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REITs Could Offer a Safe Haven to Park Investment Capital in 2019

While REITs may face higher capital costs next year, investors still see sectors with solid property fundamentals as a good bet.

Despite sluggish returns in 2018, capital is continuing to flow to REITs from a dedicated base of perennial investors who are active in up and down cycles. Those investors are working harder to place their bets on winners in an industry that is generating a mixed bag of results.

The broader REIT industry has been working to shake off less than stellar performance that has left many REITs trading below net asset value (NAV). According to the S&P US REIT Index, year-to-date returns were at 2.55 percent as of Dec. 6th. Nareit is reporting slightly better numbers, with total returns including dividend yield at 5.8 percent for U.S. equity REITs—nearly 300 basis points lower than annual returns achieved in both 2017 and 2016.

“It’s been a challenging year for a number of property sectors,” notes Stephen Boyd, a senior director at Fitch Ratings. The REIT sector as a whole tends to be very interest rate-sensitive and has also been negatively impacted by expectations for slowing growth.

Yet those returns don’t tell the whole story. The November REIT update released by MUFG Securities Americas Inc. noted that REITs may be ready to reverse recent declines with higher estimates and growth anticipated for 2019. Specifically, the more favorable outlook is encouraged by “newly pruned portfolios and positive fundamental trends, such as peaking supply levels and easing tenant transitions.” And external growth opportunities could be improving due to waning asset sale activities and solid balance sheets, according to the MUFG update.

REITs could also be getting an added boost from shifting views on interest rates. Earlier this fall, the 10-year Treasury rose from about 2.8 to 3.2 percent in a short period of a few weeks. At that time, there were concerns that the Fed could hike its rate three or four times over the next 12 months. Recent comments coming out of the Fed suggest a more neutral view, with future hikes that will be data-dependent, and the 10-year has dropped back to 2.85 percent, notes Haendel St. Juste, senior REIT analyst and a managing director at Mizuho Securities.

In addition, REITs look a lot more attractive to some these days in the context of Wall Street volatility. “In the near term, we don’t think REITs are a bad place to hide,” says St. Juste. For example, REITs have been outperforming the S&P 500, which had year-to-date returns of 0.84 percent.

Overall, the U.S. economy appears to be losing some steam, moving from about 3.5 percent GDP growth in 2018 to what could be 2.5 percent growth in 2019, notes St. Juste. There are also some concerns about signals from the bond market that the U.S. could be edging closer to a recession. “As long as we avoid a recession, this not too hot, not too cold backdrop with a range-bound 10-year Treasury is not a bad thing for REITs,” says St. Juste. REITs can perform fairly well in that type of environment, and investors are also attracted to the operational stability and dividend yields REITs offer, he adds.

Bracing for higher capital costs

REIT sector returns will likely remain fairly stable in 2019—a quality that is increasingly attractive, given the wild ride on Wall Street over the past year. The expectation is that internal growth will slow, but remain positive in the coming year. REITs have also worked to strengthen their balance sheets during this cycle by reducing leverage and adopting more conservative development strategies.

One of the biggest challenges facing REITs in the coming year will be the impact of higher costs for both debt and equity. During most of the cycle, REITs have been able to refinance higher cost debt with lower cost debt, which has helped to boost revenue growth and earnings. “The days of issuing 10-year paper under 4 percent are behind us,” says St. Juste. Debt that was issued five to seven years ago is now coming up against refinancing at higher rates that are going to eat into future earnings growth, he adds.

In addition, a number of REITs are trading at prices that are a significant discount to NAVs, which makes it difficult to access attractively priced equity. REITs are not allowed to stockpile dry powder. Their structure requires them to distribute 90 percent of taxable income as dividends, which makes them heavily reliant on external capital sources. So REITs will have to either dispose of assets, find joint venture partners or other means to fund growth on a leverage neutral basis, notes Boyd. Potentially, those challenges accessing low-cost equity could slow acquisition and development activity.

Investors look for top performers

Capital will continue to flow into the REIT sector in 2019, but investors will need to be strategic in which sectors they invest in. Some property types—and individual companies—are doing well, while others are struggling.

According to Nareit data, freestanding retail, healthcare, manufactured homes, apartments and industrial properties were all leading categories in 2018, with total returns between 10.0 to 20.5 percent. On the opposite end of the spectrum, data centers, single-family rentals and office buildings were among those property types that struggled with negative returns of -2.3 to -5.3 percent.

The two sectors that Mizuho currently likes the most are apartments and triple net retail due to the supporting fundamentals and outlook in those categories. Mizuho typically favors REITs that have good quality portfolios with better than average pricing power, good balance sheets that don’t require dilutive disposition, good earnings growth stories, cash flow growth and stocks trading at decent multiples, according to St. Juste.

Notably, office REITs and retail REITs that focus on lower quality class-B and -C malls have struggled with weaker performance. On the positive side, industrial REITs have benefitted from the growth in e-commerce. That has been a well-performing sector, especially for REITs that own infill properties that are better positioned to satisfy demand for last-mile delivery. In addition, some of the specialty REITs, such as those that operate cell towers, offer a much stronger growth story that has garnered more attention, says Boyd. Some of those sectors have also become a much bigger part of the REIT index, which makes it harder for investors to ignore, he adds.

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