Our Outlook for Real Estate Stocks
Equity REITs continue to benefit from solid growth, operating, and dividend fundamentals.
Quarter-End Insights
- Equity REITs continue to trade at premiums to fair value, based on attractive operating and balance sheet fundamentals and "growth and income" characteristics.
- We estimate annual equity REIT dividend growth of 3%-5% in the near to medium terms.
- Healthy commercial real estate supply and an improving economic environment continue to boost equity REITs' operating fundamentals, cash flows, and underlying portfolio valuations.
- We believe equity REIT valuation premiums and persistent global economic uncertainty and volatility require REIT investors to be more cautious and selective.
According to the National Association of Real Estate Investment Trusts, or NAREIT, equity REITs delivered year- and quarter-to-date total returns (through mid-June) of 11.7% and 8.0%, ahead of the 8.0% and negative 4.1% for the S&P 500, respectively. The relatively strong performance has resulted in equity REIT shares continuing to trade at valuation premiums, the catalysts being relatively high and sustainable dividend yields, improving portfolio operating fundamentals, healthy capital structures, and the potential benefits as a hedge against eventual higher interest rates and inflation. For example, on average, equity REIT dividend yields are 3.30% (range average 3.00%-6.50%), well above the 10-year Treasury and S&P 500 yield of 1.58% and 1.50%, respectively, and same-store real estate portfolio operations are either stabilizing or beginning to experience renewed growth from increased occupancy and rental rates. Equity REITs also maintain healthy debt/EBITDA and fixed-charge coverage ratios averaging 7.0 times and 2.6 times, respectively.
Another factor contributing to premium valuations is the shifting attitude toward equity REITs by investors. For example, equity REITs increasingly appear to be more widely utilized by the investment community as part of an overall "growth and income" strategy, as opposed to "income" only. This is driven by the combination of yield and equity REIT business-model growth leveraged to an improving economy, potentially benefiting portfolio operations for years to come. We estimate equity REIT shares are currently trading 15% above fair value, which is not unusually high when compared with the average long-term historical 5%-10% premiums. We believe valuation premiums will persist along with investor appetite for sustainable yield and dividend growth, and equity REITs continue to benefit from healthy commercial real estate supply and a slowly improving economic environment, which should continue to provide a boost to portfolio operating fundamentals, cash flow, and underlying portfolio valuations.
Equity REIT Valuation Premiums Likely to Continue, but Selectivity Required
Heading into the second half of 2012, we believe the combination of continuing equity REIT per share valuation premiums and persistent global market and economic uncertainty and volatility require equity REIT investors to be more cautious and selective. Differentiating factors largely will revolve around a combination of dividend-growth potential, balance sheets, and capital structures not overly dependent on the capital markets, and business models characterized by a diverse operating skill set and more consistent cash flows. Equity REITs not possessing these attributes will be relatively less competitive and more vulnerable to rising interest rates and economic and financial setbacks, in our view. From a dividend perspective, for example, we will attempt to identify not just sustainability, but long-term growth potential as interest rates eventually will begin to rise, pressuring dividend-paying stocks. We therefore will be targeting, among other items, equity REITs with AFFO dividend payout ratios below 85%, a level allowing for both greater downside protection and growth potential. In terms of capital structure, equity REITs with lower leverage that are less dependent on capital markets for growth and refinancing capital should be relatively better-positioned to expand balance sheets opportunistically and/or weather economic and financial volatility.
As for consistency of cash flow, we tend to concentrate on equity REIT business models possessing a broad operating skill set and/or a portfolio less dependent on the economic cycle, such as health care, where demand is more "need" driven. We define broad operating skill to include acquisition, development, and property-management capabilities--which we feel more appropriately positions the REIT to exploit growth opportunities and manage risk--and cash flows throughout market cycles. By contrast, equity REITs too one-dimensional are often less competitive, sidelined at points throughout the market cycle and/or are forced to consider less-than-ideal or appropriate investment opportunities.
Health-Care, Life Science, and Multifamily REITs Benefiting from Strong Fundamentals
From a real estate sector standpoint we remain most positive on health-care REITs, which we estimate are presently trading close to fair value. Supply and demand fundamentals are among the strongest in commercial real estate. Incremental new health-care real estate supply has been extremely limited the last five to 10 years while demand growth has continued to increase because of annual long-term health-care industry growth nearly 2.5 times inflation, a large and aging population of 65-plus in need of a wide range of health-care services, and health-care systems' need for reliable and cost-efficient real estate financing and services.
| Real Estate Sector Picks for Your Radar | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Projected Yield (%) | |
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| Ventas, Inc. |  | $64.00 | Narrow | Medium | 4.05 |
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| HCP, Inc. | | $40.00 | Narrow | Medium | 4.70 |
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| Health Care REIT, Inc. | | $59.00 | Narrow | Medium | 5.17 |
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| Senior Housing Properties Trust | | $25.00 | Narrow | High | 7.08 |
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| Alexandria Real Estate Equities |  | $87.00 | Narrow | Medium | 2.86 |
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| AvalonBay Communities, Inc. |  | $118.00 | Narrow | Medium | 2.74 |
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| Equity Residential | | $49.00 | None | Medium | 2.18 |
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| Data as of 06-20-12. |
We would suggest investors consider shares of Ventas (VTR), HCP (HCP), and Health Care REIT (HCN), especially on a pullback as the companies have diversified health-care portfolios across the acuity of care spectrum, manageable exposure to Medicare and Medicaid reimbursement risk, broad operating skill sets with significant organic growth potential, healthy balance sheets, and track records of creating long-term shareholder value. Add to this dividend yields averaging 4.1%-5.2%, which are secure and positioned to grow an average of 3.0%-5.0% during the next few years.
Senior Housing Properties Trust (SNH) offers a compelling valuation, a secure 7.1% dividend yield and strong balance sheet. Offsetting the positives, however, and differentiating it from the other health-care REIT peers, is a lack of tenant diversification, related-party transactions, and a higher weighted average cost of capital, which limits competitiveness and profitability.
Staying with our health-care theme, we cannot fail to mention Alexandria Real Estate Equities (ARE), which remains on our Best Ideas list and is trading 18% lower than our fair value estimate. Our investment thesis is based on a niche and high-barrier-to-entry business model benefiting from an excellent management team and well-situated real estate clusters leased to very high-quality tenants in the life-science, biotech, and pharmaceutical industries. The tenant base is less cyclical, and Alexandria's diversified real estate skill set affords more consistent operating margins and organic growth through economic cycles relative to many REIT peers. Our investment thesis also considers a valuable and very difficult-to-replicate development pipeline, above-average annual dividend growth potential of 4%-6%, and a healthy balance sheet able to support growth without being overly dependent on the capital markets.
Multifamily REITs continue to trade 20%-25% above our estimates of fair value. Behind this premium valuation has been limited multifamily supply and increasing demand associated with an uncertain single-family housing market, foreclosures, and a difficult home-lending environment, all of which have increased the pool of potential renters. The result has been strong multifamily occupancies and annual rental growth rates averaging 95.0% and 5.0%, respectively. We believe multifamily REIT share-price valuations are ahead of mid- to long-term sustainable operating fundamentals, assume five- to 10-year average annual rental growth of an unrealistic 5%, and have not fully accounted for historically low interest rates and the eventual improvement in single-family affordability and ownership in some markets. Having said this, we cannot deny that the combination of limited multifamily supply, a weak economy, and a difficult housing environment is likely to continue driving demand and incrementally higher operating cash flows and performance into 2013.
For valuation reasons, we feel investors interested in maintaining a multifamily REIT weighting should be selective, focusing on business models with more sustainable long-term rental growth and operating cash flow potential. We suggest targeting multifamily portfolios in more unaffordable single-family housing markets or catering to younger residents where affordability, practicality, and mobility are the primary deciding factors. We would therefore recommend investors consider AvalonBay (AVB) or Equity Residential (EQR) on a meaningful share-price pullback.
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