The Essential REIT
Board: Real Estate Investment Trusts
I don't know how many of you subscribe to my occasional newsletter, The Essential REIT (or even care to), but for those with nothing better to do, I am copying and pasting it here. Warning: It's of substantial length, so print it off, grab a beer and get comfortable - or you can use it in place of Ambien. It was issued on Nov 25.
While ambling out into the backyard the other day to read the newest Daniel Silva book, I happened upon my two Golden Retrievers, Riley and Kacie, who were debating a few topics that might be of current interest to REIT investors. Let’s listen in.
Kacie: REIT stocks have been acting like that lazy overweight basset hound at the end of the street. They don’t do much; but, when they do go somewhere, it’s usually in a southerly direction.
Riley: In fairness, the typical REIT stock isn’t down in price in 2013. The MSCI equity REIT index closed at 904.79 on December 31 of last year. As of Friday, it was at 904.59 – you can’t get any flatter than that (and the dividends did provide for a modest positive return). That said, it’s certainly true that they have been dropped off at the kennel while their non-REIT equity friends have been partying all year; the S&P 500, at last Friday’s close, is up 26.5% in 2013 (and the Russell 2000 is up even more).
Kacie: That’s a lot of underperformance, which is certainly paws (er, cause) for concern. So what’s wrong?
Riley: Well, it sure isn’t operating metrics; the space markets continue to recover, albeit slowly, and occupancy rates and rents are rising; concessions are down. There are very few pockets of excessive supply, even though new developments are beginning to emerge in some sectors and markets. Same-store NOI is growing at a healthy 3-4% pace, with some sectors, as always, doing better than others. And, based on anecdotal evidence and Green Street Advisors studies, commercial real estate prices are holding steady; we’ve seen a bit of cap rate levitation, due to higher bond yields after their pre-May lows, but only for lesser-quality properties in secondary and tertiary locations. Finally, REIT shares are certainly not expensive relative to their NAVs.
So it’s not poor property markets or inflated REIT prices that are causing REIT stocks to act sickly relative to their non-REIT brethren. I suspect that poor relative performance in the markets these days feeds on itself – who wants to risk his or her job by populating a stock portfolio with a bunch of – sorry, Kacie – dogs? And, of course, there are fears of another May 2013, when REIT stocks fell 6.2% due to a spiking 10-year Treasury yield and expectations that the Fed would put its QE activities into the freezer.
Kacie: But will the May sell-off in REIT stocks really repeat itself when the Fed finally throttles back?
Riley: Maybe, maybe not. There are arguments on both sides. Those who fear another May swoon, or worse, note that an anticipated reduction in QE caused the REIT trashing in the spring, and will, quite logically, cause another one the next time – particularly if bond yields escalate in response to the Fed’s less aggressive posture. Also, REITs, along with utilities, telecoms and consumer staples, are regarded as “interest rate-sensitive,” which encourages traders to take them out and shoot them when interest rates begin to rise. Others fear that rising bond yields, this time, will impact commercial real estate prices and thus bite into REITs’ NAVs.
The bulls, on the other hand (if any are left), argue that the market never discounts the same thing twice, and that REITs have already underperformed the broader market substantially and are not likely to do so again – assuming that any rise in bond yields isn’t really huge. And, if the Fed eases on the accelerator, particularly under the dovish Ms. Yellen, it will be because the US economy really is improving; this would positively impact space markets, while new supply could be less of a threat because higher interest rates would make financing for new developments more costly. Historically, rising interest rates and bond yields haven’t always killed REIT stocks. REITs’ earnings and dividends will grow faster, perhaps offsetting a rising interest rate environment. Repeat after me: REITs are not bonds!
Kacie: REITs are not bonds. REITs are not bonds. Now let’s move along. I continue to read about bubbles; is the market in bubble territory? Has the Fed’s money-printing encouraged excessive risk-taking and pushed asset prices to unsustainable levels, so that when the Fed backs off, the market will crater? This is a favorite topic among the talking snouts on Animal Planet.
Riley: The only bubble today is in the social media and cloud stocks, which are trading at levels that are almost reminiscent of the dotcom madness of 1999. And then there’s Tesla and Solar City. The typical large cap company trades at about 16x estimated earnings over the next 12 months, which certainly isn’t bubbly and actually makes sense in light of low interest rates and bond yields.
There is no doubt, however, that many investors are being pushed into risk-taking because of very low interest rates, and that liquidity may be a bit excessive due to the Fed’s antics. But let’s not forget that we have very low inflation, weak economic growth, virtually no growth in Europe, and no pressure on commodity prices or wage-driven cost increases. Competition is fierce everywhere, and that’s not likely to change. Consumers aren’t exhibiting many animal spirits, as evidenced by recent consumer confidence surveys and disappointing sales at Wal-Mart and Kohl’s – this Holiday Season could be a real downer. Medium-term consumer spending growth will almost certainly be below its long-term average, and businesses are hoarding cash.
Accordingly, we may be attributing to the Fed too much influence, and I suspect that interest rates, bond yields and stock prices would be pretty close to where they are now even without the Fed’s meddling (although the 10-year’s yield would probably be 50-100 bps higher). If so, the Fed isn’t inflating asset prices much, and prices won’t deflate much when the Fed sheaths its weapons.
But that doesn’t mean that the market won’t swoon temporarily at the first sign of QE tapering. The Greyhounds will tear their ACLs, but even the stolid Labradors selling at 16x earnings will get scratched. So will REIT stocks. Traders lead stocks around as if on a leash over the short term. Longer term, a less active Fed is quite positive for the economy and for markets.
Kacie: SNL Financial reported recently on discussions at NAREIT’s convention in San Francisco, and provided some thoughts by seasoned REIT observers and investors about REIT leverage. It seems that some of these guys are worried that REITs will lose discipline, and increase debt leverage in order to goose growth. Do you worry about these things, Riley, or do you worry more about the fact that the level of kibbles in our food bin is getting a bit low?
Riley: REITs, like other real estate investors, use debt. Perhaps the theory is that because commercial real estate is so stable an asset class, with respect to both its value and its cash flow, there is little risk in financing some of the purchase price with borrowed money. Furthermore, as debt capital usually can be rented for less than what can be earned on a commercial property, investment returns are enhanced – while risk is contained through the use of only modest debt leverage and conservative loan-to-value ratios. And, of course, the use of debt by real estate investors is like the use of spices by chefs – it’s just always been done.
Kacie: So what’s the problem?
Riley: I’ve always been somewhat skeptical of the wisdom of financing investments with debt, if Golden Retrievers can be skeptical of anything. Increasing the long-term value of its shares should be the goal of every public company management team; but, borrowing money doesn’t accomplish that for REIT organizations, except during very odd times when merely buying properties creates shareholder value. But, even then, the timing must be almost perfect, as it is not often when only REITs have the capital (or access to it) to buy properties.
Furthermore, debt incurred to buy real estate must eventually be repaid. Or, if refinanced, interest rates may be much higher then. In any event, REITs were not really designed to trade properties regularly.
Kacie: But won’t debt, even the more expensive fixed-rate variety, boost a REIT’s FFO/AFFO per share? That’s gotta be a good thing, right?
Riley: Not necessarily. Investors will value a debt-financed earnings stream more dearly, and thus won’t pay as high a multiple of earnings of a leveraged company vs. an unleveraged one. Debt leverage creates refinancing risk, and risk is a determinant of multiples and equity values. Several years ago, when credit markets nearly shut down and property values cratered, REITs with substantial debt leverage faced a situation akin to being put into a ring with a crazed pit bull. Do you think it can never happen again?
Perhaps REIT stocks wouldn’t be suffering from so much volatility if they didn’t use debt to partially finance their properties. Buying property with 50% debt leverage is like buying stocks on margin – it works well only if The Force is with us. And sometimes it isn’t. The best form of debt isn’t even debt at all – it’s preferred stock, which increases earnings leverage but never has to be repaid. But that’s a topic for another time.
Kacie: Using debt leverage may also restrict a REIT’s capital allocation options; for example, stock buybacks may be the best use of capital when shares trade at large NAV discounts, e.g., the apartment REITs, but unless properties can be sold quickly to finance stock buybacks, they will increase debt leverage – at perhaps the most inopportune times.
Riley: You are learning quickly, Kacie. Very modest debt leverage may not be a cardinal sin; Kimco’s (KIM) highly-regarded and beloved founder, Milton Cooper, has suggested a long-term leverage goal of 25%. That’s easier said than done, however, as debt reduction will penalize near-term per share earnings – a key metric for earnings-centric REIT investors. Why don’t you go visit some REIT management teams and tell them to pay down some debt?
Kacie: Ha, ha. They’d just pat my head, give me some biscuits, and tell me to chew on a Nylabone. Debt, I’m afraid, is part of the DNA of every real estate guy, and serious debt reduction in the REIT industry is a tough sell. It would be easier to persuade our fuzzy little friends, Marty and Luke, not to bark when the mailman comes.
We wish all of you a very happy Thanksgiving!