Publications

- April 1, 2019: Vol. 6, Number 4

A late-cycle REIT defense: In a challenging market, real estate may help investors protect their downside

by Tom Bohjalian

It has probably been a while since a lot of investors have given REITs a second thought, with tech stocks and other high-growth sectors dominating the market’s attention. In fact, REITs have spent the past several years out of favor, with a strong economy benefiting property values and cash flows, but not so much their share prices.

That began to change at the end of 2018, as the prospect of slowing global growth and tighter liquidity battered financial markets. In the fourth quarter, U.S. REITs defended much better than broad equities, experiencing only half the drawdown of the S&P 500. Real estate securities in Europe and Asia were also resilient, and REITs continued to outperform through the first two months of 2019.

While there have been other brief periods of relative strength for REITs in recent years, this one looks a lot more like the beginning of a broader shift in market leadership as the U.S. economy transitions from mid- to late-cycle. Historically, such periods have generally been a great time to own REITs.

In late-cycle periods — defined for this purpose as a broad deceleration in Conference Board economic indicators — REITs have outgained the S&P 500 by more than 7 percent per year on average since the start of the modern REIT era in 1991. And in recessions, the margins of outperformance have historically been even wider.

While REITs are not immune to changes in the business cycle, several likely reasons exist for their outperformance in late-cycle environments.

  1. Predictable, lease-based revenues. In tough times, you can always put off upgrading your smartphone or buying a new car. But if you’re an office tenant with a 10-year lease, you’re contractually obligated to pay your landlord, regardless of economic conditions. As a result, REIT earnings growth has generally been far more consistent than that of most sectors in the stock market.

That being said, revenue stability can vary greatly by property type. Hotels, for example, are highly cyclical, with one-day leases and a reliance on business and leisure spending. By contrast, cell-tower leases are typically structured with five-year rolling opt-outs, providing stable, long-term cash flows. It also helps that demand for tower space has little to do with the business cycle, driven instead by the ongoing expansion of wireless networks to satisfy customers’ increasing data usage.

  1. Attractive dividends. In a low-growth environment, dividends tend to play a greater part in total returns, giving investors a potential head start. At the end of 2018, real estate was about even with the energy sector as the top-yielding segment of the S&P 500. This is typical for REITs, resulting from cash-flow-oriented business models focused on operating, acquiring and developing properties that generate recurring income streams. And, whereas distributions are optional for most other companies, the Internal Revenue Service requires U.S. REITs to pay out at least 90 percent of their taxable income to shareholders.
  2. Slower growth may ease the pressure from interest rates. Though U.S. inflation has been rising, a peak in economic growth and a more challenging global economic backdrop means bond yields are unlikely to move much higher from current levels. In addition, the Federal Reserve has already struck a more dovish tone and could soon put a hold on further rate hikes.

A FAVORABLE (BUT DIVERGENT) BACKDROP FOR REAL ESTATE

Defensive characteristics alone are not enough to protect investors. We have adjusted our outlook for property values and cash flows to account for slower but still healthy economic growth in 2019. Even still, REITs continue to offer potential for attractive relative returns amid a generally favorable backdrop for U.S. commercial real estate.

Supply and demand should remain largely in balance, giving landlords some level of pricing power, which should translate into healthy earnings and dividend growth in the mid-single digits. In our view, REIT balance sheets are stronger than they have ever been, given they spent the past decade reducing leverage and extending maturity durations. Meanwhile, REIT correlations with equities are back to pre-crisis levels, ending 2018 at 0.53, underscoring the portfolio-diversification potential of real estate.

Some REIT sectors are drawing the attention of private investors after lagging both the broad equity market and private real estate in recent years. Managers of private real estate funds have been raising capital faster than they can put it to work, which, according Preqin market intelligence, has led to a record $300 billion of uninvested capital sitting on the sidelines, looking to buy the types of assets REITs already own. If the market environment turns more challenging, that could serve as a potential floor of support for REIT valuations.

But with growth rates and valuations within the REIT market diverging significantly, it’s important to be selective.

One of our favorite sectors for 2019 is cell tower REITs. These companies have a long runway for growth, as carriers continue to invest in their networks and begin preparations for the much-anticipated 5G rollout. Similarly, data centers continue to see healthy tenant demand and strong development pipelines due to the growth of information technology outsourcing and data-intensive web applications.

We also like nearly all forms of rental housing, including apartments, single-family rentals and manufactured homes. In addition to seeing significant inflows of institutional capital, we believe these sectors are benefiting from strong demographics and job growth, which are driving above-average household formation at a time when new housing supply is well below normal.

At the other end, we continue to avoid most regional mall owners, which are struggling in the face of more brick-and-mortar store closures and the rise of e-
commerce. In the long run, the best malls should emerge stronger after the weaker ones die off. But in the meantime, many will need to invest significant capital to modernize their properties, weighing on their ability to grow cash flows.

DEFENSE THROUGH DIVERSIFICATION

As we’ve seen in REITs’ strong relative performance since October, having defensive, lease-based revenues and high dividend yields can be attractive in an environment of heightened uncertainty. As you consider how to help clients protect their portfolios from what may be a more challenging and volatile environment, it could be time to give REITs another look.

 

Tom Bohjalian is head of U.S. real estate and a senior portfolio manager at Cohen & Steers. Read his complete report on the subject at this link: http://bit.ly/2XNihE1

 

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