The U.S. Real Estate Investment Trust (:REIT) industry continued its bull run in the first half of 2012, driven by strengthening fundamentals for commercial real estate and an improving outlook for the U.S. economy despite some recent doubts. The uptrend in the diffusion index further suggested that economic growth was broadening across sectors and indicated a higher probability of a firmer foundation for future growth.
Equity prices moved northwards as geopolitical noise remained relatively benign with a controlled restructuring of the Greek debt and additional liquidity provided to European banks, thereby reducing a potential threat to the global financial system.
The Fed maintained a low rate of interest and even promised to keep it there through late 2014 to sustain the economic recovery. With expected GDP growth of around 2% in 2012, positive vibes were emanating from the overall industry. Employment data was also encouraging, with an average monthly gain of 226,000 for the first quarter of the year.
However, with escalation of the European debt crisis and emerging signs of economic weakness all over the world, average employment growth dropped to a mere 75,000 per month during the second quarter of 2012. This pegged back the growth momentum to some extent as speculation of a sovereign debt crisis in Europe weighed on investors.
Nevertheless, the U.S. REIT industry outperformed the broader equity market in the first half of 2012. The FTSE NAREIT All Equity REIT Index reported total returns of 16.11% as of July 2, 2012 vs. a 13.28% and 8.58% for the NASDAQ Composite, and the S&P 500 Index, respectively.
A combination of factors has helped the listed REIT sector to stand out and gain critical mass over the past 15 to 20 years, the most notable among them being a healthy dividend payout. Total returns of 16.11% for the FTSE NAREIT All Equity REIT Index in the first half of 2012 included a share price return of 14.12%.
Investors looking for high dividend yields have historically favored the REIT sector. Solid dividend payouts are arguably the biggest enticement for REIT investors as U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends to shareholders. The dividend yield for the FTSE NAREIT All Equity REIT Index as of July 2, 2012 was 3.25%, compared to 1.58% for the 10-year U.S. Treasury Note.
During 2007 to 2009, REITs took on far less debt than private real estate investors, and many were able to sell at the top of the market when private equity investors were still buying. Importantly, during the downturn, REITs were able to acquire properties from highly leveraged investors at deeply discounted prices. This enabled them to add premium high-return assets to their portfolios.
Furthermore, REITs managed to raise capital to pay off debt, owing to a large inflow of funds as institutional investors allocated more ‘dry powder’ to the industry, making them an increasingly attractive investment proposition. In 2011, REITs raised $51.3 billion in public equity and debt, out of which $37.5 billion alone was raised though public equity despite a highly volatile market. During the first quarter of 2012, publicly traded U.S. REITs raised an aggregate of $21.2 billion in capital, which included $10.6 billion in equity.
Moreover, according to data from NAREIT, debt ratio of equity REITs (total industry debt as a percentage of its total debt and equity market capitalization) as of December 31, 2011 was 38.6% -- significantly lower than 51% at the end of second quarter 2008, which was prior to the Lehman Brothers collapse and the ‘Great Recession.’
In addition, REITs typically have a large unencumbered pool of assets, which could provide an additional avenue to raise cash during a crisis. These, in turn, have provided the requisite wherewithal to the REIT industry to make strategic acquisitions over time to fuel its inorganic growth engine. Moving forward, the REIT industry is likely to maintain the uptrend in growth for the remainder of 2012. The outlook remains by and large positive.
However, given the positive note in the investor sentiment, a number of factors still persist as a thorn in the improved market scenario. As it is is a presidential election year, chances are high that the U.S. policymakers will refrain from making any radical changes on key issues. With political uncertainty persisting until at least the elections are over, investors might play a ‘wait and see’ game before committing on better investment opportunities. This could, in turn, put a ceiling on equity returns in the latter half of 2012.
Furthermore, the strategic move to focus on austerity measures among European countries could impede regional economic growth, leading to a dearth of investor confidence in the European financial and fiscal system. In addition, economic growth in emerging markets, particularly the BRIC countries, is expected to be lesser than in recent years, driven by a relative weakness in the developed world and related uncertainties in the global business climate. All these factors could cumulatively contribute to an equity market headwind in the remainder of 2012.
In a nutshell, the long-term prospect of the REIT industry looks favorable with a mild cautionary note. Year to date, the standout performance in the industry was that of the Regional Mall REITs (a total return of 24.42% as measured by the FTSE NAREIT Equity REIT Index), followed by Mixed (22.54%), Shopping Centers (20.49%) and Industrial REITs (19.73%). The relatively underperforming sectors were Apartments (10.82%), Manufactured Homes (11.36%) and Self Storage REITs (12.69%).
We are bullish on Taubman Centers Inc. (TCO) which owns, develops, acquires and operates regional and super-regional shopping centers throughout the U.S. and Asia. (Retail shopping centers spanning over 400,000 square feet of gross leaseable area [GLA] are generally referred to as regional shopping centers, while those centers having in excess of 800,000 square feet of GLA are generally referred to as super-regional shopping centers.)
Taubman focuses on dominant retail malls that command the highest average sales productivity in the U.S., measured in terms of mall tenants’ average sales per square foot. During the first quarter of 2012, mall tenant sales per square foot improved 13.3% year-over-year, bringing the tally on a 12-month trailing basis to $659.
Furthermore, the shopping centers are located in the most affluent regions of the country, thereby enabling retailers to target high-end upscale customers and maximize their profitability. This, in turn, has enabled Taubman to command relatively premium rents for its portfolio, thereby ensuring a steady top-line growth.
In addition, Taubman has one of the strongest balance sheets in the sector with adequate liquidity. The company has also taken prudent steps to reduce operating expenses by pruning its pre-development spending in the U.S. and Asia, as well as significantly reducing its overall workforce. This, in turn, has improved the bottom line of the company.
We also remain bullish on PS Business Parks, Inc. (PSB), which owns, acquires, develops and operates commercial real estate properties such as low-rise suburban multi-tenant offices, business parks and industrial and flex assets. Located mostly in high-population markets, flex properties are a combination of warehouse and office space and can be easily configured to suit a variety of uses.
The warehouse component of the flex space is primarily used for purposes such as light manufacturing and assembly, storage and warehousing, showroom, laboratory, distribution and research and development activities. The office component of the flex space is complementary to the warehouse component, and enables businesses to accommodate management and production staff in the same facility.
PS Business Parks invests and owns commercial real estate properties in diversified markets that enables it to tap multiple industry concentrations and neutralize the operating risks associated with economic down-cycles. Consequently, the company has a relatively steady revenue stream.
The company also seeks to maximize its cash flow by controlling capital expenditures associated with re-leasing space by acquiring and owning properties that can be easily reconfigured and suit a variety of uses. This, in turn, attracts a wide variety of tenants and provides it with operating flexibility to protect and enhance market positions by capitalizing on improving real estate market fundamentals.
Another stock worth mentioning is Prologis Inc. (PLD), which acquires, develops, operates and manages industrial real estate space in North America, Asia and Europe. Prologis had merged with the erstwhile namesake company in an all-stock deal to become a behemoth of sorts in the industrial real estate sector.
The combined entity had brought two of the most complementary customer franchises on the same platform and created a $44 billion asset pool at their disposal at the time of the merger. The merger had led to potential cost savings through operational synergies and had created a stronger platform for value creation and sustainable growth in the long term.
In addition, Prologis provides industrial distribution warehouse space in some of the busiest distribution markets across the globe. The properties of the company are typically located in large, supply-constrained infill markets at close proximity to airports, seaports and ground transportation facilities, which enable rapid distribution of customers’ products. This has enabled the company to gain a significant pricing advantage over its competitors.
A significant chunk of REITs are raising capital through property level debt and equity offerings. Although both debt and equity financings provide the much-needed cash infusion, they could potentially burden an already leveraged balance sheet and dilute earnings. Property level debt is also harder to obtain and more expensive, as commercial real estate prices remain under pressure.
Although overall market fundamentals remain positive for Apartment REITs, we are a tad bearish on Apartment Investment and Management Company (AIV), or Aimco as it is popularly known. Aimco is one of the largest owners and operators of multifamily apartments in the U.S., with a strong portfolio of Class ‘B’ and Class ‘C’ properties primarily catering to the middle-income market.
The company is currently restructuring its portfolio and expects to sell almost all of its affordable properties over the next four- to five-year period, in order to concentrate entirely on the conventional real estate portfolio. Aimco also expects to reduce its investment in non-target markets and consequently increase its investment in target markets through redevelopment and acquisitions.
Despite attempts to reposition its portfolio, much of it still resides in areas where housing is relatively cheap. As the company continues to sell non-core assets and buy in higher growth, infill areas, we expect continued earnings dilution.
We also remain skeptical on Public Storage (PSA), the largest owner and operator of storage facilities in the U.S. Public Storage operates in a highly fragmented market in the U.S., with intense competition from numerous private regional and local operators. This has affected its profitability to some extent.
In addition, demand for storage facilities has witnessed a significant fall from its peak level exhibited prior to the recession, as customers have reduced their discretionary spending. To add to the woes, Public Storage has significant exposure to Florida. Florida’s economy has been particularly hard-hit by the housing meltdown, and the demand for self-storage facilities is expected to diminish with fewer home sales and falling new home construction.
Moving forward, limited supply of new construction, coupled with the growing demand for high-quality properties, bode well for the earnings prospects of REITs, in particular those that have assets in high-barriers-to-entry markets. To sum up, we firmly believe that despite a few pitfalls, REITs still make a worthy investment proposition during the second half of 2012.
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