Paul Curbo: REIT Rally Is Sustainable

Includes: DLR, GGP, MAA, SPG, VTR
by: Benjamin Shepherd

Shares of Real Estate Investment Trusts have rallied almost 90 percent since the market bottomed in March, but the jury is out on whether this recovery is warranted given the difficulties facing commercial real estate. To gain some clarity on this issue, we talked to Paul Curbo, portfolio manager for AIM Real Estate (IARAX), AIM Select Real Estate Income (ASRAX) and AIM Global Real Estate (AGREX).

What are the catalysts behind the rally in REIT shares?

Part of this recovery is a function of the weakness that afflicted this sector from 2007 through the beginning of this year. Over that period uncertainties about the availability and pricing of credit made it exceedingly difficult for analysts and investors to predict the group’s prospects as well as the fortunes of individual names. Accordingly, improvements in debt markets have played a key role in the rally. As spreads have narrowed on all sorts of asset classes--including commercial mortgages--that’s given analysts greater confidence in their valuation methods.

In addition, REITS have raised significant amounts of capital on both the debt and equity side--close to $17 billion thus far through equity issuance. Now the best REITs have the cash to weather the downturn and take advantage of attractive opportunities.

Of course, any discussion of the rally in REIT shares also should acknowledge the role that signs of economic recovery have played in buoying the broader market.

Is the rally in REIT shares sustainable?

Without question, the problems facing commercial mortgage issues still exist and must be dealt with. Although many publicly traded REITs have taken steps to address their own issues, these maneuverings won’t protect the broader real estate market from the significant number of commercial mortgages that will reach maturity over the next few years. Between 2010 and 2013 well over $1 trillion dollars of commercial and multifamily mortgages come due.

How have you positioned your portfolios to weather these challenges?

AIM Select Real Estate Income, which invests in both debt and equities, holds a portfolio that’s representative of our overall outlook and strategy, so I’ll structure my comments around that offering.

Earlier this year close to 70 percent of the fund’s investable assets were allocated toward common stocks. However, the rally has pushed markets closer to what we regard as fair value; we’ve shifted the portfolio mix to a 50-50 blend between debt and equities, which provides a degree of downside protection in the event of a short-term pullback. We’re not going to venture a prediction as to when and if such a correction will occur, but equities’ recent strength hinges on prospects for economic growth and improved fundamentals in the credit market; any hiccup in either of those areas could precipitate a bit of a selloff.

What qualities do you look for in your portfolio holdings?

Even with the rally and improving sentiment, we continue to favor companies that boast strong balance sheets; financial flexibility affords a degree of protection in a weaker economic and market environment.

Ample cash and access to credit likewise positions a company to take advantage of coming opportunities. The wave of mortgage maturities that I mentioned will bring hardship to the industry, and some weaker names inevitably will come up short in the capital department; companies with superior balance sheets can take advantage of these investment opportunities, whether that involves dealing with financially distressed owners or the banks.

Are you bullish on any particular segments of the REIT market?

Before I respond, I’d like to emphasize that in this environment investors should focus on individual names and the relative strength or weakness of a company’s balance sheet.

We like some regional malls, a segment that benefits from long-term leases. The mix of healthy and distressed landlords in this space offers opportunities for the strongest, publicly traded names.

We also like the health care and apartment segments, two groups that feature defensive names and provide a bit of safety to the portfolio.

What are some of your favorite names in the retail space?

We’re not overly bullish on the retail space. In an environment characterized by reduced consumption, lower retail spending eventually will weigh on the rents that tenants are willing to pay.

But we do like Simon Property Group (NYSE:SPG), a REIT that has $3 billion in cash and another $3 billion remaining on its line of credit--that’s on top of the $700 million in free cash flow that the firm has generated this year.

This financial strength is important for two reasons. For one, it reassures tenants that Simon will be there for the long haul and won’t go through the financial distress that’s afflicting a lot of smaller, private landlords. This stability provides an edge during tenant negotiations. And the company’s sizable war chest should enable it to cherry pick the best investment opportunities down the line. Simon’s biggest competitor, General Growth Properties (OTC: GGWPQ), recently declared bankruptcy; there should be no shortage of attractively priced assets in the retail space.

You mentioned that some apartment and health care REITs offer defensive qualities. Which names did you have in mind?

Mid-America Apartment (NYSE:MAA) is one of our top holdings. This REIT owns a portfolio of Class B apartments that tend to appeal to individuals who are renters by necessity rather than renters by choice. Focusing on this demographic keeps occupancy rates fairly stable and limits the extent of rent correction during a downturn. And the geographic mix of the company’s portfolio has held up better than some rivals.

The logic behind our health care holdings resembles our investment thesis on Simon Property Group in that these names have better-than-average balance sheets and should benefit from acquisition opportunities. But the health care segment is generally less susceptible to the economic downturn.

Take, for example, Ventas (NYSE:VTR), one of our largest positions. The REIT holds a geographically diverse portfolio that comprises over 500 health care facilities in 43 states. The focus of these properties is relatively varied, though it does have a bit of a concentration in senior housing, which isn’t immune to the economic downturn but has held up better than other segments in the marketplace. More important, only 1 percent of its leases expire next year, providing a degree of stability. Its leverage ratio ranges between 35 and 40 percent.

What are some of the aggressive names in your portfolio?

Digital Realty Trust (NYSE:DLR) is one of our more-aggressive holdings, but the company has performed well throughout the downturn and should fare well going forward because it excels in serving an underserved niche.

Digital Realty focuses on properties designed to house server farms, data warehouses and other technologies that are increasingly essential to doing business in today’s world. When companies like Facebook or JP Morgan Chase (NYSE:JPM) need properties to house their data storage equipment, they turn to Digital for a custom-built solution or space in an existing property. We expect that trend to continue, as data management has become central to productivity.

The REIT’s business has remained impressive throughout 2009. Year-to-date the company has raised the rent on expiring leases by an average of 10 to 15 percent. Boasting a solid balance sheet, Digital is in a position to make acquisitions that will yield 10 to 12 percent in the first year. To top it off, the REIT recently increased its dividend by 9 percent.

What moves have you made on the bond side of the portfolio?

Our bond portfolio generally consists of three components: preferred shares, debt issued by REITs and commercial mortgage-backed securities (CMBs). This year we’ve added significantly to the latter category, taking advantage of the uncertainty that reigned at the end of last year and early this year to scoop up quality assets and a discount. One of Invesco’s arms actually purchases and manages real estate, so we felt comfortable with our ability to evaluate the underlying collateral. We also purchased tranches at the top of the capital structure, the most secure from a valuation standpoint. These are the tranches for which the government is providing financing to potential buyers through the Troubled Asset-Backed Securities Loan Facility (TALF) and the Treasury Dept’s Public-Private Investment Program.

As economic conditions have improved and panic has subsided, the spread between yields on AAA-rated CMBs and rates on US Treasuries have narrowed from 1,400 basis points at the height of the credit crisis to around 450 today. Prior to the collapse of Bear Stearns and Lehman Brothers, this spread typically ranged between 35 and 40 basis points, so there’s room for some compression to occur.