REITs In 2019: Bargain Bin Or Bad Buys?

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Includes: APLE, BAM, BIP, CBL, CLNY, DEA, EPRT, EQR, FPI, FSP, GNL, KIM, LHO, LXP, MPW, NSH, O, OHI, PEI, PK, RLJ, SNR, SPG, STAG, VTR, WELL, WPG, WSR
by: Michael Boyd
Summary

REIT performance in 2018, while better than other areas of the market, was nothing to write home about. Dividend cut announcements rose dramatically.

Is 2019 set up to be better, particularly with economic recession concerns on the rise?

I'll make a case on how these companies are better positioned today versus yesteryear.

2018 was a rather forgettable year for stock market returns, real estate investment trusts (“REITs”) included. The sector was up low single digits as an asset class last year, and investors appear more hopeful that 2019 brings fatter returns. For investors, the questions are clear, but the answers are elusive: Will the economy keep chugging along, boosting same-store net operating income (“NOI”) metrics? Will trends in interest rate policy, recent pricing action notwithstanding, put pressure on longer term Treasuries and, by extension, cap rates? How should investors treat management teams that are resoundingly bullish yet, for the first time in more than a decade, are net disposers of assets? Those are all tough questions to answer.

Market Trends, Headwinds To Overcome

By and large, trends within nearly all commercial real estate classes have been favorable for many years. Cracks are starting to show, however. There were more dividend cuts announced in 2018 than any other prior year post the Great Recession. CBL & Associates (CBL), New Senior (SNR), Farmland Partners (FPI), LaSalle Hotel Properties (LHO), Franklin Street Properties (FSP), and Colony Capital (CLNY) all cut payouts to shareholders last year. More problems could be on the way. There are a litany of REITs that will pay out more in 2019 than they will generate in funds from operations: Park Hotels (PK), Senior Housing Properties (NSH), Whitestone REIT (WSR), Washington Prime (WPG), Pennsylvania Real estate Investment Trust (PEI), Kimco (KIM), and Global Net Lease (GNL), just to name a few. While some of these REITs have short-term drivers of that disconnect, others have impaired operations and are primed for potential cuts.

This is still a small percentage of REITs. Nearly universally, same-store NOI trends have been positive since emerging from the Great Recession. As can be seen below, whether we are talking offices, healthcare facilities, or any other asset class, there has been a march upwards when it comes to growth in earned income. Inflation-adjusting these results dents the positivity somewhat. However, all major asset classes saw rental growth that outpaced inflation on average. Only a handful of lower end firms have seen negative trends in this metric – especially over longer periods of time. This economy has truly been a rising tide that lifts all boats.

*Source: Author calculations using publicly available data

Underlying that have been strong trends within occupancy rates. Whether investors look at apartments, industrials, medical office buildings, or other areas of the market, occupancy rates are higher now than they were in the lead up to the Great Recession in 2007. Because of this, in many cases, higher earnings on a building level basis are due in large part to greater asset utilization – not hiking rates on tenants. This could be a future headwind. With average occupancy rates of equity REITs now 5% higher than they were in 2011, there is only so much more outperformance that can be extracted from the asset base. Going forward, this is one of my primary concerns when it comes to growth.

With higher income comes higher property values. The majority of valuation increases for commercial properties over the past several years has come from SSNOI growth, and not from declining cap rates. This is, in my opinion, a strong positive. Heading into the 2007-2009 economic collapse, the bulk of property appreciation came from strengthening cap rates, and not deep underlying operational improvement. In other words, buyers were willing to pay more and more money for a property even if its income did not change year to year. We do not want a repeat of that kind of environment, particularly as cap rates skate along at average levels when it comes to Treasury premiums.

The Financing Side Of The Equation

Perhaps the most underappreciated aspect of the change in REITs over the past two decades has been within implied leverage and associated debt costs. Below the NOI line, firms have benefited from substantial declines in the cost to borrow debt capital. In 2010, the average REIT was borrowing at 6% long term; today, that figure stands at 4% despite CFOs also managing to lengthen out the maturity ladder. This has created tailwinds for funds from operations (“FFO”), which directly impacts cash available for dividends, from aspects of the business that have nothing to do with the properties themselves.

*Source: Author calculations using publicly available data

The two most important debt metrics for REITs – interest expense as a percentage of NOI and overall debt load a percentage of asset value – have both come down significantly over the past twenty years. REITs are, in my opinion, less risky today than they ever have been, from a leverage perspective. This sets them up well for any economic uncertainty that might be on the way.

The Conundrum

Leadership continues to sing the praises of the REIT model. Anyone reading or hearing anything from the top executive minds is likely to come away with one takeaway: everything is going great in their business operations, and the outlook looks solid. While unlikely to hear management ever talk down their company, I think it is interesting that rosy forecasts are easy to find, and the worst you might hear is careful optimism. See the below from the CEOs of Simon Property Group (SPG), Equity Residential (EQR), and Welltower (WELL), three of the most well-respected leaders in the REIT space.

But no, we don't view 2% as steady state [NOI growth]. I mean, we try to give you a sense of where we're at, we hope to do better, but I do not under any circumstance think 2% is our steady-state.

David Simon, Simon Property Group, Q4 2018 Conference Call

We expect that 2019 will be another good year for us with strong demand across our markets creating high occupancy conditions. Continued elevated supply levels for some of our markets are keeping us cautious…. The outlook is favorable.

Mark Parrell, Equity Residential, Q4 2018 Conference Call

I would say that there we see such rich opportunities here in the U.S. at returns that are compelling that that's where most of our attention is focused.

Tom DeRosa, Welltower, 2019 Citi Global Property CEO Conference

This does, however, somewhat contrast with one data point: acquisition and disposition activity. 2018 was the first year since the Great Recession that publicly-traded REITs were net disposers of assets: REITs sold more finished properties than they bought. In fact, flipping properties today has become vastly more popular. More and more companies are engaging in active management of their asset books, swinging in and out of markets in order to get an edge.

*Source: Author calculations using publicly available data

I think this is an interesting piece of information. Despite coverage metrics at or around multi-decade lows for equity REITs, the trend has been toward asset disposals versus purchases. While some REITs have guided towards a return to buying in 2019 (Omega Healthcare (OHI), Realty Income (O) as two), it remains to be seen if this overall trend accelerates. I think this is a clear signal that “cautious optimism” is transitioning to outright caution.

Takeaway

Even if executives are right and harder times are around the corner, I view REITs as a great defensive asset class in a negative/no economic growth environment. FFO tends to stay propped up during economic weakness, and that should be particularly true, given overall balance sheet health today. While critics point to 2008 as a reason to stay away, that period was characterized heavily by a property bubble. There are no signs of that today.

As far as what to buy and what to sell, hotels remain a favorite (RLJ Lodging Trust (RLJ), Apple Hospitality Trust (APLE)) as well as office (Easterly Government Properties (DEA) and Essential Properties (EPRT)). I tend to avoid complex structures such as the Brookfield web (Brookfield Asset Management (BAM) and associated daughter firms like Brookfield Infrastructure Partners (BIP)) as well as portions of the market like healthcare (Ventas (VTR) and Medical Properties Trust (MPW)) and industrial (STAG Industrial (STAG) and Lexington Realty Trust (LXP)).

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.