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REITs Rally to Continue, Albeit at a Slower Pace
The industry booms as real estate fundamentals remain sound. The hottest areas: industrial, data centers and health care.
This years torrid rally in U.S. real estate investment trusts is likely to continue in the coming months, though at a slower pace, as fundamentals remain positive in the real estate market, analysts say.
Modest U.S. gross domestic product growth of about 2 percent is okay for real estate demand, not great, says Cedrik Lachance, director of U.S. REIT research for Green Street Advisors in Newport Beach, California. But there has been relatively limited supply over the last seven years. When you combine okay demand with relatively little supply, you end up with fundamentals that are sustainably good.
He and others expect those positive fundamentals to persist in most property sectors, as long as economic growth remains stable and real estate development doesnt overheat. Among REIT sectors that analysts favor are industrial, data centers and health care.
The national vacancy rate for commercial real estate has fallen to a 16-year low of 6.4 percent, according to research firm CoStar Group. Meanwhile, the increase of commercial real estate supply has stayed below 1 billion square feet for seven straight years. Rents climbed 4.1 percent last year, the most since 2007.
Those strong trends, along with declining interest rates, have helped the FTSE NAREIT U.S. Real Estate index register a total return of 16.35 percent so far this year through July 19, far surpassing the 7.14 percent return for the Standard & Poors 500 and the 5.52 percent return for the Barclays U.S. aggregate bond index.
REITs remain an attractive alternative to equities and bonds, says Steven Brown, global head of real estate for New Yorkbased American Century Investments. The ten-year Treasury bond yields 1.58 percent, compared with a 3.78 percent yield for the FTSE NAREIT index.
Just as a continuation of the economys seven-year recovery should sustain real estate demand, banks conservative real estatelending policies in the wake of massive losses during the financial crisis should continue to limit supply, analysts say.
Weak economic and financial conditions overseas also support REITs. As long as global volatility remains at increased levels, investors looking for stability and safety will see value in U.S. REITs, says Edward Mui, a REIT analyst for Morningstar in Chicago. Negative yields on more than $10 trillion of foreign sovereign debt also make U.S. REITs appealing to global investors.
REITs also look good on a valuation basis, analysts say. REITs now trade at a 1 percent premium to net asset value, compared with a historical average of 3 percent, says David Zonavetch, co-head of real estate securities for the Americas at Deutsche Asset Management in Chicago. REITs 7 to 9 percent cash flow growth, along with a dividend yield above 3.5 percent, makes them very attractive in the current environment, he says. American Centurys Brown expects REITs to register returns in the mid- to high single digits over the next 12 months.
Industrial REITs in the FTSE NAREIT index have been on a tear, returning 23 percent in the first half of the year. The growth of e-commerce has played a major role, with companies like Amazon.com requiring increased warehouse and distribution space. Online retail sales grew 15 percent last year, to $341.7 billion, according to the Commerce Department. That dollar amount represented 7 percent of total retail sales, and analysts expect that portion to increase further. Online shopping has greatly increased the demand for industrial space, compared to what the level of overall retail sales would suggest, Green Streets Lachance says.
San Franciscobased Prologis, the largest industrial REIT, has calculated that every dollar of online sales requires three times more distribution and warehouse space than a dollar of sales at a brick-and-mortar store. Thats because when a conventional retailer receives shipments of inventory, its usually a large amount of goods to a limited number of stores. But Internet sales can involve the delivery of a single package anywhere in the country and beyond.
Data center REITs returned a whopping 37.8 percent in the first half of 2016. These too benefit from the growth of e-commerce and from the explosion of cloud computing, which involves organizations and consumers paying to use servers in data centers operated by the likes of Alphabet, Amazon.com and Microsoft, among others, that have vast data storage capacity. We expect demand for cloud and online services to increase, which is good news for data center REITs, Brown says.
On the health care side, REITs returned 16.3 percent in the first six months of the year. A growing senior population and an increase in spending on health care generally create a positive backdrop for health care REITs, Mui says. Were fans especially of medical office buildings and senior housing. He likes all three of the major health care REITs: Ventas, HCP and Welltower.
So for income investors seeking a relatively safe way to earn a decent yield, REITs could be the answer.