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Quarter-End Insights

Slow and Steady Wins for REITs

Though many long for faster economic growth, the current environment has actually been very good for landlords--but higher rates could still sting.

Todd Lukasik
  • Slow but steady macroeconomic improvement generally translates into slow and steady increases in demand for commercial real estate space without spurring too much construction of incremental supply, a favorable condition for REITs.
  • Although interest rates have risen, they remain well below historical averages, and we think higher interest rates could be a major headwind for property valuations.
  • The commercial real estate recovery looks poised to spread from primary gateway markets to secondary ones, although we still generally prefer firms that focus on the former.

 

Many have been longing for an increase in economic growth in the United States, but the slow and steady economic recovery has actually been very good for landlords, in our view. Slow and steady economic and job growth translates into incremental demand for commercial real estate, yet the macro economy is not improving enough for developers to aggressively add incremental supply to commercial real estate stock. As such, existing landlords should continue experiencing improved occupancy rates, greater bargaining power relative to tenants, and nice increases in same-store net operating income. While we've seen some pickup in new developments among certain property types and in certain markets recently, to the extent that the slow and steady recovery continues, we think landlords will continue to enjoy a generally favorable environment.

However, we think the prospect of higher interest rates remains a risk to REIT valuations. As rates on the U.S. 10-year Treasury have risen, REIT stock prices have generally fallen. Hardest hit among REIT stocks were some of our favorite firms that use long-term lease structures, as their rental streams generally cannot quickly reset higher in an inflationary environment.

Although there has been a meaningful increase in interest rates, they remain well below historical averages, and there is risk that they will increase further, which we would view as a major headwind for REIT performance and valuations. Although higher interest rates would take some time to show up in REIT financial metrics, eventually, higher rates could cause higher debt financing costs, pressure on traditional after-interest expense measures of REIT cash flow (such as FFO, AFFO, and FAD), and higher cap rates, which could pressure investment spreads. Also, to the extent that low interest rates have diverted investor funds to REITs searching for higher yield, funds could flow out of REITs if interest rates rise further, pressuring commercial real estate and REIT valuations. Although rising interest rates might signal a strengthening economy, which could benefit real estate fundamentals, we do not expect the macro environment to improve enough to offset what could be another 125-basis-point (or more) rise in rates to levels nearer historical norms.

Industry-Level Insights
Although the commercial real estate recovery since the global financial crisis has been strongest in core, gateway markets, it appears to be spreading to secondary markets as well. Nonetheless, we think concentrating on the gateway markets--where favorable demographics promise rising long-term demand for real estate while permitting, space constraints, financing, and other challenges can effectively limit the construction of competing supply--is a solid strategy that can form the basis of an economic moat. 

Our commercial real estate coverage appears roughly fairly valued overall, but there are pockets of relative over- and undervaluation within the group. Consistent with the Morningstar investment approach, our picks focus on firms with moats, whose stocks offer investors a margin of safety relative to our fair value estimates. Moreover, all of our picks (all REITs) enjoy some of the best overall growth profiles among our entire REIT coverage. 


Top Real Estate Sector Picks
Star Rating Fair Value
Estimate 		Economic
Moat 		Fair Value
Uncertainty 		Consider
Buying
American Tower $100.00 Narrow Medium $70.00
HCP $50.00 Narrow Medium $35.00
Health Care REIT $71.00 Narrow Medium $49.70
Tanger Factory Outlet Centers $39.00 Narrow Medium $27.30
Data as of 03-13-14.

HCP (HCP) and  Health Care REIT (HCN)
Although health-care REITs HCP and Health Care REIT generally have long-term leases, which can take years (if not decades) to reset to potentially higher market rates in a robust economic environment, we think their shares have been punished unfairly lately. Despite the long-term leases, both firms generally benefit from annual rent increases in their triple-net portfolios at the rate of 2.5% or so or the change in the Consumer Price Index, whichever is greater, and Health Care REIT is currently experiencing even faster internal growth at its sizable portfolio of senior housing operating assets. In general, health-care REITs should benefit from some favorable tailwinds, including an expanding population, an aging population, and potentially tens of millions of incremental people added to the ranks of insureds because of the Affordable Care Act--all of which should drive incremental demand for health-care real estate relative to historical levels. Plus, health care is a property sector in which the vast majority of assets remain in private hands, so these firms should have opportunities to further consolidate ownership. We think current yields of 5.5% to 6.0% combined with growth prospects in the low- to mid-single-digit range (if not higher, depending on external growth opportunities) provide investors with compelling total return prospects.

 Tanger (SKT)
Tanger also benefits from favorable tailwinds, in our view. Driven by consumers' consistent desire to find bargains in both good and bad economic times, outlet centers tend to do well across real estate and economic cycles. Retailers have caught on to this phenomenon, and they are driving demand for space within existing outlet centers as well as the construction of new supply. With portfolio occupancy near 99%, Tanger looks set to continue pushing rents on tenants when leases expire, driving internal growth. Plus, robust retailer demand for the outlet concept--which is generally one of the most profitable distribution channels for retailers--is supporting the most aggressive development pipeline in Tanger's history, driving external growth. Although its current yield is low for a REIT at 2.6%, its payout ratio is also low (less than 60% of adjusted funds from operations, by our estimate), and it can use its retained cash to help fund its development pipeline without as much dilution for existing shareholders. Eventually, cash flows should support a much higher dividend, and in the meantime, we expect investors to continue to enjoy annual dividend increases, which Tanger has been doling out for 20 consecutive years now.

 American Tower (AMT)
American Tower owns wireless communication towers, on which it leases network capacity to the Verizons and AT&Ts of the world. It is essentially a play on increased mobile data usage, both in the US and around the world. Once a tower is in place, adding a new customer to a tower or expanding capacity of an existing customer on a tower generates high-margin incremental revenue. Plus, American Tower's leases with tenants generally call for 3% to 5% annual rate increases. The combination of these annual rent escalators with wireless provider demand for additional capacity to meet the needs of their subscribers' demand for premium unlimited data plans as well as next-generation networks should result in rapidly escalating cash flow for American Tower. 

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