Mon, 12 Sep 2011
REITs look overvalued in general, but certain business models and individual names still look especially attractive.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.
I'm here today with Philip Martin--he is a REIT strategist--and Jason Ren--he is a senior analyst of REITs here at Morningstar--to take a closer look at the commercial real estate industry and see if there is any opportunity for investors today.
Gentlemen, thanks for joining me.
Jason Ren: Thanks for having us.
Philip Martin: Thank you.
Glaser: So, I want to start of broadly in talking about the commercial real estate industry. We hear a lot about how residential real estate is not doing very well, but we hear less in the news about commercial real estate. How have things been going since the end of the recession? Are rents coming back on the certain sectors that are doing better? What's your general outlook in that space?
Martin: Well. I think from an Economics 101 perspective just to start broad, when you look at commercial real estate versus residential real estate, commercial real estate really doesn't have the oversupply problems that residential has, so commercial real estate is benefiting from that.
Our overall general view is that because of the healthy supply fundamentals right now, commercial real estate will rebound more quickly [than it has] coming out of past down cycles ... And then by sector, certainly different sectors are benefiting a bit differently based on where their core focus is--so health care versus lodging, versus office, versus industrial all have different fundamentals and different key drivers.
Ren: Right. So, when we're thinking about real estate, we try to think about, "Well, are they near-term leases or long-term leases," and we're finding that the sectors that rely a bit more on near-term leases--so hotels, apartments, self storage--they lost ... pricing going through the downturn fairly quickly, But conversely, as the economy has improved a bit, sentiment has improved and stabilized a bit, they are seeing pricing power come back fairly quickly. For the sectors that rely a bit more on longer-term leases to business clients, the pricing power isn't there yet.
Conversely, we also like to look at REITs that we consider to have a sustainable competitive advantage in terms of growing cash flows defensively over time. The ones that we consider to have a moat, they are doing better, so they're having high occupancies that are leading to rate growth.
Glaser: So certainly it sounds like the commercial real estate industry is a lot healthier than the residential side. Has that translated into better results for the REITs? Are they reporting better earnings, and is that having an impact on the stock price for holders of REITs?
Ren: Aside from the hotel space, which for a while there was kind of a disaster, but for many of the other sectors, the fair stability in occupancy really led to fairly minor deterioration in property-level profitability through the downturn, and now it's improving at a healthy clip as the fundamentals have come back.
We think that valuation has come back a lot quicker than fundamentals, and part of that is because the REITs fell harder than the market when the crisis hit because they were caught in a bind with regard to refinancing concerns, because REITs are required to pay out 90% of their taxable income as dividends to shareholders. So, for part of the recession, people were concerned whether REITs [would be able to] refinance and at what rate, and now that they've been able to refinance, fundamentals are improving, that's resulted in fantastic returns for REIT shareholders.
In our view, we think that those returns, valuations have come up a little faster than fundamentals have. So we think that the overall space is around 15% to 20% overvalued, but we do think that there are some opportunities in the REITs.
Martin: One thing driving valuations is the fact that commercial real estate did really come through this down cycle very well. We talked a little bit about the positive supply fundamentals which are there, but REITs have done a really terrific job underwriting commercial real estate, underwriting their tenants, and not getting supply out of whack.
So again, when we look at this down cycle, commercial real estate from an operating performance did quite well from an occupancy standpoint; rents didn't fall as drastically, and balance sheets were maintained. Certainly some balance sheet repositioning was required, but we didn't see absolute meltdowns from a portfolio operating standpoint or a balance sheet standpoint, and it’s given the sector a lot of credibility.
On top of that, you have the yield advantages; you have the dividend-growth potential, the inflation protection, and the different ways to diversify by sector and by region--whether that’s geographic region, whether that’s local regionally or internationally. So a lot of very good institutional ... or just investment attributes to the space.
Glaser: Now you mentioned dividends--this is obviously something a lot of people are interested in REITs for. People are seeking yield wherever they could find it. REITs historically have had very generous yields. Is that something that you are seeing today, and what are your prospects for, or your thoughts on dividend growth in the next few years?
Martin: We think dividend growth is really going to be quite good. I mean, historically over the last 20 years, equity REITs have grown their dividend at an average annual rate of 5%. Today, FFO dividend payout ratios are sitting at 69%. That's near the historic low of 66%; the long term average has been 73%.
So we think there is a good cushion there, a very strong cushion, to grow dividends at the historic rates even if the economy grows at a slower-than-anticipated rate. So, the cash flow cushion is there, the balance sheets are in good shape in terms of total debt levels and other balance sheet and pertinent ratio. So the balance sheet strength, the fact that the economy is slowly improving and portfolios are starting to benefit, and you have this FFO dividend payout ratio at an attractive rate. We think FFO growth can be in that 5% range in the next couple of years.
Glaser: Now you mentioned earlier that you thought that the space may be about 15% overvalued, but there were some individual shares that you thought were a little bit more attractive. Can you talk a little bit about the names that you are the most interested in right now?
Ren: I like Alexandria Real Estate Equities. They're a very solid lab space landlord/developer, and they have these longstanding relationships with the GlaxoSmithKlines, the Novartis, MITs of the world where they are developing and renting out top lab spaces, and ... these clients are not only paying rent, but they are also paying for the upkeep of the buildings as well. So at the end of the day, it's a lot of good cash flow that’s dropping down to shareholders.
We think that the yield isn't fantastic right now, but their FFO payout is only around the 40%-ish range, so we think there is plenty of room for income to increase for shareholders of that stock.
Otherwise, we think that there are some names in the health-care space. So Ventas, for example--they are yielding a healthy 4% and change. Or Health Care REIT--I think they are yielding around 5%. These have excellent balance sheets; they've been able to expand through the downturn whether via acquisitions, such as Ventas, or more through developments, like Health Care REIT. We think that, because they're able to lock in tenants over the long term and have these fixed or CPI-based escalators that even if inflation concerns come to a head, they're still able to return cash or profitability to shareholders at a rate that beats inflation.
Martin: Just piggybacking off that a bit: One of the things we are looking for are REIT business models that can provide sustainable and consistent long-term cash flows and dividend growth, etc. And we are looking for business models that are full-service in terms of real estate expertise, so we want to focus on those business models that have the acquisition development, property management expertise. So they have flexibility, and they can manage risk through the cycle.
We're also looking for--especially at this point where REITs are a bit overvalued; we are estimating they are about 15% overvalued as we sit today--but we are looking for those business models that are less sensitive to the economic cycle, so think health care, think specialized niche strategies such as Alexandria that Jason mentioned. Realty Income, which is a triple net lease rate that focuses on need-driven and value consumer retail services. They have a dividend north of 5%, and they've consistently through cycles been a strong operating performer, 95%-96% occupied. So again these companies have the ability to sustain growth and manage through cycles, because of their diversification, and a cash flow stream that is less susceptible to the economic cycle.
Glaser: Philip, Jason, thanks for actually taking the time today, appreciate it.
Martin: Thank you.
Ren: Thanks for having us.
Glaser: For Morningstar, I am Jeremy Glaser.