The following is an excerpt from the video series Dividend-Stock Deep Dive, hosted by Morningstar DividendInvestor editor David Harrell. He spoke with Morningstar analyst Kevin Brown, who focuses on real estate investment trusts. Watch the full interview.
David Harrell: In your report, you're highlighting those 27 REITs under coverage, but none of them currently earn a narrow or wide economic moat rating. Why is that? Why do none of the REITs have these, sort of, sustainable competitive advantages right now?
Kevin Brown: That's a great question. It's because at Morningstar, we have a very strict definition for what constitutes an economic moat. We do a very rigorous analysis, each and every company that we cover, and just unfortunately, none of the REITs, their portfolios, meet that strict definition. And you can give different reasons for different sectors. For, say, hotels or for office companies, they only own a very small percentage of the buildings in their sectors in the markets that they're concentrated in. Some of the most concentrated hotel REITs only own maybe 10% of the hotel rooms in the markets that they're most concentrated in. So, not enough for them to actually generate pricing power. And that doesn't even include, say, the Airbnb-type of shadow supply in those markets. So, a very small percentage of actual assets owned in the very large U.S. real estate market.
Another issue that many run into is that there's almost no barriers to entry for many of these sectors. For example, apartments in suburban settings. It's very easy to build new apartment buildings just down the street that will be very similar to what the REITs currently own. Same thing with, say, self-storage facilities. You can go down the road and build in just any plot of land a self-storage facility pretty much wherever you want. Another major issue is that they're limited by their ability to push rents on their tenants without having their tenants say, "You know what, we could just do this ourselves." I'll give the example of the industrial REITs. They have some very large tenants that can afford significant rent increases each and every year, say, Amazon, FedEx. They can afford that to a certain extent, but they can't extract extravagant profits from them without having Amazon or FedEx to say we're better off with our own facilities. The REITs provide flexibility and can expand and allow their tenants to focus on other things other than owning real estate assets, which is why it's a great marriage, but you don't want to upset your partner. So, you can't push too hard. There's a limit.
And the final thing is, many operators or tenants run very thin margins. So, you're limited to how much you can push rents, even if you are the stronger one in the leverage dynamic. For example, retail REITs. You're only able to push rent to match what revenue growth is for your retail tenants, and the retail tenants are only seeing limited sales growth at brick-and-mortar locations. Same thing with, say, the senior housing REITs. You're only able to push it as much as the operator who you hire to run the property is able to withstand without sending your operator into bankruptcy, because they're the ones who are running the facility. So, that's a big concern there. However, we do think that they can make economic profits, and they are strong companies. The source of that is more from management teams, strong management teams, rather than economic moats. And so, management teams can turn over fairly quickly. And so, it doesn't meet the definition of needing 10 to 20 years. But they can do things like many operate at margins well above the rest of their peers.
I'll give the example in hotels of Pebblebrook Hotel Trust. Their whole story is that they would buy hotels that were poorly run by other operators and come in and implement cost efficiencies and turn around the operating margin from, say, the teens into the 30s. Same thing with Welltower, a senior housing, healthcare REIT. They operate with so many different senior housing operators, that they've learned best practices and know what works best in each and every market and region. And so, they're able to tell their operators, "We think you could improve margins by doing X, Y or Z that somebody else is doing." And because they have so many different relationships and operations going on at once, they can see what works best for everybody and push those efficiencies across our whole portfolio. But that's really expertise of management; that's not necessarily institutional to the real estate itself.
So, other things that the REITs can do is they have significant ability to develop new properties at high development yields. You have the industrial REITs that are very good at this. The apartment REITs for the past decade have been very strong at doing this. And so, a lot of what they're able to do is build at a development yield higher than the market average and create a cash flow higher than the debt that they're funding it with. Then finally, many are able to secure relationships with outside developers and acquire off-market deals. For example, Invitation Homes, the single-family rental REIT, is able to work with homebuilders and buy entire communities from those homebuilders before they even hit the market. Because they can pay for the entire community up front, they're willing to cut Invitation Homes a deal and so are able to get it at better-than-market deals. And so, that's how they're able to generate cash flow. But again, that's a relationship that won't be necessarily transferred if the management team turns over. So, that's not really a moat, but it is where we think of exemplary stewardship and generates excess cash flows for many of these companies.
Harrell: Got it. So, you might look for something like the Allocation Rating or something else as opposed to looking for moats, because there's not going to be a moat rating for any of these firms?