Three reasons why REITs can continue to rally

Arthur Hurley, CFA, Senior Portfolio Manager | May 19, 2014

  • REITs have produced attractive returns YTD being up 13.60% through April (up 16% as of May 12)
  • Fundamentals remain solid, demand for commercial real estate remains strong and companies continue to increase dividends.
  • We remain positive on REITs given the relative safety of their income stream and continued prospects for growth.

The REIT market shook off the cold of the “polar vortex” with both solid share price performance and continued positive momentum in fundamentals so far in 2014.

With interest rates remaining below where many investors had expected, and with commercial real estate fundamentals remaining solid, REITs have produced attractive returns in the first four months of the year being up 13.60% through April (16% as of May 12).

REITs started the year trading at attractive relative valuations following last year’s underperformance. In 2013 the REIT sector had its worst year of performance relative to the S&P 500 Index since 1998. REITs were up 2.4% versus the S&P up 32.4%. The group’s funds from operations (FFO) multiple fell below the S&P 500 P/E Ratio for the first time since 2010, and the group traded at a double digit discount to net asset value (NAV).

So if valuation was the most compelling aspect of the REIT story at the beginning of the year, where should investors focus their attention now? I highlight below three positive investment attributes REITs still possess:

1) Fundamentals remain solid

Q1 earnings reminded investors that fundamentals in the space remain solid, and despite the bad weather chilling consumer and business activity, and causing seasonal operating costs like snow removal to be higher than typical, leasing activity remains robust. The low level of new supply in commercial real estate is at least partially offsetting the negative impact of the sub-par economic recovery. For example, property-level “same-store” net-operating-income (SS NOI) was +3.8% in the quarter. This is 90 basis points above the long-term average, and is the result of occupancies remaining elevated and market rents continuing to rise in many markets. SS NOI growth has been positive for fifteen quarters and above the long-term average for 12 quarters. The two exhibits that follow show property level income and occupancy trends.

REIT Same-Store Net Operating Income*

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REIT Same-Store Occupancy*

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*Source: SNL Financial, as of December 31, 2013

In addition to benefiting from a lack of new supply, most public real estate companies have sharpened their focus to improve portfolio exposures to better markets, which has helped them to benefit disproportionally from the current pace of job growth.

Additionally, many office and industrial management teams cited Q1 leasing volume as the best they have experienced in many years. Class A retail landlords are negotiating new lease rates at market rents that are well above expiring lease rates. And the stronger apartment markets in the country are operating at record occupancies.

2) Demand for commercial real estate remains strong

The demand for commercial real estate has proven to be very resilient despite the prospect of higher interest rates. Transaction activity remains very high across property types, and the lending environment has been vigorous to start the year. Institutional investors, private investors and foreign investors have all been participating in bidding for properties. We continue to hear about multiple bidders coming to marketed sales, and pricing has moved up since the beginning of the year. This is not likely enough to significantly move NAVs in the near term, but the trend is worth watching.

3) Dividends are still attractive and continue to grow

Companies continue to increase dividends, and we expect 2014 to be similar to 2013 with the weighted average dividend increase in the low double digits. Payout ratios remain at historic lows, with the group’s cash payout ratio at approximately 75%. The long-term average is in the low 80% range. The yield stands at 3.8%.

Given the risk of higher rates in the future, we believe the relative safety of the income stream, combined with the continued prospect for growth, positions the REIT group well relative to other income investments.

While the group is no longer trading at a steep discount to NAV, the forward earnings multiple (FFO) is still in line with the S&P forward P/E at 16 times. Given that the growth profile of the group remains compelling, and the dividend yield remains attractive we remain positive on the group relative to other income alternatives.

Disclosure

An investment in a REIT is subject to many of the same risks as a direct investment in real estate including, but not limited to: Illiquidity and valuation complexities, redemption restrictions, distribution and diversification limits, tax consequences, fees, defaults by borrowers or tenants, market saturation, balloon payments, refinancing, bankruptcy, decreases in market rates for rents and other economic, political, or regulatory occurrences affecting the real estate industry.

Dividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time and issuers may reduce or eliminate dividends paid on securities in the event of a recession or adverse event affecting a specific industry or issuer.

Arthur Hurley

CFA, Senior Portfolio Manager
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