From the October issue: This September, investors who bet on the stock market’s broad indexes got a new tool. They can now invest in real estate investment trusts separately from financial stocks and insurance firms — a category that REITs had been lumped into for more than 15 years. REITs, which own buildings that range from residential, office, retail and hotel properties to data centers, cell phone towers, prisons and farms, have certainly matured as an asset class. Yet, the same low interest rate environment that has made them so popular with investors has also made it harder for REITs to acquire new properties at valuations that make sense, industry sources told The Real Deal.
Many public real estate companies have adjusted to that change on a national level by upgrading their current properties and paying off debt to prepare for the next downturn. Another approach for those focused on the New York market is to look beyond Manhattan. But while those transitions come with some uncertainties, the index classification change is attracting attention from new potential shareholders.
For the first web installment of the Q&A, we bring you TRD’s interviews with Anthony Paolone of J.P. Morgan and Steven Marks of Fitch Ratings.
Senior REIT analyst, J.P. Morgan
Why have REITs outperformed other asset classes to such a degree and how much longer can the bull run last?
The [REIT] space has grown in size and liquidity, which has made it more mainstream for investors. Moreover, investor return requirements have shrunk. Fifteen years ago, people wanted a 10 percent return. Now they’ll settle for 8 percent or less. REITs are a good total return vehicle because of their dividends combined with growth in earnings.
REIT shares have attracted investors because they are big dividend payers.
What’s the risk that some REITs will cut their dividend payouts in the near future?
I don’t see it as a notable risk factor right now. Most of these companies are paying dividends that are less than their cash flow; they have a lot of room and pretty safe dividends.
Which class of REITs has shown the biggest returns in the past year? Why is that?
Healthcare and net lease REITs have been attractive to yield-oriented investors. These property types have low organic growth and are more bond-like in nature. Think of a health care facility or a drugstore with a 15-year lease and rent bumps of 1 to 2 percent annually. They tend to be assets that are purchased for the income more than the growth.
Which has been the poorest performing?
Storage, year-to-date, has been the worst-performing sector. It had a very strong 2015, but growth is now slowing. The stock market wants to be in front of marginal changes in growth, and thus you’ve seen investors move out of this space.
Which property types in NYC are the most and least attractive to REITs right now?
Office actually looks pretty good to us. In the apartment business, you had a pretty strong run of rent growth a few years back, but that has weakened. There are now concessions, rents are down, and there’s a surge of supply either underway or that’s been recently delivered. Where it gets interesting is on the office side. A couple of the larger office platforms, like SL Green and Vornado, are trading below real estate value. If you look through to the assets, you can buy New York City office and street retail properties cheaply through those stocks right now. Yes, there is concern about supply, at Hudson Yards and downtown at World Trade Center. But below that, in the $60 to $70 square- foot segment, these landlords are seeing double-digit rent growth. Meanwhile, fear about demand if the financial industry and tech pull back might be overblown. For financials, the culling of space occurred over the last five to seven years. They seem pretty lean at this point.
Managing director and head of U.S. REITs, Fitch Ratings
What are the most surprising trends you’re seeing with REITs that invest in NYC?
The high degree of office and multifamily development in Brooklyn — particularly the Downtown submarket — is a surprise. The market is becoming saturated with supply, and while there is an expectation of unbridled growth, it appears to be getting ahead of itself.
How do the trends in New York differ from what’s taking place nationally?
New York is unique compared with most other U.S. markets in that there is a consistent base of equity and debt investors willing and able to commit to the market, regardless of where we are in the cycle. That depth of investor demand supports higher valuations compared to all other markets, where investor demand can dry up if there is perceived or actual weaker fundamentals. Many large institutional investors view New York as a safe market and a store of value.
And how do REITs fare in competition for high-profile Manhattan properties with insurers, pension funds, private equity firms and sovereign wealth funds?
It is challenging for public companies to compete with private buyers, because REITs typically have a higher cost of capital. Private buyers can and do use significant amounts of leverage, and thus can pay more for properties than REITs. REITs can compete by having more and better local knowledge, strong relationships with existing property owners and lenders, and the ability to invest within all levels of the capital structure, such as equity, preferred stock, senior and junior debt. Also, REITs can establish strong tenant relationships and have several properties in the market to accommodate growing or shrinking tenants [by moving them] to a different property or reconfiguring space in an existing building.
Any REITS that investors should be wary of?
There are a few REITs whose dividends exceed, or are close to, their cash flows, and a dividend reduction would enhance these companies’ liquidity. In particular, Liberty Property Trust has a dividend payout ratio [a dividend of $1.90 a share, 4.88 percent yield, according to Yahoo Finance] that is well above the sector average. Fitch generally views persistently high dividend payout ratios as a weakness in corporate governance that is evidence of a focus on shareholders over bondholders.