The United States real estate market is looking better and better as Italian debt rating was cut by Fitch to just three notches above junk status to BBB+, one rating increment higher than Spain. This is shortly after Moody's cut the credit rating for the U.K. Europe's woes are pushing investors back to U.S. equities among other things. As capital continues to chase yield and avoid risk, real estate in America continues to become an attractive investment opportunity. In the current macroeconomic environment there are endless factors in play, but for a defensive investment from international influences and some European risk, American real estate is intuitive.
Investors wanting to allocate capital into the United States real estate market as it continues to recover since the recession should consider investing into a tax favored real estate business known as a Real Estate Investment Trust (REIT). PricewaterhouseCoopers and the Urban Land Institute collaborated once again on their annual Emerging Trends in Real Estate 2013 Survey. According to their survey, the 2013 forecast states "the real estate recovery is set to advance in 2013 as modest gains in leasing, rents, and pricing will extend across U.S. markets from coast-to-coast and improve prospects for all property sectors ... industrial/warehouse and hotels show the biggest survey improvements, trailed closely by downtown office." For many, investing in these varieties of real estate or any besides possibly their home is very challenging. Many real estate investments do not have to be limited to high net worth individuals or businesses. Financially and logistically, the challenges of running a rental income business strain on the average individual investors. In order to take advantage of economies of scale, investors of all types of net worth consider REITs as appropriate avenues to various distinctions of real estate.
To attempt to profit from this survey, taking a closer look into the industrial real estate market would be appropriate. Discriminating which REIT to invest in can be difficult. Top-down fundamental analysis goes beyond believing in U.S. markets and that the industrial REIT is potentially a good investment. For instance, like any investment in a business, it is important to trust the management team. In addition, while most analysts agree that net income paints a decent picture of cash flow, an investor in REITs must consider the effect of depreciation on balance sheets as well as their mandatory dividend amount (90% of taxable profits). Standard REIT analysis includes Funds From Operations (FFO) which is used remove depreciation costs among others from net income.
Investors and analysts agree net income overestimates these expenses when real estate related so FFO gives better insight into the potential to continue or grow dividend yield. Like any other investment, the price of the REIT should always be considered, so some analysis is based on a price to FFO multiple where low multiples could indicate value. Yet FFO multiples do not account for possibly the most important factor when assessing the right REIT to invest in, dividend yield. A payout ratio is the dividend per share divided by FFO, so combining an FFO multiple with the payout ratio is excellent way to evaluate a REIT.
As the United States real estate market continues to rebuild, property in areas with high job growth will presumably increase in value faster than otherwise. In order to predict rent increases and therefore increases in FFO and yield, by utilizing the Bureau of Labor Statistics' Seasonally Adjusted labor force data, an investor is able to deduce rental strength from employment improvements by state. Investors should look for great employment numbers as well as employment improvement. Job growth will be an excellent tell as to whether or not rent is susceptible to future losses or will benefit from regional economic expansion.
The analysis should then move to management, possibly the most integral piece of any business, and often the most difficult to quantify. Delving into the equity REITs that focus in industrial properties that have a significant presence in highly employed areas and/or areas with high job growth rates is an excellent start. The FFO multiple with payout ratio will help to determine the best company in the best sector, but how does an investor know they are in the right REIT if they have little to no information on the management team? The conference calls, interviews and biographies will only allow an investor so much insight, yet if actions speak louder than words, tracking the management's insider trading through SEC filings found on each company's website offers the best insight into the company's future from the perspective of management.
Attractive industrial REITS like Monmouth Real Estate Investment Corp (MNR), Stag Industrial, Inc. (STAG), Gladstone Commercial Corporation (GOOD), and First Potomac Realty Trust (FPO) will be reviewed with the above process to determine which would be the most reasonable to invest in what Pricewaterhouse Cooper surveyed to be a successful 2013 in United States real estate. To begin, the below chart lists the state by state BLS overview of unemployment by state, side-by-side with each company's 10-K state square footage allocation.
|Unemployed as a % of the total civilian labor force by state and area||Square Foot % allocations by state|
|*BLS.gov seasonally adjusted||US only|
The key takeaways from this chart are the strengths and weaknesses for each company. Strength is associated with investment allocation in low unemployment states like North Dakota and South Dakota, but forgetting year over year change is a mistake. New Hampshire for instance, has a low employment rate of 5.7%, unfortunately this is nearly a 10% increase in the rate since a year prior. Strength is also associated with large improvements or decreases in the unemployment percentage, as see in states like Nevada, Louisiana, Hawaii and Idaho, each over 20% improvement in their 2011 unemployment. Naturally, job growth of this magnitude will result in increased real estate demand increases quickly.
With respect to the ten states with the lowest unemployment rate by state, Gladstone is best allocated to benefit from sustained demand with 9.9% of its assets invested in these low unemployment states. Gladstone is followed by Monmouth with 5.2% and Stag Industrial with 2.6% allocated. First Potomac has no exposure to these top ten states. However, With respect to the ten states with the highest unemployment improvement rates, Monmouth leads the group with 36% of its square footage within environments that on average improved over 17.5% in the 12 months that ended Dec. 31, 2012. Next is Gladstone with 13.1% allocated. Stag Industrial and First Potomac each only have 9.2% and 5.4% of their assets in these states. This is a significant competitive advantage for Monmouth.
The weakness derived from this chart is determined by the percentage of square footage allocated to states experiencing increases to unemployment or those that may already have unemployment. It is important to note that buying some weakness essentially allows room for growth within the company and underlying share price. Though with respect to the ten states with the highest unemployment rates, Monmouth has 32.6%, Stag Industrial has 28.2%, while Gladstone has 24.1% and First Potomac only had zero of its assets allocated to these states. Many of these states with high unemployment are also experiencing the heaviest improvements, simply being allocated to these areas is not in and of itself a weakness. These ten states with the highest unemployment rates averaged an 8.2% drop in their readings since the prior year.
The biggest weakness in this chart is each company's allocated square footage that is experiencing environments of negative job growth since 2011, with respect to the ten states with the worst job growth in the last 12 months, Monmouth leads its competitors with the smallest exposure to these 10 states with only 8.3% allocated. Following Monmouth is Stag Industrial at 13.8%, the two companies that stand to face decreased occupancy rates, decreased total rent and therefore the risk of decreased FFO from over-allocation in these 10 states. Gladstone has 18.3% allocated to these states while First Potomac has 29.1%. The average unemployment rate change for these 10 states was an increase to unemployment of 2.6%.
Funds from operations, as mentioned previously, help to indicate what cash position a real estate company is in that is more realistic than net income since net income deducts non-cash expenses such as depreciation. Based on strong FFO, a real estate investor can be more certain of future dividends. A step further to include price would take the investor to strong dividends and potential capital appreciation through a potentially undervalued REIT. A brief review of FFO multiples yields the following chart:
Again, these are more useful with the yield in mind, current yields are 5.36% , 5.56% , 4.21% , and 7.72%. The potential for increases in capital due to share price growth also means the decrease in dividend yield, something that is often forgotten as value increases. This is why it is imperative to research the potential for dividend growth. Payout ratios are important to know what kind of management team one is dealing with. While there is a great deal of room to interpret these numbers, taken together they can offer insight into the company.
Monmouth shows the lowest payout ratio, is this a bad thing? Provided that the REIT rules are upheld then it is not a bad thing if you want your REIT to reinvest into its portfolio, however, if you want your REIT to reinvest cash back to you, then a higher payout ratio is desirable. In terms of growth outlook combined with value, Monmouth, with the lowest payout ratio and second lowest P/FFO ratio indicates a bright future. Meanwhile, First Potomac carries a higher capital risk premium with a larger P/FFO ratio and payout ratio, an investor can expect more cash and less growth with measurements like these.
The final piece of this analysis must include a review of recent insider buying and selling of company stock, especially of the management team actually running the business. For Monmouth Real Estate Investment Corporation since August 19th, 2012, it seemed the three Landy relatives that mostly run Monmouth have been on a buying binge, and although the Landys are the heaviest buyers, they aren't the only insiders buying according to SEC Filings (Form 4s) posted to its website. Momentum has been rolling for this management team, heartened by Monmouth Chief Operating Officer Michael Landy who appeared on Jim Cramer's "Mad Money" and made a great case for the REIT going forward. Insider buying is a strong signal that a management team with a historically consistent dividend not only wants to maintain the steering wheel of the company but also believes in the future of the business.
Each of these names have brought great value to their stakeholders, Stag industrial is up 20% YTD, near a 52-week high. Stag's dividend yield is currently 5.56%. This contrasts Monmouth's 5.31% YTD gain and current yield of 5.50%. Many analysts expect Stag to outperform, but momentum ends at some point and Stag has experienced insider selling as recent as mid-December, 2012. Sales in December came from the chief financial officer, chief executive officer, as well as a handful of others on the management team. Despite this, the stock price has increased continued a sharp price increase. Stag Industrial, Inc. seems attractive as it offers higher yield and has recent price momentum, but if the insiders are selling it begs the question, why? If the stock price has increased, investors should consider selling or locking in profits. On the other hand, if anyone should believe the company's underlying value will continue to increase, it's the company insiders. A manager's effort to continue to buy his or her company's shares, a behavior seen in Monmouth, builds confidence for all vested parties.
Gladstone Commercial brings great value and many consider its early success as a precursor to a bright future. The stock is up just over 5.5% YTD, near a 52-week high. Gladstone Commercial pays a 7.92% dividend yield currently and appears to have good momentum behind it since a dip in late November. Yet many in Gladstone's management team sold mid-December, 2012, with some value bought back more recently. The management team here is certainly not pressed for cash, what incentive do they have to sell any vested interest in the company they run and operate? From a potential investor's perspective, the manager's buy-in should be a pre-requisite. Investors should take caution when the value of the company and management team's vested interest the company diverge as they have for this company.
First Potomac has had a great 2013, the stock is up 14.40% YTD, right at the 52-week high. The company pays a 4.26% yield, and analysts have buy or hold recommendations. Meanwhile, First Potomac's CEO and COO both sold shares in the middle of February, 2013, among others in the management team. These members apparently bought back heavily shortly following the sales but rather than trading their stock, management at FPO could build investor confidence with a consistent investment in their company. After all, REITs are thought of as low beta instruments for investing into, many consider trading REITs as inappropriate as an insider or otherwise. The company announced a reduction to dividend payout in January, and it is easy to get nervous when management is trading the stock and the yield starts to slide.
While there are many methods when it comes to analyzing a REIT or any other security, sometimes following the leader makes the most sense. Each of the companies presented are successful and potentially great investments. As an investor, it is reassuring when management is buying their company's stock, as is the case with Monmouth. However, when management sells the stock as is recently the case with Stag Industrial, Gladstone Commercial and First Potomac, investors should reconsider any long position and ensure it is in line with their risk tolerance since it apparently was not for the management of these companies.