The FTSE EPRA/NAREIT Equity Index gained 19.7% last year, outpacing the 13% gains notched by the S&P 500. Worldwide, REITs did even better, with the FTSE EPRA/NAREIT Global Total Return Index climbing 25%. With REITs worldwide increasing dividends last year to 3.5% to 4%, they were a no-brainer for income-hungry investors. Last year U.S.-based REITs grew dividends at a double-digit pace.
In the next 12 to 24 months, fund managers expect REITs to post annual earnings growth of 7% to 10%. Much of that could yield dividends, says Rick Romano, co-portfolio manager of Prudential Global Real Estate Fund. Romano says REITs are attractive compared with the 10-year Treasury bond or corporate bonds. "On a relative return basis, if this slow growth environment continues, you should be able to get an income premium over bonds and some growth attached to that," Romano says.
This has not gone unnoticed. REITs in the S&P 500 are now trading around three times book value, while the overall market is trading at 2.2. By comparison, many other financial companies like banks are trading at less than book value. David Darst, chief investment strategist at Morgan Stanley, says REITs are closer to fair value, "maybe bordering on expensive."
Paying for Certainty
Many pros say REITs are worth it for the cash flow. Romano reckons that investors bid up the price on REITs because they are willing to pay upwards for identified earnings streams. REITs already had annual income identified on Jan. 1, he notes, while the typical S&P 500 company started the year with zero revenues. "People don't want to pay for uncertainty in today's environment," Romano says.
Others observers are even more upbeat. Ritson Ferguson, portfolio manager of the ING Global Real Estate Fund, says his research shows that the U.S. REITs are actually trading at a discount when compared to privately held property. (Listed companies hold just 10% of the world's property; the other 90% is in private hands.) Ferguson is CEO and co-CIO of CBRE Clarion Securities, a real estate services specialist, and through his firm's market intelligence, he calculates that listed REITs are trading at a 5% discount to their net asset value.
"Valuations are not stretched," Ferguson says. Retail, office buildings, apartments, industrial properties, and hotels are all trading at discounts, according to his calculations. Health care, storage, and the tiny net lease sector, comprised of companies that own big box stores with a single tenant, are all trading at premiums to their net asset values.
Rising Rents, Falling Rates
REITs have performed well over the last three years, but share prices have not been driven up purely because investors are hungry for yield. In the United States, the underlying value as an investment is improving, with occupancy rates growing close to the last peaks of 2007. Rents are rising as well—but not at a rate that justifies new construction, except for apartments. Supply is still well below the long-term average, near a 30-year low. Thanks to low interest rates, U.S. REIT balance sheets are in much better shape than any time in the last five years.
Low rates have done more than prompt investors to seek yield. They have also stoked fears of inflation, which caused a search for hard assets to protect investors, says Bob Zenouzi, chief investment officer for the Real Estate Securities and Income Solutions Groups at Delaware Investments. This combination of safety and yield has boosted REITs over the past three years. While U.S. REITs have reaped much of the benefit, global REITs joined in last year.
Over the last three years, the U.S. REIT market has outperformed while companies availed themselves of increasingly cheaper credit. Now the easy money—plus rising prices on domestic properties—is encouraging investors to go abroad to shop for bargains. "Real estate is no longer a local game. It's a global game affected by global macro events," Zenouzi says.
Witness Australian REITs, which had a very low cost of capital from 2001 to 2007. Today, they're selling because their currency is more expensive. Now the biggest U.S. REITs, including Simon Properties and Boston Properties, are buying real estate in England, China and India, as well as taking positions in other real estate investment companies, such as Klepierre, a French retail specialist. If money gets cheaper and lending conditions ease even more, Zenouzi expects to see the next tier of U.S. REITs going abroad.