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Outlook for REITs in 2020, and 2 Companies Backed by Gurus

The U.S. property market has provided stellar returns to investors throughout history. Investors, analysts and economists keep a close eye on this industry to gauge a measure of the level of economic activity. While there are many ways to invest in this sector, including directly purchasing properties, real estate investment trusts (REITs) have gained in popularity over the last couple of decades as one of the most convenient ways of gaining exposure to real assets. In the first half of this analysis, I will discuss the performance of REITs in 2019 and the expectations for 2020, the reasons behind investing in this asset class and some of the REITs that gurus are bullish on.


Why investors should consider real estate investments

Not every asset class has the same characteristics, and understanding the intrinsic nature of different types of investments is important to build a portfolio that provides an acceptable return under various market conditions. One of the primary reasons to invest in real estate is the potential for generating a higher average return over any other asset class.

The inflation-adjusted average annual return of various asset classes in developed countries:

Source: The Atlas (data as of December 2017)

Diversification benefits provide another reason to consider this investment vehicle. In a study conducted by Dr. Jeffery Fisher of John Hopkins University, it was revealed that real estate investment returns have a low correlation with stock markets around the globe, which is proof that this sector has the potential to reduce the overall risk of an investment portfolio.

Among investment gurus, Ray Dalio (Trades, Portfolio) stands out as one of the most prominent investors who have remained bullish on real estate for decades. In an interview with CNBC, Dalio said:


"Keeping cash in a savings account is the worst thing you could do because it is the surest tax on your money. You will bleed slowly to death because the after-tax returns are lower than inflation by a little per year. It's important to know how to diversify into non-cash assets like stocks, bonds, and real assets."



For his book "Money: Master the Game," Tony Robbins interviewed over 50 legendary investors, including Warren Buffett (Trades, Portfolio), Carl Icahn (Trades, Portfolio), Ray Dalio (Trades, Portfolio) and Steve Forbes, and based on the input from these successful investors, suggested that the below asset allocation strategy is what gurus believe would deliver attractive returns in all market conditions.

Source: "Money: Master the Game"

This illustrates the important role real assets such as properties play in an investor's portfolio.

Another reason to invest in this sector is the hedge provided against inflation. In an inflationary environment, it is entirely possible for a certain asset class, including stocks, to provide meager returns that do not beat the rising cost of living. According to a study conducted by the Massachusetts Institute of Technology, property prices have exhibited a high correlation with inflation from 1978 to 2016.

Source: MIT

As evident from the above illustration, both retail and apartment properties have proved to be complete hedges against inflation, whereas the other two segments have provided an acceptable level of correlation.

Performance of REITs in 2019

Stocks reached record highs in 2019 as the S&P 500 Index delivered a staggering 32% total return. REITs did not disappoint investors either, generating a return of 28.7% in this period. The below breakdown of segmental performance indicates that REITs that specialize in a few property types have outperformed others by a considerable margin.

Source: The National Association of Real Estate Investment Trusts

The low interest rate environment, the continued growth of the U.S. economy and the geopolitical stability achieved toward the latter half of the year were the main drivers of this sector in 2019.

The outlook for REITs in 2020

The financial performance of the real estate sector primarily depends on the health of the economy. Whenever recession fears emerge, investors punish REITs in a bid to diversify their investments to safer asset classes. With the signing of the Phase 1 trade deal between the U.S. and China, the possibility of an economic downturn in 2020 has significantly reduced. Economists polled by Wolters Kluwer Blue Chip Economic Indicators in December believe that there's a 33.1% chance of a recession this year, down from 38.4 % reported in June.

Barclays economist Jonathan Miller, wrote:


"We now see the risks as being more balanced with the job figures highlighting the possibility that household spending may be carrying more momentum into 2020."



This continued growth of the U.S. economy is a good sign for the real estate sector as a higher level of disposable income generally translates into higher spending, which is a blessing for many types of properties, including malls, offices and residential units.

The low interest rate environment helps the sector from two fronts as well. First, companies representing this industry can borrow funds at a low cost, and empirical evidence suggests that REITs tend to use debt to purchase new properties. This eventually leads to higher revenue and earnings as occupancy rates remain high during a period of economic growth. Second, consumers borrow more at more reasonable costs, leading to higher spending on both discretionary and non-discretionary products and services. Credit growth, therefore, is vital for the survival of this industry, and the prevailing conditions are tailor-made for continued growth in 2020.

The below graph illustrates the relationship between interest rates and the performance of REITs:

Source: The National Association of Real Estate Investment Trusts

In the most recent tightening cycle that lasted from the beginning of 2016 to 2018, the correlation between the performance of REITs and yields has been negative, which led to significant underperformance of this sector. However, in 2019, this reversed along with the decision by the Federal Open Market Committee (FOMC) to cut rates. The minutes from the Fed meeting released in December indicate that policymakers are confident of a stable monetary policy in 2020, which is a welcome sign for the real estate sector.

Analyzing the demand and supply dynamics for different types of properties is another technique that can be used to gauge a measure of the expected performance from REITs. Data as of the end of 2019 reveal that the market is in equilibrium; no excess demand or supply is present.

Source: The National Association of Real Estate Investment Trusts

As illustrated in the above chart, during the financial crisis period from 2007 to 2009, there was an excess supply in the industry. This eventually led to a collapse of REIT prices. Today, however, the situation is still balanced and there are no alarming signs for investors. In 2020, demand will most likely gain traction as a result of improving economic conditions, leading to a more stable real estate market in the United States.

Rental vacancy rates, on the other hand, tend to increase drastically during a recession as consumers do not invest in available properties. In 2009, a record-high was reported just before the bubble burst.

Vacancy rate in the United States:

Source: GuruFocus

Vacancy rates have been declining in the last few years, which is another positive sign for the industry. A significant hike is unlikely in 2020 due to prevailing macroeconomic conditions, which makes the outlook for the sector favorable this year.

The attractive dividend yields at which some REITs are trading at is another reason for investors to consider this sector. To be classified as a real estate investment trust, a company has to distribute at least 90% of their earnings to investors, which is the primary reason behind the high yields. The below table is a list of the ten largest REITs worldwide by market capitalization and their respective yields as of Wednesday.

Company

Dividend yield

American Tower Corporation

1.6%

Simon Property Group

5.57%

Crown Castle International

3.24%

Public Storage

3.59%

Prologis, Inc.

2.22%

Equinix, Inc.

1.67%

Weyerhaeuser Company

4.42%

Equity Residential

2.73%

AvalonBay Communities, Inc.

2.77%

Digital Realty Trust, Inc.

3.44%



Source: Reuters

Apart from these well-known names, many other smaller-scale companies are trading at very attractive multiples.

Two Guru-backed REITs to consider

Warren Buffett (Trades, Portfolio) owns shares of STORE Capital Corporation (NYSE:STOR), a leader in the acquisition, investment and management of single-tenant operational real estate in the United States, and its shares yield 3.62% at the market price of around $38.60 on Jan. 22. According to company filings, STORE generates approximately $130 million in annual free cash flow after distributing dividends, which has been helpful in funding its acquisition spree of properties. The cash-rich nature of the business has helped it generate better revenue growth in comparison to its peers in the last five years.

Source: Company filings

Positive performance can be expected in 2020 as well, and Wall Street analysts have an average target price of $40.63 for shares.

Ray Dalio (Trades, Portfolio) owns shares of American Tower Corporation (NYSE:AMT), another another attractive buy for 2020. The company owns, operates and develops multitenant communications real estate with a portfolio of approximately 171,000 sites. American Tower will benefit immensely from the rollout of 5G technology as the towers owned and operated by the company will play an integral part in facilitating this new technology. Shares yield just 1.6%, but that is mainly due to capital appreciation in the last couple of years. What is more attractive is that the company has hiked its dividend per share in each of the last seven years. In the third-quarter earnings call in October, management guided for higher distributions for investors in the future. Even though shares already trade at a forward price-to-funds from operations multiple of 31, if Apple (AAPL) and other leading Smartphone manufacturers release 5G-enabled devices in the second half of this year, the multiple could expand further, leading to attractive returns for investors.

Takeaway

The real estate industry is poised to perform positively in 2020, on the back of moderate economic growth expectations for the United States. The dynamics driving this sector are all supportive of further growth, and this presents attractive investment opportunities for investors. In addition to the two REITs that were discussed in this analysis, there are many companies to look out for in 2020.

Disclosure: I do not own any stocks mentioned in this article.

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This article first appeared on GuruFocus.