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No Margin of Safety in REITs Today

Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Real estate investment trusts were one of the best-performing sectors in 2014. I'm here with Josh Peters--the editor of Morningstar DividendInvestor newsletter and also the director of equity-income strategy at Morningstar--for an update on the sector. Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: So, what really drove this outperformance of REITs through the year? Was it really just that interest rates kept coming down?

Peters: That's most of it. I've been working with a thesis for the last couple of years talking about a secular shift in the American investment class, if you will, toward more income. And it's really no more complicated than demographics--the numbers that we all know about, baby boomers retiring. And that itself really understates the shift because, a generation or two ago when people retired, they had pension plans. Now, they have 401(k) accounts that need to be converted into income through investment by the individual who owns it. They don't have a pension to fall back on; [they have] some Social Security, but not the classic pension check in the mail.

So, this means that more people are going to focus on REITs and utilities, staples companies, tobacco stocks, and things like that. The really predictable businesses that generate lots of free cash flow and pay the bulk of it out to shareholders as dividends. But if you are going to look just at results in 2014 and here in the first month of 2015, it's really an interest-rate story. At the end of the 2013, the 10-year Treasury got up just over 3%, and people thought that 2014 was going to be the year that the Fed started to crank up interest rates and that the long end of the yield curve would really take off because the economy was going to take off.

Well, the economy did get a little bit better and QE came to an end, but the 10-year Treasury ended the year closer to 2% and then ducked under 2% in the first couple of weeks of 2015. And with that, REITs, it seems, have the tightest correlation of any group of stocks in the market between their valuations and interest rates. And that big, unexpected fall in interest rates--is there any other kind than an unexpected fall or an unexpected rise?--has really inflated (and I think that's the right word, "inflated") the value of most real estate investment trusts that are out there. The cash flows are very predictable, just not as predictable as what you would expect from a government bond. But as interest rates fall, people prize those steady cash flows that much more.

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Glaser: So, when you look at the fundamentals of the REITs, do you think that the businesses are performing well but that the valuations have just gotten out of hand?

Peters: I think that that is really the dominant story here--valuations. And there are very few REITs that we cover that are trading below fair value; we've got some that are trading at big premiums now to our fair value estimates. More importantly, to look at the whole group of REITs that are members of the S&P 500 Index and having that dividend yield down around 3%, that's the kind of number that I'd choke on. I have been in this game a long time; I can remember when you had high-quality, "money good"-type REITs paying 6%, 7%, or 8%.

Now, that was in a higher-interest-rate environment, say, 10 or 15 years ago. So, there's not a one-to-one correlation there. But I think you have to be very, very careful with these valuations and contemplate whether or not getting a hold of a 3% dividend yield is worth maybe missing out on years' worth of capital appreciation if valuations contract in a higher-rate environment.

Glaser: When rates do rise again, if we do see a big sell-off in REITs, are there some names that are on your radar screen? Or are you going to really steer clear from the sector for some time?

Peters: I don't think I need to steer clear. I am not worried about structural problems across the industry in terms of fundamentals. Though, one thing to watch will be what kind of effect higher interest rates in the future might have on the finances of some REITs in particular--those who are maybe financing a lot of their portfolio with short-term or variable-rate debt. If higher interest rates mean those companies are refinancing at much higher interest rates, then you've got two problems: You've got the valuation problem for the stock as interest rates rise as well as a shrinking level of cash flow available for common shareholders as bondholders and banks claim more. That's why the two REITs that I like the best have solid balance sheets with a lot of long-term borrowing that's locked in at low interest rates that's going to serve those companies well for many years to come.

Realty Income (O) and Health Care REIT (HCN) both generate a lot of very predictable, reliable cash flow that they use to fund their dividends. Realty Income is that rare animal that's as good as it's cracked up to be. They actually call themselves the monthly dividend company. Everything that goes on in that organization is oriented around paying that dividend every month, keeping it reliable, keeping it safe, and growing it in a prudent fashion over time.

And I like Health Care REIT--just the nature of the real estate. These are essential properties--whether it's senior housing or other sorts of health-care facilities, medical office buildings--that tend to provide a very reliable stream of rental income to the REIT. I'd like to own more, honestly, than just these two that I have now, but we are going to need to see more attractive valuations for me to be able to make that kind of a move.

Glaser: So, of those two that you own, do either of them look attractive now or are they also looking pretty pricey?

Peters: They look pretty pricey, but not to the point where I'm prepared to sell them and go to cash. Earlier, I described it in the sense that to get the yield you are getting now--let's say a REIT that's 20% overvalued--you might have to skip out on a couple of years' worth of capital appreciation. Maybe the stock just flattens out even though the earnings and the dividend continue to grow; but more likely, as the stock probably drops and then recovers in a higher-interest-rate environment--again, assuming that earnings and cash flow and the dividend are growing--you might find yourself, several years out, having made no progress on the stock price.

In the case of the dividends of these two companies, I think the dividends alone justify continuing to hold; but there is really no margin of safety to commit new money to these names at this point. They are the first I am going to look to recommend and call buys if we do get a pull back; but since I don't know when that's going to happen, I'm just kind of sitting here continuing to hold these positions and feeling pretty good about at least the dividend income and the growth of dividend income that we stand to get over the next couple of years. It's a tough set of trade-offs right now in income land, to be honest.

Glaser: Josh, thanks for the update. I suspect, as long-term rates rise, we are going to be talking about the sector quite a bit.

Peters: Yes, indeed. It's going to happen eventually--just don't ask me when.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching. 

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