subscribe: Posts | Comments

What's Wrong with REITs? Sector Hopes to Shake Off Weak Stock Performance in 2018


What’s Wrong with REITs? Sector Hopes to Shake Off Weak Stock Performance in 2018

Access to Capital, Solid NOI Growth Belie Lingering Underperformance of REIT Shares

One sector has noticeably missed out on the recent record run in U.S. stock prices. REITs underperformed in 2017, realizing total returns of just 5.1% for the year, according to Morgan Stanley, with REITs largely missing out on the stock market rally in the second half of the year and consistently lagging the broader market.

After watching REITs’ share prices underperform for two consecutive years, industry analysts remain cautious on their stock performance outlook again for this year, citing late-cycle signals coinciding with rising interest rates and economic uncertainty.

The recent and lingering disconnect between REIT stock performance in the last couple of years and their continuing solid property-level performance, asset values or credit quality, outside of the retail sector, has been a source of concern for REIT execs.

The lukewarm market reaction has occurred even as REITs enjoy solid access to both debt and equity markets and delivered operating results that met or slightly exceeded expectations and continue to support credit quality, according to S&P Global Ratings, which upgraded more U.S. REITs than it downgraded last year.

REITs were also active in the capital markets last year with total issuance (debt, preferred, and equity capital) up about 25%. Refinancing and acquisitions were the main reasons for the increase in issuance, according to S&P data.

While REIT execs and analysts acknowledge the challenge of competing in the market for investors when the broader stock market is delivering big returns, they still point out that REITs overall had a very good year and provide a good opportunity for certain investors.

“The big story of 2017 for REIT investors was how dramatically they underperformed the broad stock market. That’s a terribly misleading summary of the past year, but it’s useful for framing expectations for 2018,” noted Brad Case, senior vice president, research & industry information, NAREIT.

Through mid-December the REIT industry had generated total returns of 10.18%, according to the FTSE NAREIT All U.S. REITs Index. Meanwhile, the S&P 500 and Nasdaq had their best years since 2013. The broader S&P 500 jumped 19%. And the Nasdaq jumped an impressive 28%.

The REIT index performance, however, was slightly better than its long-term average: from the beginning of 1972, when the All U.S. REITs Index was created, Case noted.

On a long-term basis, REITs have also managed their properties to achieve consistent growth in net operating income (NOI) in the range of 2.5% to 4% per year on a same-property basis, according to NAREIT.

Meanwhile, recent operating performance for the REIT industry is in its “sweet spot,” according to NAREIT’s Case. “Over the last four quarters, same-property NOI growth averaged 3.2%, consistent with the industry’s long-term norm,” he added.

When other companies increase revenue and lower costs to achieve higher NOI, stock investors generally cheer. But in his outlook, Case said REITs perform best in markets that are neither too soft nor too strong.

Case notes that same-property NOI growth greater than about 4% can be “too much of a good thing,” stimulating so much new construction that it results in oversupply and reducing occupancy rates and rents, eventually suppressing same-property NOI growth to a range of 2.5% or less.

“Operating fundamentals are driven by demand and supply conditions in the real estate market, and both of those seem to be well balanced,” he noted.

Interest Rates, Retail Performance Bear Watching

Of course, interest rates figure prominently in any discussion of REIT share performance. Indeed, REIT share prices have often reacted negatively to rising interest rates over the past few years, as investors appear concerned that higher rates may impact REIT fundamentals, either through higher interest expenses or lower property valuations.

Not so fast, says NAREIT. The industry group points out that interest expenses of REITs, relative to NOI, are the lowest on record as REITs have largely used the recent run-up in property values to be net-sellers and have used sale proceeds to fortify their balance sheets with higher shareholders’ equity and lower leverage.

One notable exception has been retail REITs, whose operating performance remains under pressure due to the well-publicized issues facing retailers in certain property types, according to S&P Global.

“We expect NOI growth for the mall-based REITs to be slightly negative in the next year but think that most should withstand this pressure without significant pressure to cash flows,” noted Ana Lai, analyst with S&P Global Ratings. “We think retail REITs should remain fairly resilient given reduced leverage and a well-diversified tenant base. Moreover, many have repositioned their asset portfolios to improve quality.”

Other factors that may also be on investors’ minds is a high degree of uncertainty regarding the impact of new tax reforms signed into law last month and their impact on REITs.

S&P said the reforms could have a meaningful impact on the REIT sector given the significant use of debt in the industry. The loss of interest expense deductibility could lead REITs to changes in their capital allocation strategies toward greater issuance of preferred or common equity instead of debt.

In addition, the lower corporate tax rate could make the REIT structure less attractive than C-corps, which could adversely affect equity prices.

Analysts with Morgan Stanley & Co. recommend investors follow a defensive playbook in the year ahead as they remain cautious on REITs as risks skew to the downside. However, they are positive on some sectors with strong property fundamentals, balance sheets and liquidity, including industrial, multifamily and single-family rentals.

Out of the major subsectors, industrials and lodging led [last year] with total returns at 20.8% and 8.7%, respectively, Morgan Stanley analysts noted. Malls and strips were the only major subsectors in the red with total returns of -1.7% and -9.5%, respectively.

Source: What’s Wrong with REITs? Sector Hopes to Shake Off Weak Stock Performance in 2018

Leave a Reply

Your email address will not be published.