The Best REIT Opportunities Are in Health Care

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. With investor interest in real estate investment trusts remaining high, I wanted to sit down with Philip J. Martin, our director of REIT research, to get an overview of the sector and where there might be opportunities today.

Philip, thanks for talking with me.

Philip J. Martin: Yes. Thank you.

Glaser: So, let's just give a brief overview of what REITs are just for investors who may not be familiar with the structure?

Martin: Well, REITs are living, breathing corporations. They own diversified portfolios of real estate assets. There are certainly equity REITs that own and control the underlying asset. There are also mortgage REITs that provide mortgage financing to owners of real estate or operating companies that own real estate or commercial real estate properties.

Glaser: A lot of people think of income and REITs together, why is that? Why are REITs known for kind of paying out relatively large dividends?

Martin: Well, REITs are a tax-advantaged vehicle. They do not pay tax at the corporate level as long as they pay out 90% of their GAAP defined net income in the form of dividends to investors. So, they differ from C corporations in that they retain far less cash and are more reliant on the capital markets for growth financing.

Glaser: Why has there been this investor interest in REITs? Is it that the yields are high? Is it a diversification effect? What has really been piquing  people's interest there?

Martin: Well, it's yield. It's yield, yield, yield. On top of that I think, when the yield play was taken advantage of and continues to get taken advantage of in a good way for investors, investors started to realize that there were healthy balance sheets here, that there were cash flow streams that were improving and able to support incremental dividend growth of 5% annually in the next several years. And you have a good growth and income vehicle here. You certainly recently have the income that is inflation-protected due to the underlying asset, due to leases that have fixed rental-rate increases often tied to the Consumer Price Index. But you also have these portfolios--such as health care, commercial office, retail, and multifamily [properties]--leveraged to the economy. So, you have a good growth and income vehicle here that is attracting more and more long-term investors.

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Glaser: So, what do yields look like today compared with long-term norms for REITs?

Martin: Well, yields right now--all securities are down--but you're looking on average at 3.0%-3.5% dividend yields, with average annualized dividend growth expectations of 5% in our forecast.

Glaser: A lot of REIT investors still remember the big dividend cuts in 2008. If REITs are even so leveraged to the economy, are you worried about more dividend cuts or are payout ratios right now such that they would be able to sustain even through a downturn?

Martin: Well, we pay very close attention to dividends and a REITs ability to not only maintain dividends, but sustain dividend growth going forward because dividend growth will be a differentiating factor going forward. Right now, REITs on average pay out 69% of their FFO, or free cash flow, FFO is funds from operation, and that is more or less a free cash flow number. That compares with 72% historically. But, again, going forward, we're looking for companies that are even paying below that ratio as providing an indicator of REITs with the ability to experience above-average dividend growth going forward. So, we pay very close attention, and we think dividend payout ratios are healthy. We think there are certainly REITs that offer better growth prospects than others.

Glaser: You did mention that the sector as a whole looks little bit overvalued right now. Are the certain areas in the REIT market or certain companies that you think look undervalued or look like could be at good entry points right now?

Martin: Right now, we tend to like health care quite a bit. Health care is trading at around fair value. They have very sustainable business models with very good trends and themes. Many of the health-care REITs are dealing with health-care services providers that need growth capital. They have businesses that are less cyclical, and they are focused on cost efficiencies and improving care outcomes. The health-care REITs can provide a lot of growth capital and real estate expertise, as these health-care service providers execute their business plans. And again, the health-care REITs we cover are trading at fair value. Our favorites are HCP and Ventas.

Glaser: And on the other side, are there any REITs that look a little bit a too frothy right now, sectors that you would probably avoid?

Martin: Yes, multifamily is still pretty pricey. Multifamily continues to benefit from good tailwinds, good supply/demand fundamentals. But the prices are a bit ahead of fundamentals that we believe would be sustainable over the long term.

And going back just a bit on health care, I would be remiss if I did not focus also on Alexandria Real Estate Equities, an office/health-care REIT, primarily focused on high-barrier-to-entry, life-science clusters leased to the highest-quality biotech pharmaceutical and life-science tenants, such as GlaxoSmithKline and Novartis. The REIT has a tremendous business model and management team and is trading at about a 20% discount to our fair value estimate.

Glaser: Philip, I appreciate the update today.

Martin: Thank you very much.

Glaser: For Morningstar, I'm Jeremy Glaser.