REIT Fundamentals Look Good
The slowdown in the housing market, which has led to a huge pullback in the home-building stocks, now appears to be hitting real estate investment trusts (REITs), which invest in real estate either directly (by owning and managing properties) or indirectly (by buying mortgages).
Since the start of the year, all six categories of REITs in the Standard & Poor's Composite 1500 index of U.S. stocks have lost value. Residential REITs, which own apartment buildings, and office REITs, which focus on commercial office space, are both down around 5 percent so far this year. Retail REITs, which own malls and other retail-related properties, have lost nearly 7 percent on average.
This represents a huge turnaround, as REITs in general have returned nearly 29 percent a year for the past five years, according to Morningstar. "This erosion in performance has caused many to ask, 'Is this the beginning of the correction in real estate stocks?' " says Sam Stovall, chief investment strategist for Standard & Poor's.
Not necessarily. At least not for these REITs, which throw off a decent amount of income through the rents they collect. In fact, Standard & Poor's maintains either a "positive" or "neutral" outlook on all six REIT categories in the S&P Composite 1500.
Here's a look at S&P's thoughts, drawn from its "Global Equity Insights" report released this month, on each of the six major REIT sectors:
INDUSTRIAL REITS
What are they?
This group specializes in industrial or warehouse space.
What's S&P's take?
"We have a positive fundamental outlook on the group. Industrial REITs have historically been economic laggards. In fact, we think the group is just now beginning to fully recover from the effects of the last recession, which prompted users of industrial real estate to jettison unnecessary space, causing rental rates to decline...With the real U.S. [gross domestic product] expected to rise moderately and increased demand for industrial space, we believe same-property revenue and funds from operations will likely be positive across the industry over the next 12 months."
What trends are working either in favor of or against industrial REITs?
The resilient U.S. economy—and the accelerating global economy—should provide a tailwind to this group, especially those real estate investment trusts whose properties cater to businesses that deal in international trade.
OFFICE REITS
What are they?
This group specializes in office buildings and commercial office space.
What's S&P's take?
"Our fundamental outlook on the office REITs subindustry group is positive, based on continuing U.S. employment growth. We also believe positive net absorption of office space will lead to moderately rising rental rates on average and continued growth in cash flow from cyclical lows. The U.S. office market tends to track the overall economy on a lagged basis, reflecting an average lease term of seven to 10 years."
What trends are working either in favor of or against office REITs?
The resilient U.S. economy—and the accelerating global economy—should also provide a tailwind to this group. Low unemployment and decent job growth are also expected to boost rents, which should increase the dividend income these REITs generate. And S&P believes office rents should rise now as office space is becoming scarce. In 2003, for example, the national vacancy rate for office space stood at 17 percent. At the end of 2006, it was closer to 13 percent.
RESIDENTIAL REITS
What are they?
This group specializes in apartment buildings and other multifamily real estate complexes.
What's S&P's take?
"Our fundamental outlook for the residential REITs subindustry is neutral. During the March quarter, we believe vacancy rates for rental apartments increased for the second consecutive reporting period, reflecting seasonality as well as renewed supply. In addition, we believe renters may be starting to resist rent increases that averaged 4 percent to 6 percent in 2006...We see a few more challenges awaiting these companies later in 2007."
What trends are working either in favor of or against residential REITs?
These investment vehicles are currently enjoying a trio of tailwinds. Apartment occupancy rates remain historically high. Rising mortgage interest rates should dissuade some would-be buyers from re-entering the home ownership market. And low unemployment for the key demographic of renters—those 25 to 34—means a financially strong customer base.
But at the same time, there are three headwinds to consider. First, analysts note that with home prices falling, some renters may start to consider buying again, to take advantage of attractive pricing—regardless of mortgage interest rates. And if that occurs, demand for rental properties should slow. Second, because of the housing slowdown, property owners who had been converting their apartment buildings into condominiums have stopped doing so. In fact, some are starting to reverse course and converting condo buildings back into rental units, thereby increasing the supply of apartments on the market. Shrinking demand and increasing supply are bad news for apartment rents. Finally, there's the economy to consider. Though the U.S. economy is surprisingly resilient, it's still expected to slow this year, and that could hurt consumer spending.
RETAIL REITS
What are they?
This group specializes in shopping centers, malls, and other retail-oriented buildings.
What's S&P's take?
"We have a positive fundamental outlook on the retail REITs subindustry. With U.S. real GDP continuing to rise, consumer spending increasing, and retailers expanding, we believe same-property revenue and net operating income will likely be positive across the industry over the next 12 months. However, we expect to see differentiation among property types; we think regional and super-regional mall owners/managers will post the best performance. In addition, we think many retail REITs will continue to seek to boost earnings via other means, such as property acquisitions."
What trends are working either in favor of or against retail REITs?
While industrial REITs may benefit from the global economy, retail REITs depend more on the health of the domestic economy. And even though the U.S. economy remains strong, it's still expected to slow throughout the year. On the other hand, consumers have shown an uncanny ability to spend through financial slowdowns. And even though interest rates have been rising, they're still modest by historical standards, which should help consumers.
SPECIALIZED REITS
What are they?
This group specializes in niche properties, including lodging (hotel REITs), self-storage, and medical facilities (healthcare REITs).
What's S&P's take?
"We have a positive fundamental outlook on the specialized REITs subindustry. We believe the strong macro economy has generated increased demand for a number of the services provided by specialized REITs, including lodging, self-storage, and timber. The growth in demand for products and services has been magnified by limited supply growth in a number of groups within the subindustry as cost of construction, land availability, and investor focus on other sectors have limited new projects. We see healthcare REITs as less impacted by the general economy, with their growth influenced by trends in government reimbursement policies and population demographics. We believe stability in government policy and the aging baby-boomer population are positive trends for healthcare REITs."
What trends are working either in favor of or against specialized REITs?
It's hard to say, given that each REIT in this subcategory focuses on a very specific part of the economy. But the economy, demographic changes, and commodity prices are expected to play a big part in the appeal of this sector.
DIVERSIFIED REITS
What are they?
This group spreads its bets among several types of properties, representing a diversified collection of real estate.
What's S&P's take?
"We have a neutral fundamental outlook on this group, which holds a mix of office, industrial, retail, and in some cases, residential properties. Accordingly, we expect earnings growth largely in line with the overall REIT average."
What trends are working either in favor of or against diversified REITs?
It depends on what types of properties each REIT owns. S&P believes that those diversified REITs that own a mix of retail, industrial, healthcare, and office properties should see growth based on the health of those sectors and the economy. Those diversified REITs that own a big stake in industrial real estate should see a boost thanks to the health of the global economy. But those REITs with major stakes in residential properties could be pressured by the growing supply of rental properties hitting the market.