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Equity REITs as Part of a Long-Term Investment Plan

Resilience makes equity REITs an attractive component of a long-term strategy.

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Making the Case for Equity REITs as Part of a Long-Term Investment Strategy
We believe equity REITs should be part of a long-term investment strategy based on a number of benefits, including diversification, their ownership of high-quality commercial real estate portfolios, sustainable yield and income growth potential, flexible capital structures, and relative risk, reward, and volatility. We also feel equity REITs are well-positioned to manage through potentially challenging economic circumstances, including slower than expected economic growth and/or rising inflation or interest rate environments.

Despite relatively strong investment performance, equity REITs presently trade 35% below peak valuations, reached in February 2007, and continue to benefit from low interest rates and strong demand for asset classes, providing inflation and interest rate hedging characteristics.

Strategic Reasons to Include Equity REITs in an Investment Portfolio

Potential for Higher Return and Lower Risk
Equity REITs, when part of a diversified investment strategy, have historically helped to increase portfolio returns while also reducing risk. According to a Morningstar study, since 1972, a diversified portfolio (stocks, bonds, treasury bills) 20% allocated to equity REITs experienced an average annualized total return and Sharpe ratio of 10.5% and 0.45, respectively. For comparison purposes, the diversified portfolio with no allocation to equity REITs delivered an average annualized total return and Sharpe ratio of 10% and 0.39, respectively. The Sharpe ratio helps determine how well an investor is compensated for the risk taken in a specific investment. The higher the Sharpe ratio, the better. In short, the diversified portfolio, including a 20% REIT allocation, generated higher returns with lower risk.

Dividend Growth and Yield Sustainability
Portfolio operating and overall cash flow fundamentals appear to be improving for equity REITs, which should allow for potential dividend growth and the current sector 4.1% dividend yield to be maintained longer term. Presently, the average equity REIT FFO* dividend payout ratio is 69%, near its historic low of 66%, and below the long-term average of 73%. We feel the 69% level allows enough of a cash flow cushion to increase annual dividends at the historic 5% growth rate, even in a slower economic growth environment, and continue to outpace inflation over the long term.

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Better Liquidity, Transparency and Corporate Governance
Publicly traded equity REITs provide investors with a cost- and risk-efficient vehicle to invest in commercial real estate, an asset class that has not been known for being investor friendly in terms of being able to achieve appropriate diversification, liquidity, and transparency. Compared with the alternatives, such as direct/private commercial real estate investment and public nontraded REIT investment (SEC registered, but not traded on an exchange), the publicly traded equity REITs generally offer:

  • Meaningful operating expertise.
  • Daily liquidity.
  • Significantly better transparency (quarterly and annual filings, detailed operating and cash flow information, portfolio and balance sheet supplemental reports, quarterly conference calls).
  • More financial flexibility and access to affordable investment and financing capital through public capital markets.
  • Generally strong corporate governance and structure (destaggered boards, internally advised corporate structures with few conflicts of interests, incentivized compensation, disciplined cost/fee structures).

Total return performance has also been consistently strong, as equity REITs have achieved an average annualized 10- and 20-year total return through May 2011 of 11.8% and 11.6%, ahead of the 2.8% and 8.9% delivered by the S&P 500, respectively.

Outperformance During Challenging Economic Environments
In terms of total return performance, equity REITs have historically outperformed many peer asset classes during periods of slow economic growth, rising inflation, and rising interest rates. Since 2000, for example, equity REITs have experienced total returns of 7.6%, 11.6%, and 13.1% during periods of below median gross domestic product growth, above median inflation and rising interest rates, respectively. The total return performance exceeded the S&P 500 by 10.1%, 6.8%, and 8.4%, respectively.

 

Diversification Within the Asset Class
Equity REITs offer exposure to many different real estate sectors, such as office, industrial, retail, multifamily, healthcare, lab/R&D space, self storage, lodging, data centers, cell towers timber, and land. Equity REITs also provide significant geographic diversification potential, whether locally, regionally, or internationally. The potential for real estate sector and/or geographic diversification affords investment portfolios the ability to better manage risk and adjust strategy throughout both the economic and investment cycles.

Equity REITs Reasonably Well-Positioned for Potential Economic Headwinds
The economy faces several potential challenges, including the possibility of slower than anticipated economic growth and the threat of either rising inflation or interest rates. As previously mentioned, equity REITs have historically performed well when faced with these headwinds. We believe similar long-term future outperformance may be possible based on existing equity REIT operating and balance sheet fundamentals, the ownership of institutional quality commercial real estate, healthy commercial real estate supply, well underwritten equity REIT lease structures, and equity REIT dividend growth and yield sustainability. Below, we identify potential challenges and how we believe equity REITs may be positioned to manage the associated risk.

Rising Interest Rates

  • We believe equity REIT dividend yields, currently averaging 4.1%, and relevant spreads, when compared with other income oriented investments, can be grown and maintained longer term, even under a slower growth scenario, as FFO dividend payout ratios currently average 69%, near historic lows.
  • Portfolio operating performance has begun to slowly improve, increasing portfolio cash flow and yield potential.

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Rising Inflation

  • Since 1990, equity REITs have increased annual dividends by an average 5%, well above average annual inflation of 2.5%. We feel equity REITs, based on improving fundamentals and attractive FFO dividend payout ratios, are positioned to maintain historical dividend growth averages.
  • The majority of equity REITs structure leases with tenants that include annual minimum increases that are either fixed or tied to inflation.
  • Equity REITs which rely on near-term leases, such as hotels, storage, and apartments, can reprice tenants faster than liabilities reprice.

Further Commercial Real Estate Valuation Declines

  • Unlike past cycles, excess commercial real estate (CRE) supply/expansion did not cause or precede this downturn, and CRE has maintained a healthy balance. This should allow underlying CRE rents, cash flows, and valuations to rebound more quickly than past recoveries.

Slow Economic Growth

  • Investors can choose among a diversity of equity REITs with sector/individual, company/geographic footprint options less sensitive to the economic cycle.
  • As previously mentioned, equity REIT FFO dividend payout ratios are near historic lows. This should allow for potential "inflation-plus" dividend growth and a level of principal downside protection, even during periods of slow economic and/or equity REIT operating cash flow growth.

Debt Refinancing Risk

  • During the last two years, we estimate equity REITs have refinanced 20%-25% of aggregate debt, reducing risk and uncertainty.
  • We estimate equity REITs have 18%-20% of aggregate debt maturing through 2012. Low interest rates are currently a positive, but a rising rate environment could increase borrowing costs, reducing cash flows.
  • Debt/EBITDA and fixed charge coverage for the equity REIT sector currently averages a relatively healthy 6.4 times and 2.1 times, respectively.

Equity REIT Operating and Capital Structure Fundamentals Healthy

From a fundamental standpoint, equity REITs remain in good shape. Operationally, fundamentals are stabilizing and are beginning to slowly improve with the economy. As reported in the first quarter of 2011, equity REITs experienced average same-store net operating income growth of approximately 1%-3%, with multifamily at the upper end (6%-8%) and suburban office at the lower end (negative 5%-8%). Although lease renewal risk remains, we estimate equity REITs have an average 15%-17% of portfolio lease renewals through 2012, which we believe should not pose a significant risk to revenues. An additional operating fundamental catalyst will be the very limited new commercial real estate development over the last several years, combined with less supply to digest than previous down cycles. The combination should allow underlying property cash flows and valuations to rebound more quickly, even in a slower economic growth environment.

Capital structures across the sector have and continue to improve, providing equity REITs the ability to take advantage of increasing incremental growth opportunities. Debt/EBITDA and fixed charge coverage is currently 6.4 times and 2.1 times, improving from 7.2 times and 1.9 times two years ago, respectively. Both ratios need to improve a bit, preferably to below 6 times and above 2.5 times, respectively, and we believe they will, based on low interest rates and financing availability for high quality commercial real estate portfolios and business franchises. Additionally, we estimate the equity REIT sector has an aggregate 18%-20% of its debt maturing through 2012, a manageable amount that should not pose a significant refinancing risk.

Equity REIT Valuations Ahead of Fundamentals; We Recommend a Defensive Approach

We estimate equity REITs are trading at a 15% premium to our fair value estimate and ahead of improving economic and associated portfolio fundamentals. Having said this, however, equity REITs are continuing to trade 35% below peak valuations, reached February 2007.

Based on current valuations, and despite risk being in favor during the last few years, we recommend equity REIT portfolios be weighted more defensively, focusing on business models positioned for more sustainable long-term growth through commercial real estate and economic and financial cycles. We suggest equity REITs with:

  • A history of incremental increases in both portfolio Net Asset Value and business model fair value (Morningstar's net asset value added and fair value analysis).
  • A full-service real estate skill set (acquisition, development, property management), which we feel more appropriately positions the equity REIT to exploit growth opportunities and manage risk, and cash flows throughout the real estate cycle.
  • Lower FFO dividend payout ratios (top 20% of industry, which we currently estimate to be 35%-40%).
  • Debt/EBITDA less than 6.0 times.
  • Fixed charge coverage ratios more than 2.5 times.
  • Niche, competitively advantaged operating strategies.
  • Operating strategies and portfolios focused on need-driven, less cyclical consumer services, such as health care or necessity/value retail.
  • Operating strategies not overly dependent on strong economic and employment growth or consumer discretionary spending.

Based on the above criteria we currently recommend investors consider  Alexandria Real Estate Equities (ARE),  Ventas (VTR),  Realty Income (O), and  Corporate Office Properties Trust (OFC).

*FFO: Funds From Operations is calculated as net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from sales of property, plus real estate related depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures.

 

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