Our Outlook for Real Estate Stocks
As investors have fled to perceived safety, real estate valuations have diverged sharply.
Quarter-End Insights
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- 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.
REITs
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.
For property classes that rely more upon longer-term leases, such as retail, health care, office, and industrial, operating improvement varied. The landlords that were a closer degree of separation from consumer spending, such as retail REITs, saw a greater pickup in operating metrics relative to office and industrial landlords. Thanks to stable triple-net leases and improved senior housing occupancy trends, health-care REITs also fared well operationally, but a Medicare cut to skilled-nursing reimbursement levels in the quarter threaten to thin coverage levels. We think the operating improvement could prove lean yet again for office and industrial landlords, especially if there are a high degree of lease rollovers in the near term. And although consumer spending has proven fair through the first half of 2011, we're looking for signs from retail management teams of a possible slowdown in consumer spending. With regard to health care, we don't think near-term macro-volatility will have meaningfully affected tenant coverage levels of rent, but we're cognizant that future regulatory changes could pressure some thinly capitalized tenants further.
Heading into late 2008, the property REIT sector as a whole was overleveraged and low on liquidity. Refinancing concerns came to the fore in the balance of the year and early 2009 amidst a greater credit market seize up, and the REITs that were ill-prepared for the credit crunch had to tap the markets on expensive terms. As uncertainty engulfs the macroeconomic outlook, it's important to keep in mind that REITs, three years later, are in considerably better financial health, having deleveraged and kicked out maturity schedules to a significant degree. This access to capital markets puts them in considerably better standing than many private landlords and the public non-traded space, and we think that if banks curb extending and pretending tactics on underwater commercial real estate properties en masse, well-capitalized property REITs could grow their balance sheets opportunistically. Playing offense will largely depend on a management's team given appetite for accessing the capital markets, however, as the dividend payout requirement still necessitates very large purchases to be financed externally.
| Top Real Estate Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
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| Alexandria Real Estate Equities |  | $98.00 | Narrow | Medium | $68.60 |
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| Diamondrock Hospitality Company | | $12.00 | None | High | $7.20 |
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| Health Care REIT |  | $59.00 | Narrow | Medium | $41.30 |
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| Jones Lang LaSalle | | $86.00 | Narrow | High | $51.60 |
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| St. Joe Corporation | | $34.00 | Wide | High | $20.40 |
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| Data as of 09-23-11 |
Alexandria Real Estate Equities (ARE)
Alexandria's lease terms favorably lock in those top-shelf tenants over the long term and provide for steadily increasing payouts while keeping recurring cash expenditures at a minimum. Depending on space, lease terms can range from five to 20 years. Nearly all leases contain fixed or CPI-based rent escalators providing revenue growth and a hedge against inflationary pressures. Over 90% of Alexandria's leases on a rentable square foot basis are triple-net, leaving the tenant responsible for reimbursing Alexandria for property-level expenses and capital expenditures for maintenance and improvements. Additionally, tenants are responsible for specialized capital improvements above what Alexandria initially provides, and having sunk capital into their spaces, tenants are reluctant to leave at the end of the lease term. Alexandria's underwriting results in a stable stream of cash flow that can increase over time, with a high probability of re-leasing upon expiry.
Diamondrock Hospitality Company (DRH)
Diamondrock Hospitality boasts one of the strongest balance sheets among lodging real estate investment trusts, a key advantage since the travel market is highly cyclical. Aside from its revolver, substantially all of its debt is fixed-rate and property-specific. Near-term maturities were addressed with equity raises in 2009, and nearly all of its debt matures past 2014. Furthermore, about half the firm's hotels are unencumbered, and in a worst-case scenario, they could support additional mortgage debt. With no joint ventures or operating partnerships, there also shouldn't be any off-balance-sheet surprises. Indeed, Diamondrock's sound balance sheet should enable it to seize upon attractive acquisition opportunities as distressed hotels and senior mortgages become available.
Health Care REIT (HCN)
We think health-care real estate has its fair share of tailwinds. Demand demographics are favorable, as baby boomers are fast approaching retirement age and living longer. Moreover, the government limits competitive supply in skilled nursing. The combination of increased demand with constrained supply should drive results at health-care landlords. With debt as a percentage of gross real property owned hovering in the mid- to upper 40s and limited near-term debt maturities, Health Care REIT's debt profile affords it a good margin of safety to continue its expansionary efforts.
Jones Lang LaSalle (JLL)
Jones Lang's business has rebounded strongly with the recovery in commercial real estate. The firm benefited as commercial leasing and sale transaction markets bounced strongly in 2010 off depressed 2009 levels. We think the recovery will continue in 2011 and beyond, albeit at a slower pace, and Jones Lang, with its global brand and scale, is well positioned to continue capturing market share.
St. Joe Corporation (JOE)
Currently trading for little more than its value as a timber operator, we think St. Joe is cheap. It owns much of the yet-to-be-developed land in northwest Florida, for which it paid prices as low as $1 per acre. The company stands to benefit from significant efforts now being put forth by the region's, as well as the state's, economic developers to lure large businesses to the area, and the insertion of a new commercial airport into the middle of 75,000 St. Joe-owned acres last year will be a significant economic driver for years to come. Things will likely proceed slowly in the near term, however, as current dicey economic conditions have set back development timelines significantly.
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