REITs have performed hot and cold over the past 10 to 15 years. But, asks Christopher O’Dea, could they be just right for investors in 2019?
Overly aggressive use of debt left many real estate investment trusts (REITs) in a precarious situation when the 2008 global financial crisis broke. The ensuing underperformance left lingering concerns that a lack of transparency in governance, risk-oriented financial policy and the inherent volatility of shares listed on equity exchanges made REITs unsuitable for institutional portfolios with long-term investment horizons.
Fast forward a few years, and things have changed. Or rather, REIT management teams have generally adopted more conservative financial policies, dramatically improved governance and disclosure, and increased discipline in acquisitions and operations. At the same time, the economic and financial markets environment has evolved.
Perhaps most importantly, the long run-up in direct property prices has brought renewed focus on the valuation differential between assets held in private funds and those held in public vehicles such as REITs – as well as a more detailed assessment of the role REITs play in an institutional portfolio, and a deeper understanding of how to tap their potential.
Investment managers specialising in listed markets believe REITs are presently attractive for rental and cash-flow growth. The brighter outlook relates to improved performance potential stemming from two sources: earnings estimates have been revised up for global REITs, reflecting strong fundamentals for most property types across developed markets; and equity earnings projections have been trimmed, giving listed property an incremental edge.
Valuations are currently lower than historical averages, and the new supply of several property types is also running below long-term trends. Capital-market conditions and valuation factors are creating an environment where REITs that have strengthened their balance sheets since the crisis can issue equity to finance acquisitions – keeping their balance-sheet leverage in check and credit quality in good shape as they add income-producing assets to their earnings base.
The outlook for REITs has improved significantly in the past year, says Rick Romano, managing director and head of global real estate securities at PGIM Real Estate. “The big concern all investors wanted to talk about a year ago was whether interest rates were going to go up and what that would mean for real estate,” he says. “We haven’t heard that question this year.”
Instead, interest rates have remained low, or even become slightly more negative in some European countries and Japan. The latest policy action by the US Federal Reserve was to lower rates, if only slightly. “That’s very different from where we were a year ago,” Romano says. “With rates down and a slower global economic growth environment, we’ve entered that not-too-hot, not-too-cold scenario again. It’s Goldilocks, part two, for REITs.”
The numbers reflect that assessment. “We’ve really seen it in the earnings results,” Romano says. Projections for the growth in earnings for REITs – technically called funds from operations (FFO) – increased globally from about 8% at the start of the year to about 8.5% at mid-year. In contrast, projected earnings for the S&P 500 dwindled from 12% at the start of 2019 to 8% by mid-year.
Romano says there are two ways REITs can increase their earnings growth rates in today’s low-interest-rate environment. The first is internal growth. “We know the supply-and-demand backdrop for real estate,” Romano says.
“Even though we’re deeper into this cycle, it still remains quite strong for landlords in most property types and most markets, so we’re seeing, in some cases, re-accelerating rental growth as rents start to increase at a higher rate than they were a year ago.”
The second way comes from the impact of low interest rates on REIT balance sheets. “When interest rates are low, the REIT’s cost of capital is low,” Romano says. “When a REIT’s equity price is trading above the value of the REIT’s real estate, it can issue shares to raise capital in the secondary market and acquire properties. There have been numerous cases this year where REITs have issued equity accretively, then bought properties which have resulted in earnings growth and asset-value growth.” As listed companies, REITs “are able to use their balance sheet to make smart acquisitions to grow their earnings per share, and the result has been an increase in earnings-per-share growth from what the street had anticipated just six months ago”.
The improvement in credit quality since the financial crisis has made it possible for REITs to seize the opportunity to raise capital. “At most REITs, the balance sheet is in good shape, so they’re not issuing as much debt, and they are doing acquisitions through equity, perhaps using a smaller amount of debt, given what interest rates are,” Romano says. For acquisitions, especially large acquisitions, REITs are judiciously balancing the use of debt and equity to maintain appropriate leverage levels (figure 1).
“There are few significant concerns about leverage ratios within the space,” Romano says. “Most are being disciplined about how they allocate capital, and what sources they’re using, in terms of the equity to debt mix.”
Of course, not all REITs have the balance sheet strength to use accretive equity issuance to fund acquisitions.
“There is a dichotomy in the markets between the haves and the have-nots,” Romano says. The haves – those REITs with share prices trading above the net asset value (NAV) of the underlying property – are able to earn upward revisions to their projected [funds from operations] FFO growth rates because they are being prudent capital allocators and acquiring properties that enhance their FFO-per-share growth. The have-nots – REITs with share prices trading at a significant discount to their NAV – are good value.
“The challenge for those companies on the value side of the spectrum is how they will resolve the discount from the private market value of the real estate,” Romano says. “We’re finding opportunities at both ends of the spectrum in this dichotomous market. There are good-quality companies trading at a discount that have good management and are taking the right steps to narrow the discount. And we’ve seen some of the haves acquire have-nots – in some cases, in transactions that generate synergies for companies operating in the same markets and in some cases within property types.”
Sceptics might point to the performance of REITs during the global financial crisis, when they failed to serve as a defensive anchor for institutional portfolios. But current conditions differ markedly from a decade ago, according to Scott Crowe, chief investment strategist and portfolio manager at CenterSquare Investment Management. He believes the current investment backdrop has a number of similarities to past cycles during which REITs posted solid performance.
The financial crisis was a housing-led slowdown that spilled over to commercial property markets, and the housing market is on a firmer footing today, Crowe argues. With cap rates nearly in line with debt costs, commercial property pricing was irrational in 2007, leaving REIT balance sheets vulnerable to any correction in values. In contrast, Crowe notes, the spread between 10-year US Treasury yields and cap rates was about 330bps at mid-2019 – one of the highest spreads in recent history – and REIT leverage is conservative, with debt at just 31% of asset value today compared with 46% in 2007.
The situation now is similar to 2001, when a business-led slowdown prompted a 30-month Fed easing cycle that led to REIT outperformance of 56% relative to an equity market that had experienced a multi-year, late-cycle bull run. Then, REIT balance sheets were in a good position, and cap-rate spreads to debt costs were high, much like today. As the Fed shifts from a three-year tightening cycle to the cusp of an easing cycle, Crowe believes there is “good reason to expect that the strength of the underlying fundamentals for REITs positions them for continued outperformance”.
Investors note undervalued global REITs
Investors are taking note of the potential opportunity in global REITs. “Quite a few major global property investors that have tended to focus on the private market for a long period of time have been looking towards REITs over the last 18 to 24 months,” says Jon Cheigh, head of global real estate at Cohen & Steers.
Cheigh sees two main reasons for the renewed interest in REITs. The first reason is relative valuation. “Private property has performed well, and REITs have done pretty well, but frankly not quite as well as private markets, so I think there is some attraction to REITs on a valuation basis,” he says (figure 2).
The second reason – more significant in Cheigh’s view – is that REITs offer a more diversified opportunity at a time when two mainstays of the private-property investment market are facing serious challenges. “Retail and office have been the two big categories for 40 years, and there are questions about retail right now, and questions about office as well, with people working in different ways and the matter of the impact of WeWork,” he says.
The REIT market “has always had a much broader category of sectors, whether that be healthcare or data centres or tower REITs,” Cheigh says. “Maybe 10 or 15 years ago those sectors were somewhat unique and now we’re starting to appreciate that some of those are probably more reflective of how we’re using real estate today and how we will use it in the future.”
The result is that “REITs have more of a tailwind”, Cheigh says. Major global investors “have become more open-minded about using REITs in a more significant way in their portfolios because of valuation, and seeking exposure to newer property types as opposed to the assets they’ve been investing in for 30 or 40 years that may now face some secular headwinds”.
A key decision will be how investors deploy their next available dollar to property – and how to manage capital deployment late in the cycle. “There has certainly been a dynamic discussion of how to change what a portfolio looks like,” Cheigh says. The two main options are to allocate more capital to REITs because valuations are more attractive relative to private-market property, or to take a more targeted view and allocate to a REIT portfolio composed of alternative sectors, such as data centres, self-storage or healthcare.
Another potential advantage of REITs at this point in the cycle is that capital can be put to work more quickly. “There’s been a lot more capital going into the private side for the last three or four years and the queues to get invested are quite long, so even if you commit a dollar today, it may not get invested for two or three years on the private side,” Cheigh says. “There’s some anxiety that we’re a little bit later in the cycle, and while a recession is not right around the corner, in our view institutions would
Overly aggressive use of debt left many real estate investment trusts (REITs) in a precarious situation when the 2008 global financial crisis broke. The ensuing underperformance left lingering concerns that a lack of transparency in governance, risk-oriented financial policy and the inherent volatility of shares listed on equity exchanges made REITs unsuitable for institutional portfolios with long-term investment horizons.
Fast forward a few years, and things have changed. Or rather, REIT management teams have generally adopted more conservative financial policies, dramatically improved governance and disclosure, and increased discipline in acquisitions and operations. At the same time, the economic and financial markets environment has evolved.
Perhaps most importantly, the long run-up in direct property prices has brought renewed focus on the valuation differential between assets held in private funds and those held in public vehicles such as REITs – as well as a more detailed assessment of the role REITs play in an institutional portfolio, and a deeper understanding of how to tap their potential.
Investment managers specialising in listed markets believe REITs are presently attractive for rental and cash-flow growth. The brighter outlook relates to improved performance potential stemming from two sources: earnings estimates have been revised up for global REITs, reflecting strong fundamentals for most property types across developed markets; and equity earnings projections have been trimmed, giving listed property an incremental edge.
Valuations are currently lower than historical averages, and the new supply of several property types is also running below long-term trends. Capital-market conditions and valuation factors are creating an environment where REITs that have strengthened their balance sheets since the crisis can issue equity to finance acquisitions – keeping their balance-sheet leverage in check and credit quality in good shape as they add income-producing assets to their earnings base.
The outlook for REITs has improved significantly in the past year, says Rick Romano, managing director and head of global real estate securities at PGIM Real Estate. “The big concern all investors wanted to talk about a year ago was whether interest rates were going to go up and what that would mean for real estate,” he says. “We haven’t heard that question this year.”
Instead, interest rates have remained low, or even become slightly more negative in some European countries and Japan. The latest policy action by the US Federal Reserve was to lower rates, if only slightly. “That’s very different from where we were a year ago,” Romano says. “With rates down and a slower global economic growth environment, we’ve entered that not-too-hot, not-too-cold scenario again. It’s Goldilocks, part two, for REITs.”
The numbers reflect that assessment. “We’ve really seen it in the earnings results,” Romano says. Projections for the growth in earnings for REITs – technically called funds from operations (FFO) – increased globally from about 8% at the start of the year to about 8.5% at mid-year. In contrast, projected earnings for the S&P 500 dwindled from 12% at the start of 2019 to 8% by mid-year.
Romano says there are two ways REITs can increase their earnings growth rates in today’s low-interest-rate environment. The first is internal growth. “We know the supply-and-demand backdrop for real estate,” Romano says.
“Even though we’re deeper into this cycle, it still remains quite strong for landlords in most property types and most markets, so we’re seeing, in some cases, re-accelerating rental growth as rents start to increase at a higher rate than they were a year ago.”
The second way comes from the impact of low interest rates on REIT balance sheets. “When interest rates are low, the REIT’s cost of capital is low,” Romano says. “When a REIT’s equity price is trading above the value of the REIT’s real estate, it can issue shares to raise capital in the secondary market and acquire properties. There have been numerous cases this year where REITs have issued equity accretively, then bought properties which have resulted in earnings growth and asset-value growth.” As listed companies, REITs “are able to use their balance sheet to make smart acquisitions to grow their earnings per share, and the result has been an increase in earnings-per-share growth from what the street had anticipated just six months ago”.
The improvement in credit quality since the financial crisis has made it possible for REITs to seize the opportunity to raise capital. “At most REITs, the balance sheet is in good shape, so they’re not issuing as much debt, and they are doing acquisitions through equity, perhaps using a smaller amount of debt, given what interest rates are,” Romano says. For acquisitions, especially large acquisitions, REITs are judiciously balancing the use of debt and equity to maintain appropriate leverage levels (figure 1).
“There are few significant concerns about leverage ratios within the space,” Romano says. “Most are being disciplined about how they allocate capital, and what sources they’re using, in terms of the equity to debt mix.”
Of course, not all REITs have the balance sheet strength to use accretive equity issuance to fund acquisitions.
“There is a dichotomy in the markets between the haves and the have-nots,” Romano says. The haves – those REITs with share prices trading above the net asset value (NAV) of the underlying property – are able to earn upward revisions to their projected [funds from operations] FFO growth rates because they are being prudent capital allocators and acquiring properties that enhance their FFO-per-share growth. The have-nots – REITs with share prices trading at a significant discount to their NAV – are good value.
“The challenge for those companies on the value side of the spectrum is how they will resolve the discount from the private market value of the real estate,” Romano says. “We’re finding opportunities at both ends of the spectrum in this dichotomous market. There are good-quality companies trading at a discount that have good management and are taking the right steps to narrow the discount. And we’ve seen some of the haves acquire have-nots – in some cases, in transactions that generate synergies for companies operating in the same markets and in some cases within property types.”
Sceptics might point to the performance of REITs during the global financial crisis, when they failed to serve as a defensive anchor for institutional portfolios. But current conditions differ markedly from a decade ago, according to Scott Crowe, chief investment strategist and portfolio manager at CenterSquare Investment Management. He believes the current investment backdrop has a number of similarities to past cycles during which REITs posted solid performance.
The financial crisis was a housing-led slowdown that spilled over to commercial property markets, and the housing market is on a firmer footing today, Crowe argues. With cap rates nearly in line with debt costs, commercial property pricing was irrational in 2007, leaving REIT balance sheets vulnerable to any correction in values. In contrast, Crowe notes, the spread between 10-year US Treasury yields and cap rates was about 330bps at mid-2019 – one of the highest spreads in recent history – and REIT leverage is conservative, with debt at just 31% of asset value today compared with 46% in 2007.
The situation now is similar to 2001, when a business-led slowdown prompted a 30-month Fed easing cycle that led to REIT outperformance of 56% relative to an equity market that had experienced a multi-year, late-cycle bull run. Then, REIT balance sheets were in a good position, and cap-rate spreads to debt costs were high, much like today. As the Fed shifts from a three-year tightening cycle to the cusp of an easing cycle, Crowe believes there is “good reason to expect that the strength of the underlying fundamentals for REITs positions them for continued outperformance”.
Investors note undervalued global REITs
Investors are taking note of the potential opportunity in global REITs. “Quite a few major global property investors that have tended to focus on the private market for a long period of time have been looking towards REITs over the last 18 to 24 months,” says Jon Cheigh, head of global real estate at Cohen & Steers.
Cheigh sees two main reasons for the renewed interest in REITs. The first reason is relative valuation. “Private property has performed well, and REITs have done pretty well, but frankly not quite as well as private markets, so I think there is some attraction to REITs on a valuation basis,” he says (figure 2).
The second reason – more significant in Cheigh’s view – is that REITs offer a more diversified opportunity at a time when two mainstays of the private-property investment market are facing serious challenges. “Retail and office have been the two big categories for 40 years, and there are questions about retail right now, and questions about office as well, with people working in different ways and the matter of the impact of WeWork,” he says.
The REIT market “has always had a much broader category of sectors, whether that be healthcare or data centres or tower REITs,” Cheigh says. “Maybe 10 or 15 years ago those sectors were somewhat unique and now we’re starting to appreciate that some of those are probably more reflective of how we’re using real estate today and how we will use it in the future.”
The result is that “REITs have more of a tailwind”, Cheigh says. Major global investors “have become more open-minded about using REITs in a more significant way in their portfolios because of valuation, and seeking exposure to newer property types as opposed to the assets they’ve been investing in for 30 or 40 years that may now face some secular headwinds”.
A key decision will be how investors deploy their next available dollar to property – and how to manage capital deployment late in the cycle. “There has certainly been a dynamic discussion of how to change what a portfolio looks like,” Cheigh says. The two main options are to allocate more capital to REITs because valuations are more attractive relative to private-market property, or to take a more targeted view and allocate to a REIT portfolio composed of alternative sectors, such as data centres, self-storage or healthcare.
Another potential advantage of REITs at this point in the cycle is that capital can be put to work more quickly. “There’s been a lot more capital going into the private side for the last three or four years and the queues to get invested are quite long, so even if you commit a dollar today, it may not get invested for two or three years on the private side,” Cheigh says. “There’s some anxiety that we’re a little bit later in the cycle, and while a recession is not right around the corner, in our view institutions would rather invest a dollar today than allocate a dollar to get called in the future when valuation may be less attractive. Institutions have to maintain liquidity for that commitment until called, and there’s an opportunity cost for reserving that capital.”
Opportunities can vary globally, Cheigh says. For example, industrial property in Europe recently looked more attractive than in the US and Australia, while in Tokyo a better-than-average 6-7% rate of growth in rents made the office sector attractive. In the US, tower REITs have been performing better than average owing to continued growth of digital technologies, while most residential markets are not subject to the secular headwinds facing retail and office property and the sector – whether apartments or student housing – has been generally performing well.
Even in the New York City office market, investors should perhaps consider REITs. High-quality office assets have traded at cap rates of about 4.5%, but a Manhattan office REIT such as SL Green has been trading a cap rate closer to 5.5-6%. “From our perspective, to gain exposure to Manhattan office property, an institution shouldn’t go out and buy four office buildings, they should buy a New York City office REIT trading at a discount to where they could otherwise buy the property assets,” Cheigh says.
Of course, listed markets also serve a risk-management function. “The public market might just be sceptical that a 4.5% cap rate for Manhattan office buildings is a sustainable valuation, even if there are institutional buyers that would pay that price for the hard asset,” Cheigh says.
The solution, he suggests, is prudence. “It would be rare that an institution could sell an office building and buy that Manhattan office REIT stock, but in our view, for a portfolio considering how to deploy incremental capital right now, buying property on Wall Street is better value than buying property on Main Street.”
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