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 third and final web installment of the Q&A, we bring you TRD’s interviews with Conor Flynn of Kimco Realty and Sean Coghlan of JLL.
Chief executive officer, Kimco Realty Corporation
Real estate is getting its own category in the Global Industry Classification Standard rather than being lumped in with banks and insurance companies. What effect will this have on REITs as a sector?
We think it’s going to have a long-term positive effect on REITs, as it will bring a more diversified investor base, including generalist investors. That’s because previously, portfolio manager[s] didn’t need to invest in REITs when they were in the financial sector in order to remain benchmark neutral. With REITs being a standalone sector, investors risk being underweight if they elect not to include REITs in their portfolios.
Why have REITs outperformed other asset classes to such a degree and how much longer can the bull run last?
By definition, REITs must pay out 90 percent of their income in dividends. Global interest rates being close to zero and in some cases negative has driven a thirst for yield, which is driving capital into REITs that pay a healthy dividend.
What’s the chance of a repeat of what happened in 2007 and 2008, when REITs lost 15.7 percent and 37.7 percent, respectively?
Real estate is a cyclical business. The key is to learn from your mistakes and to try not to repeat them. In the Great Recession, a number of REITS, including Kimco, had too much leverage and were overextended. When the capital markets shut down, it had an impact on all stocks, especially REITs. REITs are a very capital intensive business. We require capital to build out space for tenants, or to redevelop assets, and to maintain the assets to the highest standard. We try and focus on what we can control, which is to make sure the company is in a position of strength for the next cycle and to have a war chest, or a tremendous amount of capital, available at all times to weather the next storm.
Which property types in NYC are the most and least attractive to Kimco right now?
Kimco focuses on open-air shopping centers, which we believe is in the sweet spot of retail today. We have a number of grocery-anchored centers in Brooklyn, Queens and Staten Island that have significant redevelopment potential. We think this asset type is the most attractive, as you can redevelop and add density and take advantage of the growing population by creating a vibrant shopping experience, with the potential for mixed use. This is our core competency, so we really stay away from high street luxury retail, office, hotels and apartments.
What are the biggest challenges Kimco faces at this point in the cycle?
Currently, one of the biggest challenges in NYC and nationally is the demand for high- quality open-air shopping centers and the lack of supply. That is why we have focused on redevelopment and working to expand and enhance the 550 assets we already own and manage. Redevelopment is the best use of our capital, as we are able to produce double-digit incremental returns. We’re directly tied to the health of the consumer, and retailer sales of late have been flat to slightly positive with recent food deflation impacting grocers. We continue to monitor this and the overall economic environment to see what impact it may have on retailers’ store opening plans and square footage needs.
How do REITs fare in competing for high-profile Manhattan properties with insurers, pension funds, private equity firms and sovereign wealth funds?
Competition in New York is fierce and we do compete with all of these players and more. Institutional investors tend to have a lower overall cost of capital and lower return threshold. For instance, insurers get premiums coming in every week and need to put that money to work so it produces some return. At Kimco, we are very cautious with new acquisitions in the current environment, yet we continue to seek out off-market opportunities and redevelopment opportunities.
Director of investor research, JLL
What are the biggest challenges for the REITs that focus on the NYC market at this point in the cycle?
Leasing activity in the office sector has been slow, totaling just 13.8 million square feet in the first half of 2016, while the historical annual average is 34.8 million square feet, presenting a challenge for landlords throughout Manhattan. Development opportunities are difficult to come by given escalated land pricing, the expiration of the 421a tax-incentive program, and the perceived oversupply in the luxury condominium segment.
What REIT initial public offerings are in the pipeline right now?
The REIT IPO market remains very quiet, with only one completed in 2016 — MGM Growth Properties completed its $1.2 billion IPO in April. Continued anxiety and volatility in the market due to uncertainty around interest rates and the economy have constrained investor appetites for new public offerings. Over the last quarter century, investors have become more discerning and sophisticated. Meanwhile, any new offering is competing for investors with major well-established REITs. It’s just a more competitive environment, and an IPO story needs to be compelling.
Do you expect some publicly listed REITs to be taken private in coming years? How often does that occur, generally?
The past two years have seen the highest level of REIT privatizations since 2007, and we do expect take-private activity to continue given the tremendous amount of capital that needs to be deployed. U.S.-based investors continue to have a robust appetite for large transactions, and off-shore capital flows could increase as investors continue to view the U.S. as the safest market to invest in. REIT valuations are relatively strong, REITs have remained disciplined in their growth, and leverage levels and balance sheets are in good shape generally. As REIT prices moderate and there is a gap between intrinsic asset value and share price, the best way to achieve these objectives may be by acquiring REITs.