Value Line is regarded as the best independent research available. More than just recommendations, Value Line provides the rationale behind its picks for greater understanding.
- Don D., California
REITs 101: Do REIT Stocks Still Have Room To Run?
The recent recession was not kind to the real estate market. Although the residential segment was the first shoe to drop, others soon followed, as the sluggish economy and rising unemployment took a toll on demand for real estate. In turn, real estate investment trusts (REITs)—long a bastion of steady, if unexciting, performance—experienced a dizzying freefall, losing nearly 80% of their value, on average.
While challenges will likely persist for the foreseeable future, market conditions have stabilized somewhat, as new development ground to a halt and the supply/demand dynamic started to move in the right direction. As real estate fundamentals improved, so too did investor sentiment about REIT issues, with the typical stock more than tripling in price from its low point of the recent recession. The question is, with REITs slowly on the road to recovery, does any one particular equity stand out for near- or long-term relative price performance?
First, it’s worth noting that REIT stocks have historically appealed mainly to investors stressing current income, since above-average dividend yields are commonplace in the sector. True, the average dividend yield within our REIT industry is about 5%, more than double that of all stocks under our review. The down side, however, is that REITs generally have lackluster long-term upside potential, which currently stands at less than 20%, versus a median of 40%-50% for all equities under Value Line coverage.
Another key distinction is how REITs measure success, for while share earnings are emphasized when evaluating most stocks, cash flow (referred to as funds from operations or FFO) is king in the world of real estate. Indeed, one of the main attractions of property ownership is the ability to generate substantial cash flow, which can ultimately be used to support a payout or investment activities.
Despite the real estate market’s roller-coaster ride of the past few years, operating performance is usually steady from one reporting period to the next, due to the long-term nature of leases. That, coupled with the industry’s broad-based share-price recovery over the past year or so, leaves little chance for upside potential in the near term. In fact, of the REIT equities under our review, nearly all are expected to trail the broader market in terms of price performance in the year ahead. There are, however, a few that offer above-average capital gains potential over the next several years.
Owners of retail properties are often among the first to be affected when operating conditions take a turn for the worse, since consumer spending on discretionary items is more easily reduced than expenditures for housing or office space. Indeed, the wave of bankruptcies during the recent recession disproportionately affected this sector. While retail REITs experienced a sharper selloff than the average for the broader REIT universe, many have rebounded sharply since, In fact, the only members of this segment that still possess noteworthy upside potential are Developers Diversified (DDR) and Penn REIT (PEI), but both come with well above-average levels of risk since consumer spending is highly sensitive to economic conditions.
Demand for medical space also suffered during the downturn, causing the average healthcare REIT to fall about 70% in price from the mid-decade highs. Healthcare Realty Trust (HR) was among those affected, and has seen its FFO plummet in recent years. The elevated jobless rate is partly to blame, since people are opting to delay medical procedures as the ranks of the uninsured continue to grow. But the recent passage of the healthcare act could mark a turning point for the segment, since it has the potential to make medical treatment more accessible to a wide swath of Americans. And, though it may be several years before it takes full effect, demand for healthcare facilities should pick up. Consequently, Healthcare Realty has worthwhile price appreciation potential out to 2013-2015.
Rounding out the group are hotel manager Hospitality Properties Trust (HPT) and ProLogis (PLD), which owns a global network of distribution centers. While they operate in different spheres of real estate, both are highly dependent on economic activity. Hospitality’s results were undermined by the rapid decline of business travel, causing the share price to fall more than 85% from its peak.
With industrial activity slumping, ProLogis witnessed a sharp drop-off in demand for warehouse and storage facilities, and a subsequent slide in the company’s operating performance. However, ProLogis expects industrial activity to continue improving, albeit gradually, in the years ahead, and has been increasing its development pipeline to meet that demand. Too, the company recently announced that it is in talks with AMB Property Corp., which owns industrial space, regarding a possible merger. If the marriage is consummated, it has the potential for significant cost savings, as well as the benefits of diversification. Nevertheless, with or without the deal, ProLogis ought to see its performance improve as the global economy continues to regain its feet.
While the aforementioned stocks offers above-average capital-gains potential out to 2013-2015, each has its pros and cons. Penn REIT and ProLogis probably have the best risk/return profiles, since much of their inherent volatility is mitigated by an excellent dividend yield. Healthcare Realty and Hospitality also feature worthwhile payouts and substantial appreciation potential, but may rebound more slowly since their respective sub-segments have an abundance of excess space to absorb. Developers Diversified does not stand out among this group over the long haul, but the stock may actually bounce back faster since the company is so dependent on consumer spending and, in turn, conditions in the broader economy.
At the time of this article’s writing, the author did not have any positions in any of the companies mentioned.