Yesterday, fellow Seeking Alpha writer Thomas Sobon wrote a terrific article (What's Wrong With The REITs?) in which he examined the mystery behind the recent REIT decline. In an intriguingly entertaining fashion, Sobon used the Sherlock Holmes analogy to help shed light on the perplexing issues that caused REITs to pull back. As Sobon explained:
That begs the question, what's wrong with the REITs? Since it is Sherlock Holmes' business to know things that other people don't know, I'm going to put on my Sherlock Holmes cape and cap, light my pipe, take out my magnifying glass and pretend that I'm telling what I know to Dr. Watson, my dimwitted associate who marvels at my magnificent and unparalleled ability to solve a mystery such as the one called, "What's wrong with the REITs?"
Sobon did a thoughtful analysis on the conundrum related to REIT valuations and I support his hypothesis that ETFs have been big contributors to the sell-off in REIT-dom. Sobon summarized his investigative report as follows:
I submit that this provides the answer to the question "What's wrong with the REITs?" It's elementary. With the three ETFs now priced below their respective levels of six months ago, I think dumping by them should be about over. I know there were comments coming from pundits on Wall Street that the REITs were being sold because of the outlook for higher interest rates. Such rates should have little effect on the operating results of most REITs. Case closed.
What's Right With REITs?
Sherlock Holmes once said:
Eliminate all other factors, and the one which remains must be the truth.
As noted above, Thomas Sobon did a great job explaining - in Sherlock Holmes style - what's "wrong" with REITs. However, in order to truly "close the case" an intelligent investor must also find out what's "right with REITs." As the legendary investor Ben Graham has said:
You are neither right nor wrong because the crowd disagrees with you. You are right because the data and reasoning are right.
So like Graham, Sherlock Holmes would not only examine the "smoking gun" but also the mystery behind the gun. What makes it work? What does it do? What makes it important? As Sherlock Holmes explained:
We know that he did not come through the door, the window, or the chimney. We also know that he could not have been concealed in the room, as there is no concealment possible. When, then, did he come?
We all know that REITs are important for investors because they provide steady dividends year-in and year-out. Accordingly, REIT dividends provide investors with appreciably higher total returns when compared with other equities.
But what about growth? We all know that the current low interest rate environment will not last and the REIT sell-off we have recently witnessed is an indicator (or head fake) that attractively record low rates will not last forever. Nonetheless, the current earnings multiples for US REITs reflect positive sentiment as the unusually high risk premium suggests that valuations remain reasonable. When comparing the average yield for commercial real estate (or cap rate) with Baa-rated corporate bonds, it's clear to view REITs in a skeptical light, especially the ability for them to grow net operating income.
So How Will REITs Grow?
Cohen & Steers believes that REITs have considerable upside and although dividend fundamentals are well supported, the yield-driven asset sector offers more than income. As illustrated below, the REIT sector has three important elements that should drive cash flow growth:
Years of historically low commercial development has resulted in scarcity of quality real estate. As Thomas Bohjalian, Executive VP and Portfolio Manager with Cohen & Steers explains (source: REITs: Building on Success white paper dated March 2013):
In a typical real estate cycle, rising property values lead to a wave of new construction, eventually creating a situation of oversupply amid peaking demand that precipitates a decline in property values. But in the latest cycle, the US never saw a surge in commercial supply. We would characterize the economic expansion in the mod-2000s as more of a buying boom than a building boom, as low interest rates and aggressive lending practices caused many properties to change hands at inflated prices. Construction costs declined sharply during the financial crisis and have since remained at historically low levels.
As Bohjalian adds:
We believe the likelihood of a new construction boom in the near future is highly remote…we do not expect construction to accelerate in some property sectors over the next few years, although not enough to meaningfully change the overall supply picture relative to demand.
Slow Economic Growth Means Positive REIT Growth
With the US economic recovery still generally modest, US REITs can still benefit from positive capital appreciation. As Bohjalian adds:
While a stronger recovery would be favorable for businesses in general, our view is that REITs simply need GDP growth and job growth to remain modestly positive. We believe even modest expansion should allow vacancies to be absorbed due to the low supply conditions, while owners of the best properties should be able to continue raising rents. As the chart below illustrates, at the bottom of late 2009, REIT same-store net operating income (SS NOI) growth grew in 8 of the next 10 quarters.
Low Financing Costs Still Making Cents
One of my frequently referenced mantras is "huge failure makes for huge success." That can also be applied to REIT-dom. During and after the Great Recession, REITs have steadily progressed with solidifying their balance sheets and enjoying strong access to capital. Perhaps driven by the "pain of excessive leverage" many REITs have structured more conservative lending policies by issuing equity and debt at extraordinarily low rates. Conversely, REITs have been able to pursue accretive acquisitions and refinance debt maturities. Here is a snapshot that illustrates the debt cost of capital for US REITs:
Now Here's the Reward
We now know what's wrong with REITs and what's right for REITs. Now it's time for the reward. As noted above, the trends (above) paint a picture of an attractive operating environment in which US REITs should continue to benefit from increased growth fundamentals. However, the key to making profits is in choosing the right locations and property sectors. The factors that one should consider when making an allocation are lease duration, asset quality, and relative value.
Since 1986 Cohen & Steers has been helping investors access opportunities in the commercial real estate market. As the first asset manager dedicated to real estate securities, Cohen & Steers has allowed investors to benefit from the resources, market access and disciplined investment process of a premier asset manager. As Thomas Bohjalian adds:
We believe the positive near-term trends for property fundamentals and the broader US economy are likely to continue, enabling REITs to continue to achieve strong and steady cash flow growth.
The summary below illustrates the returns of global real estate securities compared with a variety of other asset sectors.
Over the last 30 days, we have seen most REITs decline in price while fundamentals remain sound. In my newsletter (The Intelligent REIT Investor) I have included over a dozen equity REITs with strong growth prospects. Here is a snapshot of recent performance pricing details. For more information, check out my newsletter today.
So as Sherlock Holmes said, "I never guess. It is a shocking habit - destructive to the logical faculty." Intelligent investing is all about eliminating risk by filtering out disadvantageously positioned securities from the outset. That concept is powerfully true and that's also how Ben Graham defines the most "elementary" margin of safety rule for investing:
Finding a favorable difference between price on the one hand and indicated or appraised value on the other.
Special thanks to Thomas Sobon whose article "What's Wrong With The REITs" inspired me to write this article, "What's Right With The REITs." REITs can be a "game changer" and if you understand the "margin of safety" concept you can all sleep well at night.
Source: Cohen & Steers (REITs: Building on Success dated March 2013), SNL Financial