REIT Industry Review & Stock Picks - Zacks Analyst Interviews

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With sustained yet slow improvements in the economy, the U.S. Real Estate Investment Trust (REIT) industry outperformed the broader equity market in fiscal 2011. The FTSE NAREIT All Equity REIT Index reported total returns of 8.28% for full year 2011 vs. a 2.11% and (1.80%) for the S&P 500 Index and the NASDAQ Composite, respectively. This was preceded by two solid back-to-back fiscal performances for the industry, as the FTSE NAREIT All Equity REIT Index reported total returns of 27.95% in 2010 and 27.99% in 2009.

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 8.28% for the FTSE NAREIT All Equity REIT Index in 2011 included a share price return of 4.32%.

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 REIT Index, as of December 30, 2011, was 3.82% compared to 2.22% for the S&P 500 and 1.87% yield on the 10-year U.S. Treasury Note.

During the 2007 to 2009 period, 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 their portfolios.

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.

Moreover, according to data from NAREIT, leverage ratio of equity REITs (total debt against market capitalization) as of September 30, 2011 was 41.6%, significantly lower than 51% at the end of second quarter 2008, 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 continue outperforming the broader equity market over the past quarters.    

The standout performance in the REIT industry in fiscal 2011 was that of the Self-Storage REITs (a total return of 35.22% as measured by the FTSE NAREIT Equity REIT Index), followed by Multifamily Apartment (15.10%), Health Care (13.63%) and Retail (12.20%). The relatively underperforming sectors were Lodging/Resorts (-14.31%) and Industrial (-5.16%) REITs.

OPPORTUNITIES

We are bullish on Public Storage ( PSA ), the largest owner and operator of storage facilities in the U.S. The company has significantly increased the scale and scope of its operations through the acquisition of Shurgard Storage Centers that had a considerable presence in the European markets. Although Public Storage currently owns a 49% stake in Shurgard, the size and scope of its operations have enabled it to achieve economies of scale, thereby generating high operating margins and managerial efficiencies.

The 'Public Storage' brand is the most recognized and established name in the self-storage industry with a presence in all the major markets across 38 states in the U.S. In addition, the storage facilities of the company have a high visibility and are usually located in densely populated areas that improve the local awareness of the brand. This offers a significant upside potential for the company.

With a continued decline in the single-family homeownership rate across the U.S., apartment REITs have performed strongly in fiscal 2011. We expect the performance of the multifamily sector to remain comparatively stable in the coming quarters, as renting has emerged as the only viable option for customers who could not avail mortgage loans or are unwilling to buy a house at present.

In this environment, we remain bullish on AvalonBay Communities, Inc. ( AVB ), one of the best-positioned apartment REITs primarily focusing on developing multi-family apartment communities for higher-income clients in high-barrier-to-entry regions of the U.S. AvalonBay has Class A assets located in premium markets such as Washington DC, New York City and San Francisco, where the spread between renting and owning is still high despite home price declines.

In addition, AvalonBay has a reasonably strong balance sheet with moderate near-term debt maturities and adequate liquidity. Consequently, the company has the ability to fuel its expansion drive though inorganic growth.

Another stock worth mentioning is HCP Inc. ( HCP ), a leading healthcare REIT with one of the largest and most diversified portfolios in the healthcare sector having exposure to nearly all types of facilities. The product diversity of the company allows it to capitalize on opportunities in different markets based on individual market dynamics, and provides a hard-to-replicate competitive advantage over its peers.

In addition, HCP does not run the health care business at its facilities. Rather, it has established business relationships with a number of experienced healthcare management companies or operators who lease these properties on a long-term basis - generally for 10 to 15 years.

Healthcare is also relatively immune to the economic problems faced by office, retail and apartment companies and is the single largest industry in the US, based on Gross Domestic Product ( GDP ). Consumers will continue to spend on healthcare while cutting out discretionary purchases. This insulates the company from short-term market swings, and provides a steady source of income.

WEAKNESSES

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.

We are bearish on Host Hotels & Resorts, Inc. ( HST ), the largest lodging REIT and one of the largest owners of luxury and upper-upscale hotels. The majority of Host Hotels' properties are concentrated in the luxury and upper-upscale segments, which was the weakest performing segments during the economic downturn. While the outlook for these markets has improved, the pace of improvement remains quite uneven and unsteady.

The hotel industry is also cyclical in nature, and is heavily dependent on the overall health of the U.S. economy. Unfavorable macroeconomic conditions in the past has 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 bottom line of the company is likely to be affected, reducing its operating margins.

We also remain skeptical on Cousins Properties Inc. ( CUZ ) an REIT that acquires, finances, develops and leases office, retail and industrial properties throughout the U.S. Cousins Properties has a large development pipeline, which increases operational risks in the current credit-constrained market, exposing it to rising construction costs, entitlement delays and lease-up risk.

Furthermore, Cousins Properties generates a significant amount of revenue from its office portfolio. Office demand is highly correlated to job growth. If job losses recur, operations in the company's office portfolio are likely to suffer, thereby affecting top-line growth of the company.
 
AVALONBAY CMMTY ( AVB ): Free Stock Analysis Report
 
COUSIN PROP INC ( CUZ ): Free Stock Analysis Report
 
HCP INC ( HCP ): Free Stock Analysis Report
 
HOST HOTEL&RSRT ( HST ): Free Stock Analysis Report
 
PUBLIC STORAGE (PSA): Free Stock Analysis Report
 
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: AVB , CUZ , GDP , HCP , HST

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