REIT 2019 Outlook – Shelter from the Rotational Storms

Solid Operations Supports Steady Earnings and Dividend Growth Prospects

EXECUTIVE SUMMARY 

• 2019 Return Expectations – We think REITs will generate 5-7% total returns in 2019, with about half coming from a growing cash dividend yield of 4%. REITs are on track to generate low single digit total returns over 2018, a little below our forecast of 6-8% a year ago, as valuations have contracted more than we anticipated. In 2019, we believe REITs will produce earnings growth of 5-7%, pay a 4% cash dividend and that the earnings multiple could decline ~100bps, as interest rates move steadily albeit modestly higher. Against a possible growth/value, risk-on/risk-off market rotation, we think REIT returns in 2019 will look relatively attractive.
• Earnings Growth – Over 2019, we assume growth for most REITs will be largely driven by income increases from further solid space demand and limited new supply. Most companies should be able raise rents and maintain high portfolio occupancy.
• Dividends – The REIT sector currently offers a dividend yield of ~4%, more than double the yield of the S&P 500 Index. We believe REITs will grow their dividends by mid-upper single digits in 2019, matching the pace of their FFO/AFFO growth; and in many cases, they will exceed it. The value of the after tax REIT dividends was boosted by 17% from the Tax Cuts and Jobs Act for most individual shareholders.

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• Fund Flow – REITs are on track to raise ~$50bn in 2018 following a record $93bn raised in 2017. Private Equity Real Estate funds continue to attract elevated inflows. The investment appeal of property investment looks likely to be solid into 2019 and many large institutions are under their allocation targets in commercial real estate and looking to grow their allocations.
• Principal Assumptions and Risks – We assume an approximately 2.5% US GDP growth in 2019 and modestly higher interest rates. We regard the major risks to sector stock performance to include an acceleration in the pace of interest rate increases and/or the potential of a material economic slow-down which would lower space demand. Excessive new development which is commonly a cause of cyclical property risk, generally appears to be a low probability in most property sectors at present.

COMMENTARY 

Earnings Growth Prospects – Most companies have reported solid Y/Y quarterly growth of mid-upper single digit of FFO/AFFO per share over the first three-quarters of 2018 and we expect they will close out the year on a similar pace. Bottom line growth has been largely driven by a positive operational performance. Most REITs have maintained high portfolio occupancy in the mid 90%’s which combined with some rental pricing power and expense control has generated positive growth in NOI. We are several years into the expansionary part of the cycle but as yet there are limited signs of headwinds emerging from an imbalance of space supply exceeding demand. Assuming further solid growth in the economy which will support further space demand, REITs should be able to deliver earnings growth and higher dividends over the next year or two.

Company Earnings Guidance – A handful of companies have provided initial FY19 earnings guidance which generally have assumed largely a ‘same again’ operating environment which should help deliver similar bottom-line growth outcomes to what we see in 2018. Most companies will provide FY19 earnings guidance with their 4Q/FY18 earnings in Jan/Feb next year. We expect many will guide to Y/Y earnings/operational growth largely consistent with the early guiders. Exceptions will be those companies still rationalizing their portfolios by selling more assets than they are buying and de-levering, notably among Shopping Center and Healthcare REITs. We do anticipate in many cases that the scale of this activity and the associated earnings drag to be now largely over.

Dividend Growth – Most REITs have continued to increase their common dividend payments. Dividend coverage remains good and earnings quality high. With its 3Q18 earnings, American Tower (AMT), the largest REIT by equity market capitalization, reiterated its target of lifting its dividend payment a further 20% this year. Equinix (EQIX), the largest datacenter company, has reaffirmed that its FY18 dividend will be 14% higher than its FY17 payment. Simon Property (SPG), the mall giant, will pay a dividend 11% Y/Y higher this year. CBD office owner, Boston Properties (BXP) raised its 3Q dividend 19% Y/Y. Equity Lifestyle (ELS) will lift its payment by 11% Y/Y for 2019. We own all of the before mentioned companies in the REIT portfolio. Federal Realty (FRT), another portfolio holding which raised its dividend 2% mid-year, marking its 51st consecutive annual increase while Realty Income (O) has recently raised its distribution by 4.0% Y/Y, marking its 84th consecutive quarterly increase (that’s 21 years) and the 580th unbroken dividend declaration (and that’s 48 years and counting).

The value of after tax REIT dividends was boosted by 17% for most shareholders from the 20% Pass Through deduction included in the 2017 Tax Cuts and Jobs Act. We continue to believe the value of this tax reduction is not yet fully understood by many investors and not fully reflected in REIT stock prices. We think as investors review their 2018 taxes with their advisors early in 2019, this benefit may become better appreciated. 

Fund Flow – Institutional interest in real estate and REITs remains strong and appears likely to remain so. Many large institutional investors have target property allocations of 10-12% and are underinvested. Capital raised over first three quarters of 2018 by REITs totaled $38.4bn. This comprised $20.7bn of unsecured debt, $16.2bn of common equity and $1.5bn of preferred shares. REITs are running at an annualized pace of $51bn, which is barely half the record $92.5bn raised in FY17. Equity capital issuance has been curbed by share price discounts to NAVs. We would expect higher levels of equity issuance in 4Q18 if higher stock prices hold. Debt markets remain open at attractive terms with many REITs able to tap long term (10 years and longer) unsecured corporate debt at sub-5% levels. In the whole loan mortgage market, similarly attractive rates prevail and the Commercial Bankers Association expects commercial and residential mortgage originations in 2018 to match last year’s record $530bn ($280bn commercial, $250bn residential). CMBS issuance is projected to be a solid $85bn in 2018.

Aside from the public REITs, institutional commitments into Private Equity Real Estate (PERE) funds continues to be robust. According to Preqin, PERE funds raised $109bn (two- thirds for North America) over 2017, the fifth consecutive year of >$100bn. The 2017 total includes equity and debt funds for North America, Europe and Asia, and is less than the 2015 and 2016 fund raising levels. Note PERE funds raised 2x the equity raised by US public REITs in 2017. These PERE funds have $250bn of ‘dry powder’, approximately 60% earmarked for North America.

New development costs have been escalating with rising labor and material costs together with more difficult financing. Higher costs will curb development activity and help lift the scope for rents to go higher before new supply can be economically supported.

Mergers & Acquisitions. In part driven by discounted stock prices in 1H18, there were several transactions comprising a mix of public-to-public and public-to-private deals announced early in 2018. Higher stock prices in 2H18 have seen stock price discounts to NAV tighten and have dampened M&A activity. As noted above, the PE funds remain loaded with ample resources to deploy into property investments. We believe stock price discounts to NAV of about 15% are a trigger level for stimulating greater M&A interest, similar to stock buy-backs (see below). However, even if REIT prices do not fall back to a 15% discount, we believe there will be further M&A deals in 2019 as long term investor interest in property remains elevated. REITs are currently trading at a 9% discount to NAV.

Private Equity property giants Blackstone (BX) and Brookfield (BAM) were active buyers in 2018: BX acquired Grammercy (GPT) for $7.6bn TEV; BAM acquired General Growth (GGP) for $36bn and has agreed to buy Forest City for $11bn. Education Realty was also acquired by private equity group Greystar for $4.6bn. Additionally, public-to-public deals included Prologis (PLD) buying DCT (DCT) for $8.4bn and Pebblebrook Hotels (PEB) struck a deal to buy LaSalle Hotels (LOH) valuing LOH at $5.2bn, interestingly beating out interest from Blackstone.

Capital allocation has become a bigger part of management/investor/analyst discussions. Many companies have been actively rationalizing their portfolios over recent times with reallocation decisions being more prominent. This has included discussion of acquisitions, development, debt reduction, dividend increases and share buy-backs. We anticipate this will be a topic that will remain in the forefront in 2019. Most notably, SL Green (SLG), the Manhattan office/retail owner, bought back $1.6bn from a $2bn program, selling assets and buying back stock at a discount/reducing debt with the proceeds. Stock price discounts to NAV’s of around 15% have emerged as a general valuation point of reference to more animated discussions.

From a balance sheet perspective REITs appear solidly placed with Net debt to EBITDA ratios of 5-6x, limited variable rate exposure and extended maturities. They look positioned to be more aggressive buyers should opportunities arise and should be able to withstand higher rates and an economic slow-down should that happen.

LEADING SUB-SECTOR OUTLOOK 

Tech Related – Towers & Datacenters (19% of NAREIT Index by equity market cap at end Oct ‘18) Many of the companies in these sub-sectors continue to exhibit premium growth of >50% above sector average, fueled by strong user demand and accretive acquisitions. Investor enthusiasm for the towers is greater than for the more capital intensive datacenters. Among the tower companies, American Tower (AMT) FY18 guidance is for 12% AFFO/sh growth and Crown Castle (CCI) is guiding to 13% AFFO/sh Y/Y growth. Digital Realty (DLR), one of the largest datacenter companies, is guiding to 8% AFFO/sh Y/Y growth.

Retail (17%) – Many malls and shopping center companies reported high occupancy and positive re-leasing spreads of 5%-10%, reflecting solid tenant demand. While e-commerce, department store and weak apparel sale related woes continue to weigh heavily on investor’s minds, space demand for the good properties in good locations remained strong. There appears to be a growing consensus that we are reaching some stabilization as the retailers get to grips with revamping their businesses to combine e-tailing with bricks and mortar. We continue to look at the overall strength of management and REIT balance sheets as key points of differentiation among the retail real estate operating segment.

Residential (14%) – Apartment operational performance remains positive, and as levels of new supply appear to have peaked in some markets, they have showed signs of an acceleration in rent growth. The Sunbelt and West Coast were stronger than the Northeast. California’s ballot regarding the possibility of re-imposing rent control was defeated. In Student Housing, new supply and pricing issues continue to weigh on operational performance. Single Family rental housing continued to post solid results with NOI growth running well above apartment growth rates.

Office (9%) – Space demand in the major ‘gateway cities’ (this includes New York, Washington DC, San Francisco) is generally steady with many markets said to be in equilibrium. Investment interest has been more subdued for CBD Gateway office properties though the fourth quarter which is traditionally the most active period of the year. There is new supply coming into some markets. TAMI tenants (Technology, Advertising, Media, Information) are more active than Financial Services as dominant users of available space.

Healthcare (9%) – The once frenetic pace of healthcare property acquisitions has slowed to virtually nothing as the cost of capital has increased for REITs and prices have become elevated. Long term, the aging population remains a positive demand driver but healthcare policy remains highly uncertain in the medium-long term and senior housing is currently oversupplied. Medical Office Buildings are the best performing sub-sector, Senior Housing the weakest with Life Science, Nursing Homes and Hospitals somewhere in-between.

Industrial (8%) – Space demand from e-commerce related tenants remains strong and there is solid demand from more conventional users for more traditional properties. Supply has increased but in a number of locations, it continues to lag demand levels. A further escalation of trade disputes/protectionism would not be a positive development for warehouse/industrial space demand nor would an economic slow-down.

Storage (6%) – The development of storage space has ramped up over recent times after an extended period of little/no activity. This has prompted Public Storage (PSA), the dominant storage company, to warn of operational deceleration amidst some rising supply – Other storage companies appear less affected.

Lodging (5%) – RevPar (Revenue Per Available Room), the industry’s important performance metric, showed some improvement and fed through to higher earnings and guidance albeit from a low base. The recent increases in the new supply of rooms in NYC and San Francisco dampened results from these important markets but now appears to be progressively absorbed.

Other Sub-sectors. Diversified/Speciality (9%) – With many triple net landlords, growth in earnings is often driven by acquisition activity rather than from the operation of existing assets. As higher rates push up the cost of capital, maintaining the spread on property purchases via lower prices will be necessary to sustain externally driven growth. Iron Mountain (IRM), the data storage company, continues to report stable earnings though a strong USD and its negative impact on overseas earnings and the late cycle datacenter investments might be concerns looking ahead. Among the Gaming companies sizeable acquisition opportunities appear to be available although overall gaming sentiment has turned cautious on weaker Las Vegas/Macau news. Also relatively new to the public REIT markets are the Advertising/Billboard companies – Lamar (LAMR) and Outfront (OUT) – both are producing steady earnings improvement with some growth hopes pinned to digital/new contracts.

CONCLUSION – STEADY AS SHE GOES 

Capital is available and reasonably priced which should continue to support commercial real estate valuations. A stable to improving US macro outlook and decreasing inventory of available space should move the operating leverage of real estate owners further into positive territory. There is little new construction in the pipeline which is also a positive.

Most local commercial real estate markets appear to remain in the expansion/equilibrium portion of the cycle where demand is stable or growing and supply is shrinking with only modest new construction in the pipeline. This phase of the market cycle typically lasts five to eight years. The key takeaway here is that this is a market-by-market, property type-by- property type analysis and most markets and property types look in balance. The exceptions are apartments and hotels which appear to be in excess supply in some markets and rising concerns about the increasing supply of self-storage and industrial construction in certain other markets. But, on balance, it broadly appears that we remain in the “sweet spot” of the commercial real estate cycle.

We believe we are entering the phase in the commercial real estate cycle where it is becoming a REIT picker’s market, one in which investors benefit from a more focused and concentrated portfolio as the divergence among sectors and stocks has begun to cause more differentiated and variable returns among REITs. We expect a continued widening of performance based on geographic location, balance sheet management and business plan execution with specialty and secondary market real estate continuing to provide higher relative total returns. The rising tide has lifted all boats, and as Warren Buffet said, “Only when the tide goes out do you discover who’s been swimming naked”.

We continue to tilt our portfolio exposure toward higher quality REITs with a focus on secondary markets that appear to be showing signs of an accelerating commercial real estate recovery, while lowering our exposure in gateway markets that recovered earlier in the cycle. As we move into secondary markets, we often find that the disciplined “local sharp shooters” are best positioned to take advantage of local market recoveries. The better of these players tend to be far more nimble than their larger counterparts and it requires fewer and smaller transactions to “move the earnings needle” for these REITs. We believe that the secondary market commercial real estate recovery will allow these REITs to outperform during what might be characterized as the sweet spot of the US commercial real estate cycle.

The Uniplan REIT Team November 20, 2018