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Cautious Optimism for REITs

Demand is decelerating but still robust.

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REITWeek 2016, the annual investor forum for the real estate investment trust industry, took place in New York last week. REIT management teams gave nearly 140 presentations, and we left with the following themes and takeaways.

Management teams are positive about underlying demand. Many REITs are still experiencing historically high levels of occupancy, which has helped fuel robust income growth for the past several years. Although this is moderating, there currently isn't a clear catalyst to negatively affect operations dramatically, though long-term demand questions remain for specific asset classes and markets (retail, skilled nursing facilities, Houston).

Supply concerns are limited to specific markets and asset classes for now. Markets like Washington, D.C., New York, and San Francisco have elevated levels of new supply in multifamily units and office space. Senior housing construction is still a concern in low-barrier markets. And we heard several times that the United States has too much retail space. Our favorite line was, "Malls aren't overbuilt, they are underdemolished."

Asset prices are high, and REITs are net sellers. Capital demand for real estate remains robust, and REITs are using the opportunity to harvest value, refine portfolios, deleverage, and self-fund development. However, this also means that attractive acquisition opportunities are rare. The path to higher interest rates is still questionable, especially after the recent jobs report.

Leverage is important, but liquidity and cost of capital are key. Much focus has been on monitoring leverage levels since the last downturn. In turn, firms have been more conservative with their capital structures. However, many REITs have also amended their credit facilities, expanding capacity and lowering cost. Altogether, REITs want balance sheet strength but also the flexibility to take advantage of any opportunities that potential weakness may shake loose; this is how many firms made some of their best deals during the last downturn.

We believe REITs are generally healthy today, given robust albeit decelerating demand demonstrated by high occupancy, solid rent growth, and investment demand, at least for the highest-quality assets. While we think many parts of the commercial real estate market are mean-reverting, reflecting temporary supply and demand dislocations throughout the real estate cycle, it is also important to look for structural changes that affect overall long-term demand. In our coverage, we are currently especially sensitive to skilled nursing facilities owned by healthcare REITs and retail assets.

The skilled nursing industry is in transition as a result of healthcare regulation; it represents a required service in the healthcare continuum but will most likely look much different than in the past, with clear winners and losers based on the level of healthcare quality and value that services providers are able to produce. While the demand for healthcare services is supported by the vast baby boomer generation getting older, we think healthcare regulation will continue to challenge skilled nursing in the near to medium term. The healthcare REITs we cover have been reducing their exposure over the past 12 months, partially mitigating these unknowns.  Ventas (VTR) spun off its skilled nursing portfolio into a separate publicly traded REIT and therefore only has marginal exposure, while  HCP (HCP) announced intentions to spin off its troubled HCR ManorCare portfolio later this year.  Welltower's (HCN) portfolio, mostly assets operated by publicly traded Genesis Healthcare (GEN), is maintaining rent coverage for now but will have significant exposure to the space in the future.

While not a new phenomenon, e-commerce continues to disrupt traditional retail and is forcing the industry to adapt, culling weaker retailers and forcing others to rethink (and generally reduce) their physical store strategies. We believe e-commerce, currently representing approximately 8% of retail sales by some estimates, will grow for many years to come. Performance for weaker assets (those with weak tenants, unattractive locations, and/or poor physical quality) is most likely to deteriorate as the supply/demand equation continues to tilt out of favor. Retail REITs in our coverage have been refining their portfolios for several years to offset the impact. However, the industry continues to change, and we expect the spread between high- and low-quality assets to extend, intensifying the need for active asset and portfolio management for retail REITs.

REITs' deleveraging can be seen as both defensive and offensive. On one hand, REITs and REIT investors are particularly sensitive to leverage, given issues experienced during the last downturn. And as the economic outlook becomes more uncertain, capital markets tend to slow. However, we don't think the act of deleveraging or selling assets is necessarily a sign that REITs see a downturn in the near future; rather we think it's more a reaction to the current risk/return landscape. No matter the market, healthy companies with strong balance sheets will have relatively better access to capital and able to be opportunistic about potential asset acquisitions or even mergers and acquisitions activity, and we think that difference is exacerbated by greater market uncertainty.

Another interesting overall theme was the increasing interest from generalist investors in REITs as a result of the much-anticipated creation of a new real estate sector under the Global Industry Classification Standard structure Aug. 31, 2016. While management teams believe the new sector will be a positive for REITs as a whole--a view we share--they also communicated challenges of getting nontraditional REIT investors up the learning curve for a new industry and competing, at least initially, for the additional capital support the new shareholder base represents. Overall, we expect an increased level of exposure and attention to the REIT sector as investors become more knowledgeable about an often-overlooked part of the market. While we don't necessarily think market values will increase relative to intrinsic asset values because of the added demand, we do think more participation will add liquidity for REIT securities and potentially decrease overall volatility.

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