New status, new era, new issues for REITs

Public real estate companies get boost from a reclassification on the stock market, but low interest rates make it harder for them to find deals

From left: Hans Nordby, Sean Coghlan and Conor Flynn
From left: Hans Nordby, Sean Coghlan and Conor Flynn

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 J.P. Morgan 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.

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. REITs represented just 2 percent of total investment volume in the borough through the first half of the year, compared to 11 percent in all of 2015 and 15 percent in 2014, according to JLL. But while those transitions come with some uncertainties, the index classification change is attracting attention from new potential shareholders. “We are already starting to see that many generalist investors are trying to ramp up and educate themselves on the nuances and nomenclature of the REIT industry,” said Conor Flynn, CEO of the New York-based REIT Kimco Realty Corporation — the largest publicly traded owner and operator of open-air shopping centers in the U.S. For more on the latest challenges and trends affecting REITs, we turn to the experts.

Anthony Paolone
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.

Steven Marks
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.

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.

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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.

Conor Flynn
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

Sean Coghlan
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.