The Outlook For The REIT Sector In 2018

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Includes: ASRAX, AWP, DRA, DRN, DRV, DRW, FFR, FREL, FRI, FTY, GQRE, GRI, IARAX, ICF, IFAS, IFEU, IFGL, IFNA, IGR, IYR, JRI, JRS, KBWY, LRET, MORL, MORT, NRO, NURE, PSR, REET, REK, REM, REZ, RFI, RIF, RIT, RNP, ROOF, RORE, RQI, RRGIX, RWO, RWR, RWX, SCHH, SRET, SRS, URE, USRT, VNQ, VNQI, WPS, WREI, XLRE
by: John Engle
Summary

REIT share prices are in discount territory and property prices are high, making new equity acquisitions expensive.

2018 looks set to be a year of consolidation and refinancing rather than one of new acquisitions; industry consolidation through M&A should be expected over new capital deployment.

More REIT presence in, and correlation with, the S&P 500 and other relevant indices may damage the asset class’s value as a diversification tool.

The year ahead should hold few surprises for REIT investors, but investors looking for diversification might best start looking elsewhere.

I always avoid prophesying beforehand because it is much better to prophesy after the event has already taken place.

– Winston Churchill

As 2017 comes to a close, and as major real estate industry trackers such as PwC put out their predictions for next year, it is worth taking some time to consider what is in store for REIT investors in the year ahead (despite Mr. Churchill’s admonition).

At present, 2018 looks set to be a year of consolidation and sector-wide inward-facing corporate finance, with comparatively limited action buying new properties. Let's take a look at why we should reasonably expect that to be the case.

Conservatism Pays Dividends

The forbearance among major REIT managers who have held off significant property purchases in 2017 will continue to look prudent in 2018. With publicly traded REIT shares trading relatively close to the value of their underlying properties, and with property prices rising toward (or surpassing) their pre-crisis levels, there are few bargains around for REIT managers to gobble up.

More likely than new acquisitions, REITs will be using the current market conditions as an opportunity for a harvesting period, selling off properties in the more white-hot markets to free up capital for distribution and eventual reallocation to new properties or for corporate finance activities.

Overall, the conservatism that has prevailed lately, and that should reasonably be expected to hold in the next year, is well judged. Historically, REIT managers have had patchy records when it came to market timing, continuing to expand equity acquisitions even as their share prices compressed toward their net asset values and as property prices grew beyond reasonable levels. This time around it looks like most major managers are heeding the lessons of history and playing a defensive game that will leave fewer REITs exposed to the inevitable next down cycle.

Merger Mania

The real action in the REIT sector will instead be faced inward. 2018 should see an acceleration of industry consolidation as big REIT players merge or buy out smaller operators. With harvested gains from asset selloffs, more aggressive managers will likely channel their energies toward M&A rather than trying to scoop up new properties. With property expensive, and REITs themselves relatively cheap, other REITs will prove to be some of the most appetizing targets in 2018.

Size has advantages in the real estate sector, with economies of scale beckoning many managers seeking to deploy capital efficiently, as well to make their own capital structures more economical. REITs will look for means of streamlining management of larger asset portfolios grown through mass acquisition rather than through piecemeal property purchases.

Provided competition within the sector does not get too heated, many REITs will be able to build more efficient, larger-scale operations during 2018 and beyond. Yet the risk of battles starting could always start inflating REIT share prices and render such consolidation efforts far less appealing.

Investors in the sector will have to hope that REIT managers prove as prudently forbearing in M&A as they have been with new equity acquisitions. They would be wise to leave the big asset acquisitions at absurd prices to the private equity funds that are sitting on historic levels of dry powder and are desperate for opportunistic plays in particular (of which there are a diminishing number at the deal size such funds will even bothering looking at).

Consolidation Crimps Diversification

One of the big problems with REITs, one that has been growing since 2001, when the first of them were admitted to the S&P 500 index, may be exacerbated through 2018. That problem is the flip-side of scale: Because REITs are now included in the S&P 500 (fully 30 are now part of the index), they are tied to the performance of the broader market.

The rapid rise in the correlation between REITs and the stock market has been striking. The sector was once an easily accessible and dependable source of diversification for investors. That was proven out as recently as 2000 when the market downturn sent the S&P 500 down nearly 10%, while at the same time REITs were up by more than 30%. But a lot can change in a few years. During the 2008 financial crisis, for example, REITs nearly mirrored the fall of the rest of the stock market, though they did rebound with greater gusto than the broader market.

Investors’ Eye View

Many investors still see REITs in the 2000-era light rather than how they are now. That is a dangerous view to cling to, given REITs’ growing presence in and influence on (and from) the S&P 500. With consolidation on the cards for the sector in 2018, the correlation between REITs and the stock market will only continue to grow.

With that in mind, REIT investors looking to the sector for the purpose of diversification might consider casting a wider net. Private REITs, private funds, or direct property investing might furnish better long-term diversification benefits. But for investors interested in REITs for their income-generation capacity, then 2018 should hold few serious worries. As REITs harvest profits from asset sales and distribute fatter dividends to shareholders, consolidation should help to keep those dividends growing by shrinking overhead to a degree.

How current and potential REIT shareholders behave depends on whether they are in it for the income or for diversification. Public REITs can no longer be counted on to deliver both.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.