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Quarter-End Insights

Our Outlook for Real Estate Stocks

In general, real estate stocks have tempered toward fair value.

Jason Ren
  • The intrasector flight to more defensive names tempered in the fourth quarter.
  • Other than lodging, recent macro-volatility doesn't suggest high potential for materially sharp reversals in firming near-term operating metrics.
  • Relative to private investors, and the public non-traded REIT space, publicly traded REITs remain well-positioned.

 

Along with the rest of the market, real estate stocks gyrated in the fourth quarter. However, relative to fair value, real estate stocks will likely finish the quarter at approximately fair value, similar to levels three months prior. This is in stark contrast to heights achieved earlier this year, which saw highs of nearly 1.3 times fair value, prior to macroeconomic concerns coming to a head. We highlighted five stocks at the close of the third quarter,  Alexandria Real Estate Equities (ARE),  Diamondrock Hospitality (DRH),  Health Care REIT (HCN),  Jones Lang LaSalle (JLL), and  St. Joe (JOE). Although we continue to highlight these firms, we caution that the five are less compelling than they were at the close of the third quarter, as Alexandria, Diamondrock, Health Care REIT, Jones Lang LaSalle, and St Joe have risen by approximately, 8%, 33%, 7%, 10%, and 6% respectively, since the publication of the last quarter-end insight.

Since peak pricing premiums earlier this year, macroeconomic uncertainty and regulatory scrutiny on tenant revenue have taken their toll, dropping the sector to roughly fair value. Within the sector, a flight to safety toward cyclically defensive property sectors continues to exist, owing to fears of a slowdown in the macroeconomy. Additionally, stocks less dependent on near-term access to capital markets continue to be priced at a premium, as well.

REITs
Heading into 2012, we remain wary of the lofty valuations afforded to the property classes in REITs that have benefited from recent macroeconomic 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 most 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 the National Association of Real Estate Investment Trusts. We continue to think that the commercial real estate cycle is in the early innings of improvement, and though 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--continued to see rental rate improvement in the third quarter, which generally led to operating income margin expansion. However, because those classes renew leases on a near-term basis, their revenue streams are more cyclically sensitive. Although lodging REITs appear undervalued to us, we caution that they are the most cyclically concerning. While occupancy gains since the trough of the recession have the lodging REITs under coverage within striking distance of occupancy levels last seen in peaks last decade, booking windows have remained short in the space, so gains could deteriorate quickly. We also note that the third quarter ended in early September for both Diamondrock and Host, prior to heightened levels of dislocation during the close of that month. 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 multifamily units. While single-family construction boomed during the housing bubble, multifamily construction sputtered. Credit conditions remain tight, and with memories of housing equity destruction still fresh in people's minds, demand for multifamily remains quite healthy. Indeed, we think it's likely that year-over -ear occupancy and rate metrics will continue to show improvement in the fourth quarter. Although we don't like the supply dynamics of the storage space, the demand for storage units rides the coattails of multifamily demand, which remains healthy for the time being. Even though valuations in the latter sectors, multifamily and storage, have tempered lately, we caution investors that they still generally suggest that positives will persist well beyond the near term. We think this is unlikely. 

For property classes that rely more upon longer-term leases, such as retail, health care, office, and industrial, operating improvement has varied. The landlords that are a closer degree of separation from consumer spending, such as retail REITs, have seen 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 have also fared well operationally, but a Medicare cut to skilled-nursing reimbursement levels, which began in the fourth quarter, will probably thin coverage levels. We think the operating improvement could prove lean yet again for office and industrial landlords, especially if there is a high degree of lease rollovers in the near term. And although consumer spending has proved fair through most 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 amid 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 continues to pressure 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 continues to put them in considerably better standing than many private landlords and the public nontraded 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 expand their balance sheets opportunistically. Playing offense will largely depend on a management's given appetite for access to the capital markets, however, as the dividend-payout requirement still necessitates very large purchases to be financed externally.

 Top Real Estate Picks
   Star Rating Fair Value
Estimate 		Economic
Moat 		Fair Value
Uncertainty 		Consider
Buying
Alexandria Real Estate Equities $87.00 Narrow Medium $60.90
Diamondrock Hospitality $12.00 None High $7.20
Health Care REIT $59.00 Narrow Medium $41.30
Jones Lang LaSalle $86.00 Narrow High $51.60
St. Joe $30.00 Wide High $18.00
Data as of 12-16-2011.

 

 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. More than 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 (JOE)
St. Joe owns much of the yet-to-be-developed land in Bay and Gulf Counties in northwest Florida, for which it paid prices as low as $1 per acre several decades ago. The insertion of a new commercial airport into the middle of 75,000 St. Joe-owned acres in 2010 will be a significant economic driver for years to come in Bay County, and the company stands to benefit from stepped up efforts by the region's, as well as the state's, economic developers to lure large manufacturers into the area. South of the airport in Gulf County, St. Joe enjoys the vast majority of the land on which a deep-water port will someday be operating in Port St. Joe. We think the combination of these two commercial drivers, in addition to Joe's residential projects makes for potentially lucrative profits for this unique company as the region develops during the coming decades. 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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