As cap rates continue to push into all time low levels, the market appears skittish regarding REIT valuations. At face value this doesn't make sense - lower cap rates mean a higher Net Asset Value and should translate to higher share prices. Concurrently, operational metrics continue to strengthen across all markets, yet current stock prices are lagging.
I will focus on the industrial sector as that is my expertise. Clearly the market is bypassing the short term NAV increase and proceeding to perceived risk of rising cap rates and future valuation loss. This is a defensive manner of investing, which I appreciate but that I generally disagree with in the short term - emphasis on short term!
With the US dollar strengthening, foreign capital is moving into US real estate. Global economic malaise enhances the inflow of capital, which is helping to keep interest rates low. Meanwhile the US economy remains strong, benefiting from a conservative economic recovery that has finally trickled down to small business owners. Despite government headwinds that tax small businesses, such as workers comp, heathcare costs and increased taxation, businesses are growing and doing so with an efficient and conservative cost structure. Banks have conservative lending standards.
I do not believe that US business nor real estate is poised for significant returns - rather I think that overall returns on investment in business and real estate will continue to function on relatively thin margins. However, interest rates will continue to stay low, and likely rise slowly over time when the fed begins to alter strategy. Bank spreads have room to tighten, and a moderate increase in rates will provide potential for business margins to rise. During this period the return on industrial real estate, with cap rates in the 4.5 to 6.5% range across market areas and product types, looks favorable compared with other opportunities.
The key is to avoid a rapid rise in interest rates. My current view is that the global environment and general transparent nature of business today makes it likely that interest rates will take some time to increase, and the change will be very gradual. With this in mind, I think the market is undervaluing industrial real estate.
I currently am seeing cap rate compression in all markets, especially for longer term leases. As yields continue to compress on the most obvious, conservative investments, the money is looking to other avenues to garner additional yield. Cap rates have been compressing moderately in Class B assets and in secondary and tertiary markets, and that trend should continue.
Meanwhile, operational fundamentals are strong and rental rates are rising across the board. As rates rise and cap rates tighten, REIT valuations should be increasing. I expect that REITs will likely look to increase dividends in upcoming quarters, and that the stock market values have a good chance to move up along with prolonged low cap rates and increasing returns.
The specter down the road is a market change. Unfortunately, REITs are not motivated to liquidate assets at the right time. Essentially they would be putting themselves out of business... I am bullish on REITs short term, and would look to REITS with low leverage and entrepreneurial management that has a history of taking profits at the right time.
Pat Maloney is a 25 year veteran of industrial real estate, spending 14 years as a senior executive with Prologis (NYSE:PLD), and 9 years as a broker with CBRE (CBG), prior to starting his own firm, Circle Industrial, in 2013.