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Reasonable Leverage, Growth Prospects, Moats, and Valuation Guide Our REIT Picks

Our favorites can do well even with potentially higher interest rates.

Favorable macro conditions including slow and steady economic growth and low interest rates have benefited real estate investment trusts since the downturn, but it is unclear how long these tailwinds will last. Though the recent macro backdrop has delivered a rising tide that lifted many, if not all, REIT boats, we think investors should consider repositioning REIT portfolios to include firms whose cash-flow prospects look attractive, whether or not the favorable macro environment remains in place. Our favorite REITs currently-- HCP (HCP),  Ventas (VTR),  Tanger Factory Outlet Centers (SKT), and  American Tower (AMT)--enjoy reasonable leverage, solid growth prospects, competitive advantages, and relatively attractive valuations, all characteristics that should serve investors well whether or not the macro environment changes.

Though the extent of the impact is debatable, REIT investors generally acknowledge that the macro environment since the economy has emerged from the downturn has been beneficial to commercial real estate owners. The slow and steady growth in the economy has not prompted developer ebullience, which has limited the introduction of new supply into the market. Consequently, the incremental demand from the improving economy has largely accrued to existing landlords in the form of higher occupancies, higher rental rates, and solid same-store net operating income growth. In fact, for some REITs we follow, many portfolio operating and general financial metrics are tracking at or near all-time highs. For large U.S. REITs, same-store NOI growth is near prior peak levels, in aggregate.

Change in Same-Store Net Operating Income for REIT Peer Group

Furthermore, the low-interest-rate environment has greatly influenced property valuations. REITs have been refinancing debt at lower interest rates, lowering overall interest expense, and leaving more cash available for equity investors. Also, with debt funding costs low, buyers have bid up property values, while institutional allocations toward real estate have increased overall. Consequently, some property indexes are showing that prices have returned to precrisis levels.

We've postulated that the low interest-rate environment has caused funds to flow into commercial real estate investments, as property cash flow yields look increasingly attractive while interest rates fall, thus further boosting prices through supply/demand dynamics. Recent studies have shown increased institutional investor interest in and allocations toward commercial real estate, while flows into commercial real estate mutual funds have been on the rise. Furthermore, private equity funds have raised tens of billions of dollars for real estate investments.

We think the rising tide caused by multiple favorable industry tailwinds--including slow and steady economic growth, low interest rates, and sizable fund flows into the sector--has lifted most, if not all, REIT boats. Overall, Morningstar's REIT coverage appears to be slightly overvalued relative to our estimates, on average. As a result, REIT investors should take stock of their holdings, potentially repositioning their portfolios toward REITs that both look relatively attractive in the current environment and are positioned well for a potential change in the macro picture, including a potential rise in interest rates.

Stock Price Relative to Morningstar Fair Value Estimates

REITs With Short Lease Durations Appear Pricey
Conventional wisdom holds that REIT investors should allocate funds toward landlords with short lease durations in a rising-interest-rate environment, which is likely to be accompanied by an improving economy; landlords with short lease durations will be able to reset their leases to higher market rates as incremental demand materializes. With higher rents, these landlords will achieve higher cash flows, helping offset the potentially negative impact of higher debt interest funding costs. (Landlords with long average lease terms, on the other hand, will have to wait years before they can fully reprice their in-place lease rolls, as only a portion of leases expire each year.)

While it's difficult to argue with this logic, we caution investors that among our coverage, REITs with shorter lease durations (self-storage and multifamily REITs, in particular) appear pricey relative to the rest of our coverage and appear to be operating at peak or near-peak performance levels. Consequently, we don't think these investments provide investors an acceptable margin of safety currently.

We Favor Margins of Safety, Modest Leverage, Solid Growth Prospects, Moats
In a market environment where REITs generally appear overvalued, our current REIT favorites have relatively attractive margins of safety compared with our fair value estimates.

Because of most REITs' well-laddered and lengthy debt maturity schedules, it would take years for a sharp rise in interest rates to be fully incorporated into REITs' earnings. Nonetheless, we would expect REITs with relatively modest levels of leverage and low debt-service costs relative to cash flows to generally fare better in a rising-interest-rate environment. Our current REIT picks fall in the top quartile of REIT peers in terms of EBITDA/interest coverage.

In addition to margins of safety and reasonable leverage, we think investors should consider REITs with well-defined internal and external growth prospects and competitive advantages. REITs with well-defined growth prospects that are not fully reflected in current share prices should do well whether or not the macro environment changes. Additionally, the REITs we favor currently have done well across economic cycles, reflecting their competitive advantages, in our opinion. Similarly, we think their moats provide an additional margin of safety relative to the average REIT.

HCP Is a Dividend Aristocrat
Although HCP's dividend payout ratio is on the high side relative to many REITs, we think it is acceptable, given its triple-net-heavy portfolio. HCP has one of the most impressive historical dividend records among all REITs, and with 29 consecutive years of dividend increases, it is among the Dividend Aristocrats.

With annual rent escalators on most triple-net leases of 2.5%-3.5% or the actual change in the consumer price index, whichever is greater, organic growth should at least keep up with inflation. Incremental growth may come through future accretive external investments, via either investments alongside operating partners as they expand their businesses to meet the increasing need for health-care services, or further consolidation of ownership in the fragmented health-care real estate sector.

At nearly one third of HCP's businesses, HCR ManorCare is HCP's largest tenant and a major source of expected future cash flow. Though we see no immediate cause for concern, we also see no near-term solution--absent rent renegotiation--to HCR ManorCare's subpar (currently less than 1.0 times) facility-level rent coverage. Consequently, investors in HCP should be comfortable accepting the risks around HCP's exposure to this tenant, because it is a situation that is unlikely to meaningfully improve in the near term, absent renegotiation of the lease terms.

We award HCP a narrow moat based mainly on the benefits of customer switching costs associated with its largely triple-net-leased property portfolio. In addition to making its tenants responsible for all costs associated with the property operations, including ongoing property maintenance expenses, HCP's leases generally include enhancements such as master lease structures, corporate guarantees, and other credit enhancements. We think HCP's medical office buildings enjoy intangible benefits associated with owning properties either located directly on or affiliated with hospital campuses, which drives business to HCP's MOB tenants, resulting in superior property operating performance.

Ventas' RIDEA Exposure Promises Faster Potential Growth
With the lowest dividend payout ratio among the health-care REITs we follow, Ventas' well-covered dividend appears to have a sizable margin of safety and healthy growth prospects. Its record of dividend growth is impressive, and by our measure, Ventas has been more successful converting external investments into per-share dividend growth than many REIT peers.

Annual rent escalators on most triple-net leases generally fall in the range of 2.5%-3.5% or the actual change in CPI, whichever is greater, while Ventas' RIDEA (operating) assets have been averaging mid-single-digit rates of internal growth over the past few years. We expect RIDEA growth to slow, resulting in organic growth for this part of its portfolio that nonetheless outpaces inflation somewhat. Similar to peer HCP, incremental growth may come through future accretive external investments, via either investments alongside operating partners as they expand their businesses to meet the increasing need for health-care services, or further consolidation of ownership within the fragmented health-care real estate sector. Among health-care REITs, Ventas has been one of the more active health-care property acquirers of late.

While Ventas' overall senior housing operating portfolio, also known as its RIDEA portfolio, performed in line with our expectations during the second quarter, with reported cash-based same-store NOI growth of 4.0%, the divergence in performance between its U.S. and Canada RIDEA assets was shockingly large. The firm reported a 6.0% increase in SSNOI for its U.S. properties, while SSNOI at its Canada properties fell 18.2%. Fortunately for the firm, U.S. assets dominate Ventas' RIDEA portfolio, with just 12 of its 218 legacy senior housing operating properties located in Canada.

The fact that Ventas' senior housing operating assets in Canada are suffering such substantial declines in cash flows lends support to our view that these types of RIDEA-owned properties can potentially exhibit greater cash flow variability (and even cash flow declines) than health-care REITs' traditional triple-net sale-leaseback assets. Though we would be very surprised if Ventas' overall RIDEA portfolio ever were to experience an 18% decline in cash flow in any given year-over-year period (mainly because its overall 200-plus property RIDEA portfolio is more diversified than the 12 assets owned in Canada), its recent experience in Canada does highlight the risk of potential cash flow variability in this portion of its investment base, which currently makes up 28% of Ventas' total NOI.

We award Ventas a narrow moat based mainly on the benefits of customer switching costs associated with its triple-net-leased property portfolio and intangible benefits associated with its senior housing operating (RIDEA) properties and medical office building assets. Like HCP, Ventas' triple-net leases are generally favorable to the landlord, making tenants responsible for all costs associated with the property operations, including ongoing property maintenance expenses, and often including other enhancements such as master lease structures, corporate guarantees, and other credit enhancements. Ventas' medical office buildings also enjoy intangible benefits associated with owning properties either located directly on or affiliated with hospital campuses, and its senior housing operating assets are in areas with favorable demographics, which generally translate into higher-than-average rents and superior property operating performance.

Consumers' Strong Interest in Outlets Drives Tanger's Growth
Tanger has one of the lowest dividend payout ratios among REITs we follow. Though the firm is currently using approximately $65 million in retained annual cash flow to help fund its robust development pipeline (and reduce its need to issue incremental equity), eventually it should be able to support a higher payout ratio, juicing dividend growth prospects. Tanger has paid an increased cash dividend every year since its initial public offering.

Tanger's occupancy rate and EBITDA margin are tracking near historical high-water marks, so organic growth will probably need to come from rental rate increases. We estimate that Tanger's in-place rents are at least 6% below current market rates. The combination of low-single-digit annual rent increases on the bulk of the firm's lease portfolio and our expectation of double-digit re-leasing spreads suggests that roughly 3% annual organic growth over the medium term is achievable. Furthermore, we think the outlet industry faces a long runway of potential square footage expansion (potentially 60%-70%), and we expect Tanger to win its fair share of future developments, providing incremental growth of roughly 4% per year.

As the only pure-play outlet center REIT, Tanger is uniquely exposed to consumer and retailer interest in and demand for the outlet distribution channel. Though we remain convinced that outlet is currently underrepresented in the U.S. and Canada, if we're wrong, Tanger's business would suffer. Not only would its future development pipeline be smaller than we forecast, but returns on current development projects could fail to live up to our expectations, and existing assets could suffer operational declines in occupancy and rents. Given Tanger's (and the outlet channel's) relative stability across economic cycles, combined with retailer reports that outlet is one of the most profitable distribution channels (rivaling online), we view this as a potential, but unlikely, risk.

Tanger earns a narrow moat sourced from intangible benefits associated with its strong brand in outlets and its ownership of centers in locations that allow its tenants to operate profitable stores and Tanger to earn superior returns on invested capital.

American Tower Benefits From Strong Secular Trends in Coverage Expansion
Though American Tower has the lowest dividend payout ratio in our coverage universe, that rate should rise as the firm burns through its net operating losses. We expect American Tower to eventually pay out 50%-60% of AFFO, and it is committed to increasing its dividend per share at a 20% compound annual rate over the next few years. (In the first half of 2014, the firm's dividend grew 25% from the year-ago period.)

American Tower has tripled its tower count since 2008 (now more than 70,000 towers across five continents) and continues to grow at an accelerated rate as carriers around the world actively deploy advanced data networks. High data growth and rising voice usage will continue to fuel capacity investments from the carriers. Tower lease-up--adding additional tenants to an existing tower--results in very high-margin incremental revenue for American Tower. Also, the spectrum licenses require extensive network deployment commitments that drive a visible and sustainable (long-term noncancelable contracts) long-term runway for cash-flow generation. The firm has guided that it will double its AFFO per share from 2012 to 2017.

Strong business trends support the firm's return on invested capital expansion prospects and were the primary drivers behind our recent fair value estimate upgrade. Management has also become more optimistic on its prospects, exemplified by recent full-year guidance (at the midpoint) increases in site rental revenue, EBITDA, and AFFO of 1.1%, 2.1%, and 1.7%, respectively. We believe the firm is perfectly positioned to continue its outperformance.

The underlying sources of American Tower's moat are materially strengthening for a number of reasons. There are considerable barriers to entry into the industry, given zoning restrictions, and the time it takes to get a zoning permit (as long as four years) is increasing. The network effect is also strengthening as the service radius of a tower continues to shrink. Given the laws of physics and the increased throughput required to use today's mobile data applications, the average tower's service radius has declined nearly 90% over the past two decades. Lastly, economies of scale allow the firms to become increasingly profitable as they add tenants. Given the low amount of overhead, incremental EBITDA margins are roughly 90%.

Todd Lukasik owns shares of American Tower.

Todd Lukasik does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.