REIT Fundamentals: Solid Financial Stability, Slowing Growth

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Includes: EPR, F, IIPR, NOBL, T, VFH, VHT, VNQ
by: Arturo Neto, CFA
Summary

REITs have performed well YTD and have become a safe haven for investors fearing a prolonged trade war.

REITs have strengthened their balance sheet since the last tightening cycle and are much better positioned today than they were at the end of the last cycle.

Residential REITs and Industrials continue to exhibit the strongest fundamental performance, while Office and Shopping Center REITs are stabilizing.

At The Income Strategist, we focus on a variety of different income producing asset classes, but that doesn't mean we are always bullish on these asset classes. For example, while we have in-depth coverage of REITs and our portfolios are predominantly made up of REITs, we believe that despite their defensive characteristics, the overall sector looks a bit stretched and is less likely to exhibit the same growth we have seen in recent years. An article titled When Investor Sentiment is Too Bullish on REITs, Look for Weakness - which was co-produced with The Belgian Dentist highlights the extreme bullishness in the sector and how sentiment tends to be a contrarian indicator - in other words, bullish sentiment is negative for the sector.

With the recent stock market pullback, REITs pulled back as well, but less so than most other sectors - a result of their solid fundamentals and domestic-focused operations. However, as I've mentioned many times in the past, each REIT sub-sector is driven by its own unique drivers and investors need to navigate these sub-sectors carefully instead of investing in REITs with a broad stroke like the Vanguard Real Estate ETF (VNQ). In fact, one sub-sector we like and that we are still bullish on was covered in Increase in Housing Starts Might Signal Headwinds for Residential REITs, but we are becoming more cautious as home affordability increases and rental rates continue to rise. At some point, the buy vs. rent decision will favor buying, which could be the end of this cycle for residential REITs. That said, the end isn't yet imminent.

Recent recommendations we have made outside the REIT space include AT&T (T), Ford (F), and the ProShares S&P 500 Dividend Aristocrats ETF (NOBL), which focuses on dividend growth stocks. These securities meet our criteria for either high and stable income, or income growth potential - both strategies that we favor in the current environment.

In this article, we highlight broad REIT fundamentals and while they are certainly much better than they were in years past, additional growth in revenues, FFO, and dividends, could be more muted than what many investors have grown accustomed to. It's still a favored dividend paying sector but expectations should be tempered to reflect the current environment.

REIT Fundamentals: Solid Financial Stability, Slowing Growth

It's a stock pickers market again. At least it was this past month. For the first time since October 2018, the difference in performance between the best and worst performing sector was greater than 10%. The Vanguard Financials ETF (VFH)had a return of 8.6% in April, compared to a loss of 2.7% for the Vanguard Healthcare ETF (VHT). It will be interesting to see if active managers had a good month relative to the index, a challenge that many managers have failed to overcome as sector dispersion has remained relatively low. That would also imply the same dispersion trends within underlying stocks. High dispersion among stock returns is usually a better environment for active managers that rely on specific stock-picking.

Once again, Technology was among the Top 2 performing sectors and have now returns over 27% YTD, while Industrials and Consumer Discretionary each had 22% YTD returns.

Our asset allocation suggestions published last month have turned out quite well. We were most overweight to Technology and Consumer Discretionary, and underweight to Utilities, Consumer Staples, and REITs. We did, however, completely miss the outperformance by Financials.

REITs

REIT fundamentals continue to improve in certain areas but did see some weakness on others, although we are still moderately bullish on the sector.

Our view from late last year is still valid – We think this is a great time for investors to pick up good REIT investments that could potentially enhance their portfolio income well into retirement.

Balance sheets remain strong and unlike in the previous FOMC tightening cycle, REITs overall are much less levered this time around. Not that it matters much if this week's FED comments that there will be no more rate hikes holds true.

Debt to Total Assets

The continued financial strength of REITs has been a positive development in light of renewed interest in REITs for either their domestic focus or yield characteristics. Had debt to total assets been much higher, I may have been concerned with their longer-term viability and would have been more cautious increasing exposure in light of what I think are somewhat stretched valuations. But debt levels have remained and their lowest levels historically.

Interest Coverage

One of the benefits of a low interest rate environment is that REITs have been able to issue debt at historically low levels while growing net operating income in the process and this trend has continued throughout the current tightening cycle.

Since mid-2006, the interest expense to NOI ratio has steadily improved from around 35% to around 20% as of the last quarter, but unlike in the previous cycle, interest expense as a percent of NOI has remained flat.

If rates do start declining again or remain flat, the current interest/NOI could persist for quite some time and may even decline further as NOI grows.

There was a slight uptick in the weighted average interest rate on long-term debt for equity REITs this past quarter, but the rates are still so low that it is barely wroth mentioning. With rates remaining flat or potentially declining in 2019, I have very little concerns that rates will be a challenge for future REIT capital raises.

Not surprisingly, as rates have declined and NOI has increased, the weighted average interest coverage ratio of All Equity REITs has remained healthy at roughly 4.5x. Last quarter's slight decline has reversed this quarter.

Source: NAREIT Tracker Q12019

The weighted average term to maturity of on debt of All Equity REITs has increased to its highest level since 2002. As REITs refinance their debt and with expectations of higher rates, many of them issued long-term debt to lock in lower rates for longer.

Funds from Operations

Funds from operations or FFO, is a better indicator of a REIT's performance than the more traditional earnings per share reported by most other companies. The reason for this is the high amount of depreciation inherent in a portfolio of real estate that depresses earnings and doesn't really reveal much about the underlying performance of the REIT. So for all intents and purposes, FFO is to REITs what EPS is to other companies.

Most of the trends we saw last year have continued so far this past year. REIT sub-sectors that had positive FFO growth one year ago also had positive FFO growth over the last 12 months. A few notable changes include a dramatic slowdown in Single Family Home REITs and an acceleration in FFO growth among Specialty REITs.

SFH REITs had 61% FFO growth last year compared to just 16.5% this year, a result of the ramp up in acquisitions two years ago and the fact that SFH REITs are relatively new. Specialty REITs are a mixed bunch so difficult to evaluate the specific drivers of FFO growth from a macro perspective. However, a detailed view by individual companies indicates strong FFO growth by Innovative Industrial Properties (IIPR), one of our portfolio holdings that focuses on Cannabis real estate related properties, and to a lesser extent EPR Properties (EPR), which had a one-time item that inflated 2018 FFO.

Source: NAREIT Tracker Q12019

Net Operating Income

Net operating income accelerated to 4.7% in Q1 compared to the same period one year earlier. This was a pickup from the 3.7% last quarter. Interestingly, performance was more consistent across sub-sectors this quarter compared to last quarter. SFH REITs slowed considerably compared to last year, consistent with the slowdown in FFO, but all other sub-sectors were fairly consistent.

Most of the FFO growth on a trailing twelve month basis was driven by Infrastructure REITs, with 17% NOI growth over the last 12 months and a 15% NOI increase among Specialty REITs.

Regional Malls, Shopping Centers, and Healthcare REITs continue to struggle and they were joined this past quarter by Timber REITs, which had a 10% decline in NOI as they were impacted by a slowdown in homebuilding and lower lumber prices.

Source: NAREIT Tracker Q12019

Same Store Net Operating income

Same store NOI growth remains strong in the residential REIT space including Single Family Homes, Manufactured Homes, and Apartments. The housing market has failed to regain traction and affordability has been an ongoing issue, along with lack of supply – all of which have been driving up rental rates and benefiting residential REITs.

SS NOI growth exceeded 6% in SFH REITs and Manufactured Homes while Industrial REITs and Office REITs showed strong growth in excess of 4%.

Source: NAREIT Tracker Q12019

The uptick in Residential REIT NOI can also be seen in the chart below, where All Equity REITs remained somewhat flat, while Residential REITs had a noticeable increase in growth.

Source: NAREIT Tracker Q12019

A further breakdown of the Residential REIT space shows consistency across all three sub-sectors with Single Family Homes and Manufactured Homes both growing NOI at above 5%.

Source: NAREIT Tracker Q12019

Risks

Risks to each sector are not only highly dependent on underlying fundamentals of the property types, but on the amount of activity within each sector as it relates to net acquisitions and property development. The greater the amount of supply coming online the greater the amount of risk to competitive dynamics and pressure on pricing.

The chart below highlights the level of activity within each sector. Where there was a high level of activity – those sectors on the right – there was usually a greater amount of dispositions than acquisitions. This is being driven by not only the repositioning strategies being deployed by REITs based on the changing dynamics of their markets, but by heightened valuation levels that have made it attractive to sell assets at a premium.

Industrial REITs went from net dispositions last quarter to being net acquirers this quarter with over $1 billion in acquisitions and a noticeable drop in asset sales.

Not surprisingly, Residential REITs had plenty of activity this past quarter as well, with over $1.4 billion in acquisitions led by $1 billion in acquisitions by Apartment REITs alone.

Lastly, Retail REITs were also big acquirers this past quarter and almost all of the activity was in the Free Standing space.

On the right hand side of the chart below, we also see that Office REITs continue to sell off assets in excess of their acquisitions, as are Healthcare REITs, both of which were big net sellers last quarter as well.

Despite the increase in retail net acquisitions, however, as we mentioned before, it was almost entirely driven by Free Standing acquisitions. This is a continuation of the trend we have seen over the last few quarters, particularly as Shopping Center REITs were repositioning their portfolios. While we think Shopping Center REITs are at the tail end of their disposition activity, they still had net dispositions this past quarter.

Source: NAREIT Tracker Q12019

Summary of Sector Positioning

We made some very minor allocation changes in the last quarter based on valuations and recent price changes, as well as some changes in the macro economic environment.

We continue to like Shopping Center REITs and believe they are at the tail-end of repositioning, which should result in a bifurcation of future winners and losers. Those that have adapted well to omni-channel approaches and upgraded their properties to provide better consumer experiences should perform better than those that were slower to react.

Industrial REITs continue to perform well and are benefiting from omni-channel strategies being deployed by previously brick and mortar focused retailers. We see more opportunities in secondary and tertiary markets now that many of the coastal cities have been bid up.

The rest of our allocation percentages are below. Please note that the Strategic Allocation represents the percentage market cap for each sub-sector as they are represented in the NAREIT Index. Any allocations above or below those percentages – which are shown in the Tactical column – represent our overweight or underweight to each sub-sector.

Source: Author

Disclosure: I am/we are long EPR, IIPR. 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.

Additional disclosure: This article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It does not provide individualized advice or recommendations for any specific reader. Also note that we may not cover all relevant risks related to the ideas presented in this article. Readers should conduct their own due diligence and carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances. Furthermore, none of the ideas presented here are necessarily related to NFG Wealth Advisors or any portfolio managed by NFG.