Our Outlook for Real Estate Stocks
Equity REIT fundamentals remain healthy, but per-share valuation premiums warrant selectivity.
Equity REITs Continue to Benefit from Solid Growth, Operating, and Dividend Fundamentals
After trading at 10%-15% premiums to our estimate of fair value throughout most of 2012, shares of equity REITs currently trade at a 5%-10% premium. Rather than anything specifically related to weakening equity REIT operating or sector fundamentals, the reduced premium is more a reflection of macroeconomic concerns related to the fiscal cliff and Europe. According to the National Association of Real Estate Investment Trusts, equity REITs delivered year-to-date and quarter-to-date total returns, through November, of 14.1% and negative 0.9%, compared with the 15% and negative 1.3% for the S&P 500, respectively. Of note is the strong year-to-date performance of several more economically cyclical real estate sectors. For example, after posting negative full-year 2011 total returns, the industrial and retail shopping center sectors are among the top performers in 2012, with year-to-date total returns of 22.6% and 23.0%, respectively. The outperformance from the more economically cyclical sectors perhaps indicates a more sustainable economic recovery going forward.
The respectable overall performance, relative to the broad market, has resulted in equity REIT shares continuing to trade at valuation premiums, with 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 3.6% (range average 2.5%-6.5%), well above the 10-year Treasury and S&P 500 yields of 1.6% and 2.1%, respectively. Dividend-payout ratios averaging 68% should allow for average annual near-term dividend growth of 5%. Add to this improving cash flow as 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 balance sheets, with debt/EBITDA and fixed-charge coverage ratios averaging 7.0 times and 2.6 times, respectively. We believe another factor contributing to premium valuations is the shifting attitude toward equity REITs by investors. For example, equity REITs continue to be more widely utilized, by an increasingly broader investor base, as part of an overall growth and income strategy, as opposed to an income only. This is driven by a unique combination of relatively attractive yields 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 5%-10% above fair value, in line with average historical premiums. We believe valuation premiums will persist as investor appetite for sustainable yield and dividend growth persists, 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 2013 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 will largely 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 durable 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 are not just focused on sustainability, but long-term growth potential as interest rates will eventually begin to rise, pressuring dividend-paying stocks. We therefore will be targeting, among other items, equity REITs with adjusted funds from operations, or AFFO, dividend-payout ratios below 85%, a level allowing for both relatively greater downside protection and growth potential.
In terms of capital structure, equity REITs with lower leverage and less dependent on capital markets for growth and refinancing 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 cash flows throughout market cycles, as well as acquisition, development and property management capabilities, which we feel more appropriately positions the REIT to exploit growth opportunities and manage risk. By contrast, equity REITs too one-dimensional are often less competitive and sidelined at points throughout the market cycle and/or forced to consider less-than-ideal or less-than-appropriate investment opportunities.
Health-Care, Life Science, and Multifamily REITs Benefiting From Strong Themes and Fundamentals.
|Real Estate Sector Picks for Your Radar
| Fair Value
| Fair Value
|Health Care REIT
|Senior Housing Properties Trust
|Alexandria Real Estate Equities
|Data as of 12-18-12.
From a real estate sector standpoint, we remain most positive on health-care REITs based on valuation, along with sustainability of dividends, operating performance, and cash flow. We estimate shares are trading in line with fair value and that business models and portfolios should continue to benefit, through economic cycles and uncertainty, from the need-driven nature of health-care services. 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. But demand growth has continued to increase due to consistent annual long-term health-care industry growth nearly 2.5 times inflation, a large and aging population older than 65 in need of a wide range of health-care services, and the fact that care providers/health-care systems need reliable and cost- and care-efficient real estate financing and services. 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, a broad operating skill set with significant organic-growth potential, healthy balance sheets, and track records of creating long-term shareholder value. Add to this dividend yields ranging from 3.9% to 7.7%, many of 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 6.9% 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 idea list and is trading 20% below 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 business model focused on well-situated life science real estate clusters leased to very high-quality tenants in the life science, biotech, and pharmaceutical sectors. 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 5%, and a healthy balance sheet able to support growth without being overly dependent on the capital markets.
Multifamily REITs continue to trade 15% above our estimate of fair value. Behind the 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% and 5%, respectively. We believe multifamily REIT share-price valuations are ahead of mid- to longer-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 to drive 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 those that cater to younger residents where affordability, practicality, and mobility are the primary deciding factors. We would therefore recommend investors consider AvalonBay Communities (AVB) on a meaningful share-price pullback.
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