REITs (Real Estate Investment Trusts) have a reputation for being complicated, unwieldy asset classes. It’s underserved – they’re actually one of the simpler companies to invest in due to their business model.
Let’s define what a REIT is to better understand how it works. It is a company that owns a portfolio of real estate properties and receives income in the form of rent and capital appreciation on the property. A simple model, but highly effective. Furthermore, REIT’s must pass on at least 90% of their profits to shareholders thanks to a specific tax structure that allows them to bypass income taxation. This enables them to pay higher-than-average dividends which often catches the eye of income seeking investors.
Perhaps the confusion regarding what REITs are and the associated real estate crisis of 2008 explains the difficulty investors have had in the sector over the past few years. A quick peek at the Vanguard REIT Index ETF (VNQ) 2-year performance looks more like the Superman roller coaster ride at Six Flags than a stock chart.
The sector’s unusual volatility can clearly be seen. It’s rate of return is roughly 15% over a two year time period, but has experienced large swings in value during that time. In May of 2013, the stock price was just over $78; in January of this year, the stock had dropped down to less than $65. Now it looks as if the price is climbing again with a current value of $77.13.
Traditionally, REIT’s have been considered an investment with less-than-average volatility. However, the mortgage crisis and introduction of ETFs changed that paradigm and temporarily forced volatility levels to artificially high levels – in some cases even more so than the general market.
The after-effects of the mortgage bubble has dragged down REITs performance in the past few years and the Fed taper has served only to exacerbate the worry. Concerns regarding rising rates have made real estate investors skittish and kept them from reinvesting in the sector.
It’s in this environment that opportunity flourishes – the real estate sector is really about to shift gears.
Real Estate Investment Trusts Are Outperforming This Year
ETF volumes appear to be returning to normal and volatility levels appear to be decreasing even as REIT values increase. While the past five years has been difficult, the past six months are encouraging. The reasons investors have been using to keep their distance no longer applies.
Year-to-date performance of the Vanguard REIT Index ETF also tells a different story than the one investors have been hearing – up 22%.
The common adage in investing, “past performance doesn’t guarantee future results” seems applicable for REITs now. Consider the facts: while fears of rising interest rates haven’t quite been eliminated, they are still at relatively low levels compared to years past. Most real estate companies have prepared for rate increases as well with debt restructuring and refinancing. In fact, higher interest rates may prove to be a boon for REITs. Increasing rates serve to keep rents high and revenues in the black.
REITs are capital intensive operations and the ability to acquire financing is of the utmost importance. For 2014, REIT’s raised $76.96 billion in investment funds compared to $73.33 billion in 2013. For investors, it shows that new capital flows more freely and is indicative of the positive economic mood of the country.
The dividend that accompanies a REIT is a big appeal for interested investors. The average REIT yields 4%. Compare that with the relatively languid 2.4% of the 10-year treasury and it’s easy to see what the attraction is.
The economy seems to be back on track despite a dip in growth data earlier in the year. Consumer confidence hit a 7-year high in August while unemployment numbers continue to drop. This information directly translates into good news for REITs.
Real estate demand post-recession is building with businesses who have been limited by the economy look to expand and children, who’ve been forced to live with their parents due to poor job prospects, seek out their own residences.
New construction is still at low levels limiting the available supply while demand continues to creep upward. Thanks to the Fed’s actions of aggressively targeting interest rates around zero, the REIT industry will benefit.
Where To Look For REIT Bargains
REITs are usually structured as owners and managers of different types of properties such as shopping centers, apartments, offices, hotels, industrial or other facilities. As such, shareholders can enjoy the ownership benefits of real estate without needing to be landlords. Because REITs are so varied, shareholders can take advantage of the individual opportunities presented in each REIT segment by focusing on specific markets.
A rising tide in real estate will lift all REIT classes but some segments, such as commercial and residential real estate, will see the biggest benefits.
Commercial real estate has begun growing faster than other real estate asset classes and should continue to do so into 2015. Total funds spent on non-residential facilities has increased 10% over the past year – a reason for “cautious optimism” in the sector.
Office vacancies have fallen below 16% and should remain unchanged well into the 3rd quarter of 2015. Rents however are expected to increase 2.6% this year and 3.2% next year. Rising private sector employment should drive growth in the office sector for several years.
Vacancies in the industrial market fell from 8.9% in the third quarter of 2014 and should fall to 8.5% for the same quarter for 2015. Rents in industrial facilities increased 2.4% for 2014 and should rise to 2.8% next year.
U.S. manufacturing activity hit a 3 ½ year high in August thanks to a surge of new orders while the Institute for Supply Management (ISM) said that its index of national factory activity rose to 59.0 last month. When the gauge rises above 50, it indicates expansion in the manufacturing sector.
Hotels and other lodging companies are reporting higher occupancy rates, up 5% year-over-year to 70.6%, even as the average daily rate climbed 5.4%. Revenues per available room shot up 10.7% as well.
According to Smith Travel Research, 2015 is expected to be a record year for hotel occupancy. Strong lodging demand and low supply should contribute to increased earnings for hotel and lodging REITs. There’s been a 50% increase in hotel construction in the past year to account for increased demand, but total growth will only be about 1.3% in 2015.
For residential REITs, the catalyst for growth is the improving job market for millennials and other young workers. As they begin to join the workforce, they will seek out apartment rental properties which should help to drive up rates and keep occupancy high.
Multi-family facilities such as apartments are likely to see vacancies drop from 4.1% to 4% in the 3rd quarter for 2015. The low vacancy rate means that landlords are able to charge higher rents which helps improve property management companies’ margins and revenues.
Average rents are expected to rise 4% for 2014 and 2015 and more than 180,000 new apartment units have become available in the past 12 months. The relatively slow recovery in the housing market is keeping rental demand strong, especially for younger Americans.
Rising interest rates along with a growing economy may serve to keep rental demand strong for the foreseeable future. New construction costs and financing will become more expensive and create a disconnect between traditional home ownership and renting.
Top REIT’s For Investors
Like any market sector, not all companies are created equal. Here’s our list for the strongest REITs in the office, industrial, hotel, and multi-family space:
- Boston Properties (BXP)
This company engages in Class A office properties with a strong presence in Boston, New York, San Francisco, and Washington D.C. Commercial real estate is in high demand according to a report by CBRE Group, a real estate services company. The research showed an average cost increase of 2.3% in the first quarter year-over-year while some metropolitan markets oversaw increases of more than 10%. Boston Properties has high operating margins of 33% and a dividend yield of 2.2%. The stock has climbed 22% YTD and looks to be fairly valued at around $130 based on future EPS growth, trading at at around a 7.5% discount to this valuation.
- Public Storage (PSA)
The eponymous self-storage company has over 2,200 locations totaling more than 142 million square feet of rental space in the U.S. and Europe making it one of the largest landlords in the world. Unlike most REITs it has a low debt-to-equity ratio of just 0.08 giving the company plenty of room to weather adverse economic conditions. It also pays a dividend of 3.2% and is up 18% YTD. A fair value estimation of the stock places it at around $180 based on future earnings estimates.
- LaSalle Hotel Properties (LHO)
LaSalle oversees 45 hotels with a focus on upscale luxury accommodations. The company’s revenue growth has outpaced the industry average growing at more than 10% while quarterly earnings growth year-over-year is nearly 183%. The relatively high dividend of 4.1% makes it an attractive stock to own, especially considering it has raised its dividend 240% since 2012. The stock has had a strong year so far rising 22% YTD. The stock’s fair value is around $38 based on its estimated EPS growth.
- Home Properties (HME)
As its name suggests, this company is a residential REIT. It manages rental properties primarily along the East coast of the U.S. The company is an aggressive acquirer of properties with more than 40,000 apartments purchased for $4 billion in the past 10 years and plans to invest $250 million in multi-family units within the next 12 months. It has high operating margins of 32% and has performed well YTD – up 23%. It has the highest dividend yield of the four REIT’s on our list with 4.6%. Based on the stock’s EPS growth estimates, it should be fairly valued at $70.
Overall, REIT’s have outperformed so far this year. The Vanguard REIT Index ETF is up 22% compared to the S&P 500’s gain of around 9.25%. The strong gains can be partially attributed to the sectors poor performance in 2013 as well as a renewed vigor in the real estate industry.
The yield on the 10-year treasury note is expected to reach 3.5% by the end of the year while the Fed should continue to taper and target zero interest on short term rates. Because REIT’s tend to borrow short-term in order to finance longer term loans and mortgages, we can expect a significant tailwind going into 2015.
Investors should be able to profit from capital appreciation in REIT equities in addition to the strong dividend yields found with this asset class. The average yield on a REIT is likely to remain in the 4% range – still well above average savings rates. This should help to drive volumes and stock prices higher going into the next year.
CEO, Elite Wealth Management
Full Disclosures: http://elitewm.com/disclosures/
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions on the companies mentioned through stocks, options or other securities.