Our Outlook for Real Estate Stocks

• Real estate stocks are trading at a slight premium to fair value.  
• Equity REIT dividend fundamentals remain healthy, and we think dividend growth exceeding inflation is possible in the near to medium term. 
• There remain significant upside and downside drivers to near-term real estate stock pricing sectorwide, which have little to do with organic cash-generating ability.  

Lured by sustainable cash yields and a slowly improving U.S. economic picture, investors bid up real estate stocks across industries, giving brief pause when eurozone concerns came to a head. As capital market stability returned toward the end of the quarter, it appears that real estate stocks, in aggregate will likely finish at a slight premium, in aggregate, to our estimate of fair value.  

Although the overall sector trades at a slight premium to fair value, we recognize that there are factors in play that could cause significant deviance in the near term, which have little to do with the organic cash-generating ability of existing property bases. We continue to think that public companies generally have better access to capital and are attractively positioned relative to private players. This could play a significant role in balance sheet growth during 2012, as hundreds of billions loans made during the peak cycle years comes due. 

Depending on the degree to which banks have decided to end so-called extend-and-pretend tactics, there could be opportunities to acquire into trophy properties and locales at a discount. Moreover, even though we don't think the real estate cycle is there yet, another upside risk to stock values arises from the potential of private companies buying out public ones. We note that Lehman Brothers' purchase of Archstone and Blackstone's purchase of Equity Office signified peaking markets in the last upcycle. Complicating matters is the somewhat moribund commercial mortgage-backed securities market. We view the CMBS market as an attractive vehicle by which REITs can dispose of their lower-tier product and obtain the capital needed to upgrade property portfolios. However, as the CMBS market remains in neutral, this means of recycling assets has been parked. 

REITs
Generally, the first quarter confirmed to us that fundamental improvements seen through most of 2011 continue to hold in the near term. This bodes reasonably well for investors, though we caution that valuations in a few industries, such as multifamily, retail, and office, appear stretched. We view valuations in the hotel and health-care industries as more fairly valued. 

Industrywide, REITs are currently yielding around 3.5%, and dividend payout as a percentage of funds from operation, in aggregate, is around 70%, according to the National Association of Real Estate Investment Trusts. Our thinking of payout maintainability holds from prior quarters; in sum, dividends are sustainable at recent levels. REITs which increased their dividends through the downturn have more breathing room as the economy, and their tenants' financial health, has improved, while those that cut their dividends have brought back cash payments to levels that remain significantly below prerecession highs on both an absolute basis and relative to Funds From Operations and Adjusted Funds from Operations. 

Property classes that rely upon shorter-term leases--apartments, lodging, and storage--continued to see rental-rate improvement in the fourth quarter, resulting in margin expansion. Regarding fourth-quarter earnings, which encompass a longer time frame for landlords,  Diamondrock Hospitality (DRH) and  Host Hotels & Resorts  (HST) confirmed to us that the lodging recovery remained intact, fairly unaffected by macroeconomic uncertainty in the U.S. and Europe. Indeed, though the highly cyclical nature of lodging operations means that that fundamentals can turn on a dime, we think the companies remain in good financial health with manageable near-term maturity scheduled and right-sized balance sheets. 

Near-term fundamentals remain Goldilocks 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. Although construction has picked up recently, we note that the lag between starts and completions is typically around one-and-a-half to two years, so existing multifamily owners, even in areas with significantly increased supply, such as Washington, D.C., should still continue to see low supply. 

Positive demand drivers complement the supply picture. As the economy has improved, echo boomers have decoupled from recessionary living conditions, such as taking on additional roommates or living with the parents, that have kept household formation below trend. As the economy has improved, decoupling and household formation has increased, but as mortgage credit conditions remain tight, people have been forced to look to renting. While mortgage rates remain at around all-time lows, we don't think the single-family housing market will reverse out of the doldrums quickly, but it's likely that year-over-year occupancy and rate metrics will continue to show improvement for apartment landlords under coverage. Although we view the supply dynamics of the storage space as less favorable, the demand for storage units rides the coattails of multifamily demand, which remains healthy for the time being. That said, we continue to think that recent valuations in those industries suggest that positives will persist well beyond the near term, but we believe this is unlikely. ​

For property classes that rely more upon longer-term leases, such as retail, health care, office, and industrial, operating improvement continues to differ. The landlords that are a closer degree of separation from the consumer, such as retail REITs, have seen a greater pickup in operating metrics relative to office and industrial landlords. Due 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, has thinned coverage levels. We continue to think that the major skilled-nursing tenants of REITs,  Health Care REIT (HCN),  Ventas (VTR), and  HCP (HCP), will continue to make rental payments, however, as coverage levels delineated on conference calls offer sufficient margins of safety and hew our prior thoughts on coverage haircuts that would occur. 

That said, we think 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 was robust in 2011, we don't think that double-digit tenant-sales growth per square foot, which is what some mall landlords such as  Taubman Centers and  Simon Property Group (SPG) have seen, is sustainable in the long run. 

With regard to health care, we don't think near-term macro volatility will meaningfully affect tenant coverage levels of rent, but we're cognizant that future regulatory changes could pressure some thinly capitalized tenants further.

Top Real Estate Sector 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
Senior Housing Properties Trust		$28.00	Narrow	High	$16.80
Data as of 03-20-2012.

 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. Thus far in 2012, we note that it has tapped the unsecured debt market, which significantly lowers the need for dilutive capital for the firm to complete its near-term development needs. 

 Diamondrock Hospitality (DRH) (
)Diamondrock Hospitality continues to boast one of the strongest balance sheets among lodging real estate investment trusts, a key advantage as the travel market is highly cyclical. Its revolver and debt maturity schedule remain top-tier, in our view. 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. Moreover, we note that the company is yielding a sustainable 3% at recent trading prices. 

 Senior Housing Properties Trust (SNH) (
)We recommend investors consider shares of Senior Housing Properties Trust for a blend of value, income, consistency, and growth potential, all factors helping to differentiate the company from many of its REIT peers. The stock is currently yielding around 7%, and we think there is room to increase the dividend as annual rent kickers move the needle in 2012. Also, company's balance sheet is healthy and should support growth without being overly dependent on potentially volatile capital markets. Conservative leverage and fixed-charge coverage levels, coupled with more than $500 million in available investment capital support our thinking that the company is attractively positioned to grow safely. A focus on need-driven health care has propelled the company to high-single-digit operating portfolio yields consistently, supporting above-average dividend and EBITDA growth. However, we do have concerns, principally the firm's lack of tenant diversification and the fact that an external party--REIT Management and Research--conducts Senior Housing's management decisions. Five Star, a publicly traded senior-living operator, accounts for about half of the portfolio's net operating income. Five Star is also affiliated with the company, and the related-party relationship fosters conflict-of-interest concerns. We account for these risks with our high fair value uncertainty rating, which reflects our thoughts on margin of safety.

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