New status, new era for REITs: Q&A, Part II

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.

The strong performance of the sector prompted that coding change. Since 2000, REITs have returned an average of 12 percent a year, versus 7.9 percent returns on high-yield bonds, and 4.1 percent returns on large-cap U.S. stocks, according to JPMorgan Asset Management. 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. The index classification change is attracting attention from new potential shareholders.

For the second web installment of the Q&A, we bring you TRD’s interviews with David Lukes of Equity One and Hans Nordby of Co-Star Group.

David Lukes
Chief executive officer, Equity One

Which property types in NYC are the most and least attractive to Equity One right now?
Our existing asset base, which includes everything from the new Barneys store in Chelsea to Trader Joe’s in Queens and a recently completed development site in the Bronx, is performing extremely well, which just reinforces our demand to own more retail assets in the area as long as we can get them for a reasonable price. Our best investments have been in locations where the tenant does exceptional business and can afford the occupancy cost of being in our building. In some NYC locations, we’re not seeing the store profitability offer much safety to the landlord and therefore the value story is absent.

What sort of buying and selling activity are you expecting from REITs in the last quarter of 2016 and in 2017 when it comes to NYC properties?
The wild card I can foresee is [if] street retail vacancy increases. If existing owners capitulate and accept that their rent expectations are too high, asset prices will correct, allowing the market to clear a pent-up supply of assets for sale. That sort of price correction would almost certainly allow the public markets places to increase their buying activity. Equally, though, if current owners stick to their guns on rents, you could see street retail transaction volumes generally slow over the next year.

How do REITs fare in competing for high-profile Manhattan properties with insurers, pension funds, private equity firms and sovereign wealth funds?
When REIT shares are trading at premium valuations, as they were up until just a couple of weeks ago, REITs have an advantage and should take market share. But historically, this has happened only for limited time periods. When our stocks are trading at or below spot asset value, private buyers who generally have lower return hurdles and higher appetites for leverage can often beat us.

What are the biggest challenges Equity One faces at this point in the cycle?
I’m happy to say that our list of real challenges is limited at the moment. Our assets, which are located in the best gateway markets in the country, are in high demand from tenants, so day-to-day operations are strong. That leaves us with longer-term challenges like gaining tenant and municipal approvals for a long list of future redevelopments in Bethesda [Maryland], Cambridge, Los Angeles, San Francisco and Atlanta, and retaining and rewarding our top-notch talent.

Hans Nordby
Portfolio strategy managing director, Co-Star Group

Which property types in NYC are the most and least attractive to REITs right now?
Many REITs are accomplished developers and builders. With trophy assets trading at prices at or over the price to build a new building, the best investments may be those the REIT builds for its own book. In particular, the office sector appears attractive. Over the next four years, 13.6 million square feet of new office buildings are forecast [for] delivery. While that may sound like a big number, that represents only 2.4 percent of Manhattan’s office inventory. In contrast, 11.1 percent of San Jose’s office inventory is expected to deliver over that same period. New assets in Manhattan lease up well and stay that way for a long time. Is there a risk of delivering that building into a recession? Sure, but that same risk could be an even worse bet for someone who overpays now and doesn’t have a top-quality building. Older buildings require capital investment that a new building does not, and may face more challenges maintaining occupancy than a newer building.

There is some opportunity in the [residential] sector for investors in market average or workforce housing. Less luxurious complexes are likely to hold up better in terms of occupancy as the supply wave impacts the market, as they are slightly more affordable for renters. There is no shortage of people who’d like to live in New York, but not everyone can afford to do so. REITs might do well to pick up portfolios of these “affordable” options, not all that differently from what Blackstone has done by picking up Stuyvesant Town and Kips Bay Court.

What are the most surprising trends you’re seeing with REITs that invest in the five boroughs?
The fact that REITs have pushed into Brooklyn and Queens. The general idea is: Take advantage of some of the fastest growing, most rapidly gentrifying neighborhoods in the city. For instance, Vornado purchased a 440,000-square-foot Class B building in Long Island City [in March 2015]. The push allowed it to take advantage of a little higher yield going in and the ongoing craze with “creative” office in neighborhoods that might be desirable to tech tenants.

How do REITs fare in competing for high-profile Manhattan properties with insurers, pension funds, private equity firms and sovereign wealth funds?
Since early 2015, REITs have been less competitive in the acquisition of high-profile Manhattan assets. For many REITs, their dividend yields are higher than the going-in yields for assets trading. Therefore, the deals would dilute near-term earnings. As a result, many REITs have rightfully shifted to development — or redevelopment of existing assets.