As investors have fled to perceived safety, real estate valuations have diverged sharply.
--There has been an intra-sector flight to safety toward more defensive names.
--Other than lodging, recent macro-volatility doesn't suggest high potential for materially sharp reversals in near-term operating fundamentals across sectors.
--Relative to private investors, and the public non-traded REIT space, publicly traded REITs remain well-positioned.
Mr. Market took real estate stock investors for a ride in the third quarter. Improved operating fundamentals, higher cash dividend payouts, and a brighter transactions market bid up Morningstar's aggregate price/fair-value estimate ratio of real estate stocks to 1.3 in late July. Since that peak, macroeconomic uncertainty and regulatory scrutiny on tenant revenue have taken their toll, dropping the sector to roughly fair value. But the decline has been uneven; intra-sector, there's been a flight to safety toward cyclically defensive property sectors owing to fears of a slowdown in the macroeconomy. Additionally, investors have favored stocks that bear less dependence on near-term access to capital markets.
Heading into the fourth quarter, we are wary of the lofty valuations afforded to the property classes in REITs that have benefited from recent macro-volatility. Still, while some sectors--especially those that renew leases on a near-term basis, such as lodging--could see a reversal in operating performance, we generally think that the fundamental improvements seen through the first half of 2011 should hold in the near term. This bodes reasonably well for investors.
Industrywide, REITs are currently yielding around 4%, and dividend payout as a percentage of funds from operation, in aggregate, is approximately 70%, according to NAREIT. We continue to think that the commercial real estate cycle is in the early innings of improvement, and while there could be payout concerns on a granular company-by-company basis, the industry as a whole likely won't suffer rolling dividend cuts across the board.
Property classes that rely upon shorter-term leases--apartments, lodging, and storage--saw rental rate improvement in the second quarter, which led to operating income margin expansion. However, since those classes renew leases on a near-term basis, their revenue streams are more cyclically sensitive. We're most concerned with lodging REITs. Although occupancy gains since the trough of the recession had the lodging REITs under coverage within striking distance of occupancy levels last seen in 2007 and 2008, booking windows have remained short in the space, so gains could deteriorate quickly. Still, with balance sheets right-sized since the close of the recession and low levels of recourse debt due in the near term, we think lodging REITs, like most other REITs under coverage, remain in good financial health.
Near-term fundamentals are brighter for apartment and self-storage REITs, owing to favorable supply and demand dynamics for multi-family. While single-family construction boomed during the housing bubble, multi-family construction sputtered. Credit conditions remain tight, and with memories of housing equity destruction still fresh in people's minds, demand for multi-family remains quite healthy. Indeed, we doubt occupancy and rental rate metrics dipped meaningfully in the third quarter of 2011 compared with the third quarter of 2010. Although we don't like the supply dynamics of the storage space, the demand for storage units rides the coattails of multi-family, which remains healthy for the time being. Though valuations in the latter sectors, multi-family and storage, have tempered lately, we caution investors that they still generally suggest that near-term positives will persist beyond the near term.