Despite modest returns from REITs in both 2016 and 2017, investors may still be somewhat shy about increasing their allocation. After all, REITs are supposed to underperform when rates are rising and we are in the midst of a Fed tightening cycle. While recent developments suggest the pace of tightening may slow and/or be closer to the end of this cycle than we are to the beginning, REITs have still been one of the worst performing sectors over the last 12 months.
As the graph below shows, the Vanguard Real Estate ETF (NYSEARCA:VNQ) was one of the three worst performing sectors in 6 out of the last 12 months but has been in the top half for two out of the last three months even though last month was a disaster across the board.
But despite tepid enthusiasm from investors, REIT fundamentals continue to improve and we don't see any reason for this to change anytime soon. We view this as a great time for investors to pick up good REIT investments that could potentially enhance their portfolio income well into retirement.
Furthermore, balance sheets have never been stronger and REITs have never been more efficient operationally, so on an aggregate level, risks within the sector have been dramatically reduced.
Debt to Total Assets
Despite REITs requiring constant raising of capital to fund additional acquisitions and/or development, debt to total assets has decreased steadily since peaking in late 2008/early 2009. In fact, debt continued to decline even during the last Fed tightening cycle from 2004 to 2006 and seems to be trending down in the current cycle as well. That’s not to say that debt levels won’t spike in the near future – the last big spike was shortly after the Fed stopped tightening. That spike was partly due to a dramatic decline in stock prices, but at least in this cycle, REITs are less leveraged than they were at the end of the last one.
Interest Coverage
One of the benefits of a low interest rate environment is that REITs have been able to issue debt at historically low levels while growing net operating income in the process. Since mid-2006, the interest expense to NOI ratio has steadily improved from around 35% to around 20% as of the last quarter.
And the weighted average interest rate on long-term debt has declined from around 6% in late 2006 to just above 4%.
That has led to a record high interest coverage ratio of 5x from a pre-recession level of just 3x in 2006. So even as the Fed hikes rates and the cost of borrowing rises, there is still considerable room before debt coverage ratios become a burden operationally.
While higher rates will eventually lead to higher borrowing costs, REITs have generally done a good job of rolling over their debt so that rate resets are pushed out further into the future. The current weighted average term to maturity on debt for all equity REITs is over 70 months – and while rates may rise further, FFO and NOI should continue to rise as well. Both have been growing at a steady clip over the last few years and in some sectors, growth has remained robust.
Funds from Operations
Funds from operations or FFO, is a better indicator of a REIT's performance than the more traditional earnings per share reported by most other companies. The reason for this is the high amount of depreciation inherent in a portfolio of real estate that depresses earnings and doesn't really reveal much about the underlying performance of the REIT. So for all intents and purposes, FFO is to REITs what EPS is to other companies.
In Q3 2018, FFO for listed equity REITs decreased by 0.7% from the prior quarter but was up a solid 11.1% from the year ago period. The per share data was slightly lower, with -1.3% declines in FFO from the previous quarter but 6.5% growth from a year ago.
Only Healthcare REITs and Diversified REITs had declines in FFO over the last twelve-month period compared to the same period last year. Single-Family Home REITs, on the other hand, had 34% growth over the same period and much of that came in the last quarter. With mortgage rates higher than they were a year ago, we expect continued strength in this sector as consumers pass up buying a home and rent for longer periods of time.
There was one metric that jumped out at us when we recalculated the change in FFO to take into account additional REITs that are now included in each sector that were not included 11 months ago. The change in FFO per REIT was similar to the aggregate total for all sectors except for Free Standing Retail. That includes the likes of Realty Income (O), National Retail Properties (NNN) and Store Capital (STOR). The decline in FFO per REIT despite the overall growth in FFO for the sector might indicate imminent challenges for continued growth. Something worth watching.
Net Operating Income
Net operating income has also been increasing although not to the extent of FFO. Overall NOI decreased 2.1% from the prior quarter but was up 4.8% from a year ago period. While the per share NOI was down 2.6% from the prior quarter and flat to last year.
Breaking it down by sector we see a wide variety of results, however.
There were several sectors with strong growth in NOI exceeding 15% including Industrial, Single Family Homes, Infrastructure, and Data Centers. Three of those sectors are directly or indirectly related to technological innovation and data demand, as well as the growth of online retailing and its logistics.
The fourth – Single Family REITs – have grown out of the real estate bust in 2006 that allowed large institutional buyers to streamline the purchase and management of single family homes on a large scale.
The obvious 'losers' in NOI were the Regional Malls and Shopping Center REITs, which sit on the opposite end of the online retailing frenzy. However, Free Standing REITs, which are typically associated with corner drug stores or convenience stores, grew NOI by 6.3%.
The question now is whether any of these sectors look reasonably valued and if so, where might we find some opportunities to increase exposure.
NOI/Market Cap as a relative value indicator
While not a perfect indicator of value, we can use the aggregate net operating income of each sector relative to its market cap, and compare the same metric to the year ago period – to determine a sector's current valuation compared to December 2017.
A back of the envelop calculation that could guide us into a more in-depth analysis is shown below. Sectors with a higher NOI/Market Cap rate than they had 11 months ago would be a good place to begin a search for undervalued companies. That's not to say there will be attractive opportunities – as these metrics could be skewed by one or two companies within each sector. But if looking at allocation decisions – once fundamentals are determined, we can incorporate this analysis as part of the valuation analysis at an aggregate level.
Sectors with higher NOI/Market Cap than December 2017 include: Office, Shopping Centers, Regional Malls, Single Family Homes, Diversified, Lodging, Infrastructure, and Data Centers.
Office REITs and Shopping Center REITs are two of the worst performing sectors over the last year, as well as Regional Malls and Single Family Homes.
Meanwhile, Free Standing, Manufactured Homes, and Healthcare have NOI/Market Cap that is noticeably lower than it was just 11 months ago. Part of the reason is performance over the last 12 months, as well as relatively slower growth in NOI.
Free Standing REITs are up 18% in the last year, while Manufactured Homes and Healthcare are up 7.1% and 6.4%, respectively. It makes sense, then, that by this metric, these REIT sectors look slightly overvalued compared to the others. Particularly since these sectors lagged other sectors in FFO and NOI growth.
Same Store Net Operating income
We can also use same-store NOI growth to determine a sector's growth potential within its current portfolio and without having to grow by acquisitions – which would require either additional share offerings or borrowing.
SS NOI growth exceeded 5% in both Manufactured Homes and Industrial, followed by Single Family Homes and Office REITS. (Note: information not provided for Free Standing REITs)
We particularly like the growth potential within Residential REITs, especially the Single Family sector, as well as a resurgence in Office REITs, which we believe are now somewhat undervalued.
Risks
Risks to each sector are not only highly dependent on underlying fundamentals of the property types, but on the amount of activity within each sector as it relates to net acquisitions and property development. The greater the amount of supply coming online the greater the amount of risk to competitive dynamics and pressure on pricing.
On the acquisition front, the majority of acquisitions are occurring within the Retail sector, but because of a high level of dispositions, the highest level of net acquisitions is occurring in the Specialty and Self-Storage sectors. For many of the other sectors, while there is heightened activity, in the case of Office, Residential, Healthcare, and Lodging, there has been an overall net decrease in portfolio sizes.
Despite the increase in retail net acquisitions, however, we want to point out that it has been driven entirely by an increase in activity within the Free Standing sector, while Shopping Centers and Regional Malls have been in disposition mode. This is yet another risk we point out for Free Standing REITs in the near future. We are therefore reducing our exposure to Free Standing as we explain below.
Within the Residential sector, there have been net dispositions, driven by a net reduction in both the Apartment and Single Family Home sectors even as Manufactured Homes acquired more assets during the period than they sold. For this reason and others mentioned throughout this article, we are increasing our exposure to Single Family Homes and decreasing our exposure to Manufactured homes.
Property Development
One area of concern in some of our favored sectors is the amount of property development in the pipeline. Development is highest within the Office REIT sector and is generally at its highest level ever for all REITs. This is partly due to the growth of REITs generally, and REITs still own a small fraction of property types they operate in - but short-term development among REITs within sectors also indicates a heightened level of interest in those sectors by private investors – and we could reasonably assume that there is a large inventory of private development not accounted for. Still, using publicly available information as a gauge gives us pause. Sectors HOT in the development pipeline include Office, Industrial, and Data Centers, while development in Residential, Healthcare, and Self-Storage has slowed.
Summary of Sector Positioning
We are increasing our allocation to Industrial to neutral from a slight underweight – based on growth in FFO and NOI and despite strong development and acquisition activity. We believe the impact of online retailing will only accelerate further as more and more retailers implement an omni-channel strategy to compete with Amazon (AMZN) and others. Industrial REITs have returned just 1.5% over the past year but have recently gained momentum.
We are also increasing our Single Family Home exposure on concerns about affordability and higher rates, even if rates stabilize at current levels.
After being bearish on Office REITs for some time, we are now increasing our allocation to a slight overweight based on renewed growth in FFO and more reasonable valuations and net dispositions even as development picks up.
To balance out our increases in the above sectors, we are decreasing exposure to Free Standing REITs, based on tepid SS NOI growth and rich valuations, as well as Health Care REITs, for many of the same reasons, even as the sector downsizes through dispositions. Free Standing REITs have had the highest 1-year returns of all sectors with an 18% return and Healthcare has had a return of 7.7% YTD.
Our positioning by sector is below. Note that the Strategic weights are based on the aggregate market caps of each REIT sector as represented within the NAREIT Index. In other words, Office REITs make up 8% of the total market cap of all REITs within the NAREIT index. We then over or under weight to each sector based on our views.
REITs rated Buy within our Focus List include:
- PotlatchDeltic (PCH)
- UMH Properties (UMH)
- Ventas (VTR)
- Global Self-Storage (SELF)
- City Office REIT (CIO)
- Sabra Healthcare (SBRA)
- CoreSite Realty Corp (COR)
- Innovative Industrial Properties (IIPR)
- Independence Realty Trust (IRT)
- Healthcare Trust of America (HTA)
- Preferred Apartment Communities (APTS)
- Kimco Realty (KIM)
- Simon Property Group (SPG)
- Monmouth Real Estate Investment Corp (MNR)
- HCP Inc. (HCP)
- Annaly Capital (NLY)
And our Premium REIT List includes:
- Weyerhaeuser (WY)
- Host Hotels & Resorts (HST)
- Public Storage (PSA)
- Equity Residential (EQR)
- Brandywine Realty Trust (BDN)
- American Tower Corp. (AMT)
- Regency Centers (REG)
- Realty Income (O)
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