The U.S. Real Estate Investment Trust (REIT) industry had a
lackluster third quarter after a relatively strong run in the
first half of 2012, with a below-par performance in the months of
August and September. However, on a macro aspect, the industry
was well on course to steamroll the negative investor sentiments
as historically REITs have two positive months for every negative
month in a bull market. To add a feather to its cap, currently
REITs also have been in a three-and-a-half-year cycle into the
bull market with an average return of about 20% in each year,
preceded by a two-year downturn.
APARTMENT INVT (AIV): Free Stock Analysis
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The uptrend in the year-to-date diffusion index further suggested
that economic growth was broadening across sectors and indicated
a higher probability of a firmer foundation for future growth.
Barring minor hiccups, overall equity prices moved northwards as
geopolitical noise remained relatively congenial with the
Pandora's Box of the eurozone crisis remaining well in control.
In addition, the U.S. GDP growth was comparatively healthy at 2%
in the third quarter as consumer spending picked up, along with
higher government outlays and gains in residential construction.
With an expected GDP growth of around 2% in the remainder of
2012, the overall industry offered a harbinger of a slow yet
steady revival of the economy. Employment data was also
encouraging with an average monthly gain of 146,000 jobs for the
third quarter, significantly up from 67,000 per month during the
previous quarter. Furthermore, the unemployment rate plummeted
below the 8% mark for the first time in the last four years to
7.8% and was expected to be 7.9% in the next year.
During the third quarter of 2012, the FTSE NAREIT All REITs Index
recorded total returns of 1.85% compared to 6.35% for the S&P
500. For the first nine months of the year, however, the trend
was reversed with the FTSE NAREIT All REITs Index reporting total
returns of 17.57% compared to 16.44% for the S&P 500.
A combination of factors has helped the listed REIT sector to
stand out and gain critical mass over the past 15 to 20 years,
the most notable among them being a healthy dividend payout.
Total returns of 15.74% for the FTSE NAREIT All REITs Index (as
of October 26, 2012) included a share price return of 11.92%.
Investors looking for high dividend yields have historically
favored the REIT sector. Solid dividend payouts are arguably the
biggest enticement for REIT investors as U.S. law requires REITs
to distribute 90% of their annual taxable income in the form of
dividends to shareholders. The dividend yield for the FTSE NAREIT
All Equity REITs Index as of October 26, 2012, was 3.41% compared
to 1.76% for the 10-year U.S. Treasury Note.
During 2007 to 2009, REITs took on far less debt than private
real estate investors, and many were able to sell at the top of
the market when private equity investors were still buying.
Importantly, during the downturn, REITs were able to acquire
properties from highly leveraged investors at deeply discounted
prices. This enabled them to add premium high-return assets to
Furthermore, REITs managed to raise capital to pay off debt,
owing to a large inflow of funds as institutional investors
allocated more 'dry powder' to the industry, making them an
increasingly attractive investment proposition. In 2011, REITs
raised $51.3 billion in public equity and debt, out of which
$37.5 billion alone was raised though public equity despite a
highly volatile market. During the first nine months of 2012,
publicly traded U.S. REITs have already surpassed that and raised
an aggregate of $54.3 billion in capital, which included $36.9
billion in equity.
Moreover, according to data from NAREIT, debt ratio of equity
REITs (total industry debt as a percentage of its total debt and
equity market capitalization) by the end of second quarter 2012
was 34.6% - significantly lower than 51% at the end of second
quarter 2008 and prior to the Lehman Brothers collapse due to the
'Great Recession.' In addition, REITs typically have a large
unencumbered pool of assets, which could provide an additional
avenue to raise cash during a crisis. These in turn have provided
the requisite wherewithal to the REIT industry to make strategic
acquisitions over time to fuel its inorganic growth engine.
Moving forward, the REIT industry is likely to maintain the
uptrend in growth for the remainder of 2012. The outlook remains
by and large positive.
However, given the positive note in investor sentiment, a number
of factors still persist as a thorn in the improved market
scenario. With heights of political uncertainty due to the
imminent presidential elections in the U.S., investors might play
a 'wait and watch' game before committing on better investment
opportunities. In addition, rising concerns about the 'fiscal
cliff', with over $600 billion in government spending cuts and
tax increases slated to kick start in 2013, is taking its toll as
most companies are reducing capital expenditures. These in turn
could put a ceiling on equity returns in the next year.
Furthermore, the strategic move to focus on austerity measures
among European countries could impede regional economic growth,
leading to a dearth of investor confidence in the European
financial and fiscal system. In addition, economic growth in
emerging markets, particularly the BRIC countries, is expected to
be lesser than in recent years, driven by a relative weakness in
the developed world and related uncertainties in the global
business climate. All these factors could cumulatively contribute
to an equity market headwind in the remainder of 2012 and in
In a nutshell, the long-term prospect of the REIT industry looks
favorable with a mild cautionary note. Year to date, the standout
performance in the industry was that of the Timber REITs (a total
return of 32.75% as measured by the FTSE NAREIT Equity REITs
Index as of October 26, 2012), followed by Infrastructure
(22.97%), Shopping Centers (22.82%), Industrial REITs (22.37%),
and Regional Mall (22.25%). The relatively underperforming
sectors were Apartments (3.77%), Lodging/Resorts (4.70%), and
Diversified REITs (5.11%).
We are bullish on
Plum Creek Timber Co. Inc.
) that owns one of the largest and most geographically
diversified private timberlands in the U.S. The company produces
lumber, plywood and medium density fiberboard in its wood
products manufacturing facilities. Plum Creek's diversified
timber and land base provides excellent operational flexibility
to respond to changing market conditions amid a challenging
In addition, the upsurge in demographic trends driving housing
markets and demand for real estate properties across the nation
provides a strong economic backdrop for the company to
demonstrate solid financial performance in the future. Housing
starts are expected to be up 25% in 2012, and increase from
750,000 starts in the current year to 900,000 in 2013.
Plum Creek benefits from large economies of scale and capitalizes
on the increasing value of timber over time to offset several
negative effects of cyclical commodity pricing. Furthermore, Plum
Creek makes prudent investments in the growth of its timberland
assets and harvests trees at the most 'economically mature' point
in the life cycle of a tree. The company also acquires attractive
timberlands and uses advanced practices to improve productivity
of its forests, which augments its timber inventory.
We also remain bullish on
Simon Property Group Inc.
) the largest publicly traded retail REIT in North America, with
assets in almost all retail distribution channels. The company's
international presence gives it a more sustainable long-term
growth story than its domestically focused peers. The geographic
and product diversity of the company also insulate it from market
volatility to a great extent and provide a steady source of
The company has one of the strongest comparable sales per square
foot in the industry. Comparable sales in the combined portfolio
were $562 per square foot during third quarter 2012, compared to
$514 in the prior-year quarter. In addition, Simon Property
generally enters into long-term leases with companies, which
insulate it from short-term market swings that have weighed on
other players in the industry. With a favorable supply/demand
relationship, rising earnings estimates, robust growth
projections, and a healthy dividend yield, Simon Property offers
an enticing upside potential going forward.
Another stock worth mentioning is
) that acquires, develops, operates and manages industrial real
estate space in North America, Asia and Europe. Prologis had
merged with the erstwhile namesake company in an all-stock deal
to become a behemoth of sorts in the industrial real estate
sector. The combined entity had brought two of the most
complementary customer franchises on the same platform and
created a $44 billion worth of asset pool at their disposal at
the time of merger. The merger had led to potential cost savings
through operational synergies and had created a stronger platform
for value creation and sustainable growth in the long term.
In addition, Prologis provides industrial distribution warehouse
space in some of the busiest distribution markets across the
globe. The properties of the company are typically located in
large, supply-constrained infill markets at close proximity to
airports, seaports and ground transportation facilities, which
enable rapid distribution of customers' products. This has
enabled the company to gain a significant pricing advantage over
A significant chunk of REITs are raising capital through property
level debt and equity offerings. Although both debt and equity
financings provide the much-needed cash infusion, they could
potentially burden an already leveraged balance sheet and dilute
earnings. Property level debt is also harder to obtain and more
expensive, as commercial real estate prices remain under
Although overall market fundamentals remain positive for
Apartment REITs, we are a tad bearish on
Apartment Investment and Management Company
) as it is popularly known as. Aimco is one of the largest owners
and operators of multifamily apartments in the U.S., with a
strong portfolio of Class 'B' and Class 'C' properties primarily
catering to the middle-income market. The company is currently
restructuring its portfolio and expects to sell almost all of its
affordable properties over the next four- to five-year period to
concentrate entirely on the conventional real estate portfolio.
Aimco also expects to reduce its investment in non-target markets
and consequently increase its investment in target markets
through redevelopment and acquisitions. Despite attempts to
reposition its portfolio, much of the company's portfolio still
resides in areas where housing is relatively cheap. As the
company continues to sell non-core assets and buy in higher
growth, infill areas, we expect continued earnings dilution.
We also remain skeptical on
Host Hotels & Resorts Inc.
), the largest lodging REIT in the U.S. The majority of Host
Hotels' properties are concentrated in the luxury and
upper-upscale segments, which had been the weakest performing
segments during the economic downturn. The hotel industry is also
cyclical in nature, and is heavily dependent on the overall
health of the U.S. economy, which is yet to spring back to its
Unfavorable macroeconomic conditions in the past have compelled
customers to cut back on discretionary spending and prefer lower
priced brands over premium ones. Consequently, demand for Host
Hotels had reduced comparatively and if the trend reoccurs in
future, the company would be under severe stress to maintain
Moving forward, limited supply of new construction coupled with
the growing demand for high-quality properties bode well for the
earnings prospects of REITs, in particular those that have assets
in high barriers-to-entry markets. To sum up, we firmly believe
that despite a few pitfalls, REITs still make a worthy investment
proposition during the remainder of 2012 and in 2013.