for the foreseeable future.

Given our view of a relatively benign interest rate environment in 2020, the net lease stocks benefit from having an attractive cost of capital and healthy external growth pipelines, driving cash flow and dividend growth. That said, valuations are rich, especially on a NAV basis, and core growth is more modest than other sectors.

Q: You and your team at Citi recently took top honors again in the REIT category of Institutional Investor’s annual rankings of the top equity analysts on Wall Street. What do you attribute your winning track record and success to?

First and foremost, it’s the team. We could never achieve the success without the tireless efforts and contributions that our analysts and senior associates make each and every day. As a team, we love working together, challenging each other and supporting each other to deliver thoughtful and insightful independent research and considerable corporate access for our clients, including our flagship Global Property CEO Conference in March.

Our franchise maintains significant breadth and depth of real estate coverage globally with nearly 100 U.S. real estate companies and hundreds of global real estate companies covered at the firm. In addition, our long-tenured team is not afraid to ask difficult questions, be an agent for change, and lead the charge for industry best practices. Lastly, our team benefits from being at Citi—where we have global resources, a dedicated salesforce, and experts in so many different verticals which allow us to provide additional insights and value to our clients.

Q: How would you describe the health of the real estate capital markets?

The capital markets, including debt and equity, are generally wide open, with many different finance options at the company and asset level. Interest rates have come down and debt spreads have narrowed, leading to a huge refinancing wave which has significantly lengthened REIT debt maturity schedules and lowered all-in costs.

In addition, many REITs have seen their share prices rebound, providing them an all-in cost of capital advantage to acquire and grow. At the same time, continued equity issuance or secondaries could add a lot of supply and sap up demand for shares. Given the significant ATM usage, we continue to believe better disclosure is needed.

Q: What are some of the positive factors driving REIT shares today?

Most REIT sectors and stocks benefit from growing and well-covered dividends, stable cash flows from longer lease duration, and significant private capital looking to invest and lend to the space. This should keep cap rates low and supportive of low new supply, which in turn should also help operating fundamentals. REITs also benefit from low leverage, with wide access to low-cost debt and equity capital providing the ability to invest opportunistically and drive future growth.

In fact, both sides of REIT balance sheets are in the best shape they have ever been, with the left side (the assets) benefiting from significant portfolio repositioning over the last decade and the right side (debt and equity) benefiting from de-leveraging and a significant amount of debt refinancing. This has extended durations, lowered rates, and laddered maturities.