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4 REITs That Can Weather Through Rising Rates

Rising interest rates can be a valuation headwind for the REIT sector, but some REITs are better positioned than others, says Morningstar's Todd Lukasik.

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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Todd Lukasik. He's a senior REIT analyst at Morningstar. We'll look at the real estate market and if there are any opportunities.

Todd, thanks for joining me.

Todd Lukasik: Thanks for having me.

Glaser: Let's take a look at how the fundamentals of the commercial real estate market have been doing in this slow-growth world. When you look across commercial real estate, what are you seeing right now?

Lukasik: Certainly, during the downturn, there was a big drop in operating performance for REITs across all sectors, generally. But the slow-and-steady recovery in the economy has been very good for existing landlords. And basically, the slow-and-steady growth has resulted in incremental demand; but it hasn't been strong enough, such that developers have been building a lot of incremental supply.

So, that incremental demand that we've been seeing from the slow-and-steady growth in the economy has largely accrued to existing landlords, and that's led to improvements in occupancy rates and rental rates across all property sectors at this point. And some property sectors are actually operating at levels that are consistent with prior cyclical peaks in terms of levels of occupancy and EBITDA [earnings before interest, taxes, depreciation, and amortization] margin.

Glaser: How have interest rates impacted real estate investment trusts? Often, people think of them as interest-rate sensitive. Have the low rates been a big help and how worried are you about a potentially rising-rate environment?

Lukasik: I think there are a few things to consider with the low-interest-rate environment. One is the interest that that's caused in commercial real estate as other sources of yield have become less attractive; it's made things like dividend yields for REITs and income yields, in general, on properties look more attractive. And we've seen institutional investors increase allocations toward commercial real estate, and fund flows into commercial real estate have been very strong lately. We think that has boosted real estate prices as well.

The other impact is that as interest rates fall, real estate investment trusts, which rely heavily on leverage to finance their acquisitions, are able to either issue new debt or refinance old debt as it matures at lower levels of interest rates. This means they're paying less in interest expense, and there's more cash available. REIT earnings, such as FFO [funds from operations] or AFFO [adjusted funds from operations], have been able to grow a little bit more quickly than they could have otherwise. [The lower interest rates have] also supported potentially higher dividend payments than you would get otherwise as well.

Glaser: So, when rates do start to rise, what do you think the impact is going to be? Are we going to see a repeat of the 2008-09 big downturn in REIT prices?

Lukasik: A rising-interest-rate environment, we think, is going to be a valuation headwind for the REIT sector in general. Among our coverage, most of the REITs have well-laddered and lengthy debt-maturity schedules, so an increase in interest rates wouldn't have an immediate impact on those cash flows. It would take years for a higher-interest-rate environment to flow through to the financials of the REITs. But from a valuation perspective, prices can reset pretty quickly. And we think that what was once a tailwind, in terms of a low-interest-rate environment, would become a headwind if rates rise--especially if they rise quickly.

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Glaser: You mentioned that some sectors maybe are looking at a closer cyclical peak than others. When you look across the real estate sectors, which do you think are maybe a little bit more attractive and which are less so?

Lukasik: One of the pieces of conventional wisdom is that, in a rising-interest-rate environment, you'd want to own property types that have shorter lease durations--the idea being that a rising-interest-rate environment will be accompanied by an improving economy. And if the economy is improving, that will lead to incremental demand for commercial real estate.

So, places like multifamily or self-storage that tend to have leases with tenants that are a year or less would then be able to--after that year runs out if the economy has been strong--to raise their rents on existing tenants and, therefore, increase their cash flows, which would help offset the potential negative impacts of a rising-interest-rate environment.

In our research, we think those two property sectors in particular, multifamily and self-storage, are operating at or near levels that are consistent with prior cyclical peaks in terms of occupancy and EBITDA margin. And they also happen to be two sectors of our coverage that appear to be most overvalued at this point relative to our fair value estimate.

So, for those reasons, these kinds of traditional areas where investors have thought about putting money in during a rising-interest-rate environment, those two areas today do not--in our opinion--seem to offer an appropriate margin of safety for investors.

Glaser: On the other hand, then, are there areas that maybe do look more attractive?

Lukasik: Yes. Again, it goes against conventional wisdom, I guess, in a couple of instances. We like a couple of health-care REITs right now, and they have very long-term triple-net leases, which traditionally are not in favor with investors during rising-interest-rate environments. Those are HCP (HCP) and Ventas (VTR).

We like those today, nonetheless, because even though there may be a rising-interest-rate environment, their lease payments from tenants also tend to rise at a rate of 2.5% to 3.5% a year--or the change in CPI [Consumer Price Index]--whichever is greater. So, they do have some protection in a rising-interest-rate environment, and they're able to grow their cash flows even though interest rates are rising. They don't have flat cash flows, year on year. They also have a big industry-consolidation opportunity ahead of them and should benefit from a growing and aging population, which should be demanding more health-care services--which generally require real estate for delivery.

Two other areas we like have similar themes in that they have strong internal-growth and external-growth prospects. One of them is Tanger Factory Outlet Centers (SKT). They own outlet malls around the country and in Canada. The other one is American Tower (AMT), which owns cell phone towers across the country and internationally.

Glaser: So, it's important to keep an eye on valuation through this interest-rate environment.

Lukasik: Absolutely. Right now, we think REITs are about 5% to 10% overvalued in general; so, we do think it's a good time for investors to look at what they're holding in their REIT portfolios and think about reorienting to REITs that look relatively attractive--both in today's environment but also if the environment potentially changes.

Glaser: Todd, I certainly appreciate your thoughts today.

Lukasik: Thanks very much, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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