Are REITs Overvalued?
Straight answers from Morningstar's REIT team.
In DividendInvestor, Morningstar’s newsletter focused on high-yielding and high-quality dividend payers, we regularly examine different income-producing sectors such as pipelines, REITs and utilities. (Investors can access a risk-free trial issue of DividendInvestor here.)
In February, DividendInvestor zeroed in on the real estate investment trust sector with analysts Arthur Oduma, Julian Perlmutter and Ryan Dobratz. Together they cover more than 60 property and mortgage REIT stocks as well as the homebuilding industry.
Morningstar DividendInvestor: REIT stocks have crushed the market over the past few years.
Arthur Oduma: Following the stock market crash led by Internet stocks, real estate has been viewed as a safe haven. The increasing popularity of dividends has played into this, and a long period of low interest rates has meant competing income-yielding assets could not match hefty REIT yields. But the runup has also had to do with a shortage of supply—the entire sector combined is worth about as much as Microsoft (MSFT) alone.
MDI: Have the fundamentals improved as much?
Oduma: Ironically, REIT stocks have done very well in the last five years even as fundamentals like lease pricing and occupancy rates have been poor. By contrast, fundamentals are now showing signs of improvement, yet REIT stocks have underperformed lately.
Ryan Dobratz: Real estate just doesn't appreciate 30% and 38% in back-to-back years. Prices may be out of touch here.
MDI: What might higher rates to do to REIT stocks?
Oduma: Some property sectors may benefit. For instance, higher rates mean higher mortgage costs and lower home-ownership rates, boosting the rental pool for apartment REITs. Higher rates often accompany vibrant economic growth, which means strong job creation creating demand for office space.
But generally speaking, REITs' cash flows will suffer as their cost of capital rises. And in the capital markets, higher interest rates will make Treasuries and corporate bonds more appealing as investments, reducing demand for REIT stocks. REIT yields would have to rise (and prices fall) to remain competitive.
MDI: What’s the outlook for lease pricing? Is there still excess supply on the market?
Oduma: It depends on the property sector: In offices, there hasn't been much building in the last few years. Rents have been too low to justify new construction, meaning the supply/demand balance remains favorable in many cities. But the industrial market is perennially oversupplied.
Dobratz: In retail, leases are being signed around all-time highs and properties have the least amount of vacant space they have had for quite a while. Supply growth is limited, consumer spending is holding up, and unemployment continues to fall.
Julian Perlmutter: Hotel and apartment prices are finally returning to their pre-9/11 levels. I don't believe there is excess supply on the market, since both of these sectors are consistently losing bidding wars to condo converters. With recent demand for condominiums, developers can outbid for properties since their break-even time is less than for a hotel or apartment.
MDI: What separates a good REIT from a bad REIT?
Dobratz: Strong locations and excellent management. You obviously want a REIT to have a strong balance sheet, access to capital, and a low payout ratio so the company can fund growth.
But strong locations and superb management take the cake. A great example is Federal Realty Trust (FRT). An attractive portfolio allows the company to be very selective in deciding where to allocate capital, which is why it has increased the dividend the last 37 years.
Another talented management team is Vornado's (VNO). This team simply extracts the most value from each location—thus creating value for shareholders that other management teams overlook. Overall, this is a management team that I would want to buy into.
Oduma: We look at how long management has been at the helm, or at least in the real estate business. Real estate is relationship-driven to a larger extent than many other businesses. We like to see management own a sizable proportion of the business—specifically, are its holdings significantly larger than its annual pay?
We also look at dividend security. A red flag is REITs that consistently pay out more than they are generating (greater than 100% payout ratio based on funds from operations); they are either selling properties and/or borrowing to meet their dividends, which is unsustainable in the long run.
MDI: In general, what kind of total return should an investor expect from an REIT?
Dobratz: The 20-year average return for the NAREIT index is 13.4%. I don't believe we can expect those kinds of returns over the next 20 years, but I do think we can be confident in receiving a 10% annualized annual return over the long haul (dividend and appreciation).
I'd wait until things cooled off a bit until I dove in headfirst, though.
MDI: What are your favorite REITs?
Oduma: Many of the REITs on our coverage are still richly priced. But there are some I would still hold if I owned them already: Boston Properties (BXP), Mack-Cali (CLI), Catellus (CDX), Duke (DRE), and Kilroy (KRC). Their dividends are more secure compared to most peers’.
Perlmutter: Camden Property Trust (CPT) is a REIT I have a lot of respect for. It has a great track record and I think it will be in the game for a long time. But I would rather wait and see how its current merger pans out.
MDI: Are valuations excessive enough that existing owners should consider selling?
Perlmutter: If you've already seen a nice capital gain from REIT shares and have higher total-return expectations than the current yields, I think the time to check out is here. I believe prices have nowhere to go but down.
Dobratz: If REIT insiders sold $200 million of their stock in the fourth quarter of 2004, why should you shy away from taking profits? I would walk away in a lot of cases.
MDI: Thanks for sharing your insights, guys.
This article is from a recent issue of Morningstar DividendInvestor, our monthly newsletter dedicated to helping investors find high-dividend stocks with superior long-term return potential. To review a risk-free trial issue of DividendInvestor and receive three free investing reports, click here.
Josh Peters, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.