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.
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 2013.
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
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 macroeconomic
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 income.
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 its competitors.
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 pressure.
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 full vigor.
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.
APARTMENT INVT (AIV): Free Stock Analysis
HOST HOTEL&RSRT (HST): Free Stock Analysis
PLUM CREEK TMBR (PCL): Free Stock Analysis
PROLOGIS INC (PLD): Free Stock Analysis Report
SIMON PROPERTY (SPG): Free Stock Analysis
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