REIT Analysts Offer Insight on Interest Rates and Tax Reform

Amidst a wave of market volatility, REIT analysts offer insight into the broader picture.

REIT magazine: May/June 2018

There has been no shortage of market volatility to keep investors on their toes in the first part of 2018. REIT stocks have felt the pressure of several external factors—both positive and negative. So, how should investors view the broader picture of underlying fundamentals and anticipate likely trends in the second half of the year?

To help sort through the market noise, REIT magazine spoke with five analysts to get their insight on how interest rates, tax reform, valuations and other trends are shaping sentiment, and what investors should focus on in times of uncertainty.

How would you describe the current state of REIT fundamentals?

Jeff Langbaum: In a word, solid. There aren’t very many trouble areas, but at the same time there aren’t many spots where demand is outstripping supply.

 Alexander Goldfarb: Overall, I would say fundamentals are pretty good. The warehouse sector is very strong, and office fundamentals are doing well. 

Apartments are dealing with a lot of supply. Retail has had its well-publicized issues, but if you look at occupancy levels you’re still at 94 to 95 percent; NOI growth rates are still in the positive range and releasing spreads are around 10 percent.

Haendel St. Juste: Still mostly in a good place across most REIT sectors, but we are now in the late cycle so I expect the deceleration continues. We certainly have been blessed by not having to deal with supply in a broad way this time around, with a few exceptions.

Christopher Lucas: You’re definitely seeing more modest, organic growth. Lease spreads have come in and the supply issues in certain markets are certainly creating some moderation to performance. 

As you look ahead, what factors are most likely to impact the REIT market in the second half?

Langbaum: Interest rates, still, and jobs as a measure of economic direction. Stocks are still trading heavily on the direction of interest rates and moves in the 10-year Treasury yield.  A lot of attention had been on tax reform legislation. For tax reform to have a real impact on real estate, it has to come down to fueling increased employment and wages.

Goldfarb: If interest rates are driven by continued economic expansion and people feeling more comfortable with the economy, then REITs should start to do well in the back half of the year. Continued job growth is probably the hardest part because we’re at full employment, but you are seeing a flow-through in wage increases.

St. Juste: There are definitely underlying factors that need to be considered—an improving economy, improving demand for space, and improving pricing power for landlords. But, certainly, people are thinking we are in the late cycle with slowing growth, rising cap rates, and rising interest rates.

Lucas: Interest rate expectations and the impact on the pace of economic growth and inflation expectations from the tax cut are all really important considerations for the back half of the year. If we see some better-than-expected results and more optimism relating to where earnings are trending, those things could certainly be a positive catalyst.

Do you anticipate any of those factors will drive movement on REIT valuations?

Langbaum: I don’t see anything on the near-term horizon to change where we are. With the rate environment, with financials poised to benefit from tax reform, with fear of overvaluation of some real estate asset classes, there’s not really a compelling reason for capital allocated elsewhere to rotate.

Lucas: Valuations are very attractive at this level. It doesn’t mean they can’t get discounted more, but right now, it feels like we’re getting closer to a tipping point where you start to see REITs do relatively better and that should raise valuations.

St. Juste: You certainly don’t get the sense that generalist investors, who are important in terms of moving the needle, are too excited about coming into the REIT market. It certainly feels that with slowing growth and potentially higher cap rates, that the math works against NAVs.

Sheila McGrath: REITs have been negatively impacted this year by shifting expectations for higher interest rates.  While REIT share prices look particularly attractive versus NAV estimates, the generalist investors, meanwhile, focus more on multiples and dividend yield than NAV.  The NAV statistic will become more important if there’s more M&A activity.

Speaking of M&A, how much activity should we expect in the second half?

McGrath: The backdrop is set for some selective activity. Assets in the public market are cheaper than the private market at this point, so it just depends on how long the stocks remain down at these levels. We would not be at all surprised if some companies without obvious succession planning, or those that may be priced at a discount and don’t have a clear strategy to close that gap, seek out strategic alternatives.

Langbaum: Where valuations are, relative to the fairly stable fundamental dynamics, does present the opportunity for M&A. In this environment, you probably would see more likelihood of privatizations rather than company-to-company deals in the public market.

Goldfarb: M&A in REIT-land is just tough in general. A lot of REITs don’t really exude a public willingness to engage in M&A. It’s tough for sellers to get the numbers that they’d like considering where their shares were a year ago. For buyers, they’re not going to pay up. 

St. Juste: I think the backdrop is supportive of it. However, you need to be ready to tell a compelling story if you’re trading at a discount to NAV and looking to buy another company.

Lucas: There are pieces that are coming into place now that start to make it more interesting. The one piece that had been missing for a while was really on the debt side. Money has been raised by private equity shops for debt funds, and I think that provides greater flexibility for potentially underwriting M&A transactions. 

What about IPO activity?

McGrath: We don’t expect broad-based REIT IPO activity. We do think that select, niche plays that are a little bit differentiated are possible.

Lucas: Unless it’s something unique that the market really doesn’t already have an opportunity to invest in, it would be very challenging. IPO investors look for discounts to comparable investments. With REITs generally trading at a discount to underlying real estate assets, an IPO is unlikely to provide a tolerable outcome for the sponsor.

Langbaum: To the extent that there are IPOs, it would be niche-type companies. The market is not as attractive as it was two to three years ago. 

St. Juste: The market is generally more difficult to navigate today due to rate uncertainty, weakness in the stocks and valuations broadly speaking. That’s not to say it’s closed off, but there are easier times to bring a company public than right now.

Are there any REIT sectors you’re watching for their upside potential?

Lucas: At some point we should see retail, both malls and shopping centers, outperform just given how poorly those stocks have done relative to their peers from a fundamentals perspective. We’d also look at industrial. It’s not discounted like retail, but secular demand just continues to grow. 

Langbaum: I would highlight the urban office sector, especially in New York, which has been really beaten down of late. If the financial market there sees a tangible benefit from tax reform and a significant improvement in the jobs picture and expansion, that could lead to a change in both the direct property level performance and sentiment toward some of those companies.  

For single-family rental REITs, there is still opportunity for margin improvement on the expense side that could bode well.

St. Juste:  I’m also still a big fan of single-family rental. There’s a growth and value dynamic there that has rate and inflation built-in hedges. Apartment REITs should do well also, with supply coming down a little bit. I’m also a bit warmer on malls than I was a year ago.

With so much market volatility it is easy for an investor to get lost in the noise. What should REIT investors focus on in times of short-term volatility?

Lucas: Investors should look for management teams and balance sheets that can deliver solid returns, regardless of the volatility or the economic activity that we have going forward. It’s no different than other periods where quality matters. Ultimately, owning quality will generate very attractive risk-adjusted returns over the longer haul.

McGrath: Once we get more clarity on the interest rate outlook these market corrections can often, in hindsight, be an attractive investment opportunity in the REIT sector. If there is some M&A at a premium to where stocks are trading, that often generates interest from value investors or investors who aren’t typically focused on our sector. 

History shows us that REITs do benefit from a stronger economy and that these short-term disruptions, as the perception of interest rates shifts, often present a very good entry point.

Langbaum:  I would pay a lot of attention to the balance sheet. A strong, clean, well-laddered and highly-liquid balance sheet can buy a lot of time and set companies up to be able to take advantage quickly when opportunities present themselves. 

I would also look at management quality and track record and performance through past cycles—companies that have been there before and managed their way through challenging times.

Drilling down on that, are there particular attributes you value in REIT management teams?

McGrath: Cycle-tested, commitment to transparency and disclosures, focus on differentiated long-term growth plans and an understanding of the importance of strong balance sheet management. With those items, you end up sifting out the best-in-class REITs.

Langbaum: The most important attribute is the ability to look at where you are, believe in your strategy and stay the course.

Goldfarb: Investment discipline and operational acumen over the cycle. In an environment of headwinds, good management teams tend to stand out.

St. Juste: Given some of the discounts, the onus is more on management to perform at this point in the cycle. We’re not at the point where a rising tide lifts all boats. Investors want to see companies work hard to mine and create shareholder value.

Lucas: We’re looking for the same things we always do: transparency; quality of the execution in their operations; their capital allocation decision making; the consistency of their performance; and their long-term executive vision that they understand. 

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