The Valuentum analyst team talks REITs and the reasons why REIT investors should pay close attention to changes in Treasury rates. Various secular themes across the data center, healthcare, office, and mall REITs are discussed, and an explanation for the sector’s systematically poor raw, unadjusted Dividend Cushion ratios is covered. ~8 mins.
Tickerized for various ETFs and the holdings in the VNQ.
Brian Nelson, CFA:
In September, REITs were officially broken out from the financial sector to their own sector of the S&P 500 — some 30 or so stocks with $600 billion in market capitalization, or about 3% of the S&P 500. Could this change have marked a peak in performance for equity and mortgage REIT stocks? Are investors now all in so to speak?
I am Brian Nelson for Valuentum Securities, and today I have with me Mr. Kris Rosemann and Mr. Chris Araos. We’re going to talk all about REITs. Mr. Kris Rosemann, what is a major thing we are seeing right now within the REIT environment?
Kris Rosemann:
So what we are seeing is a small move in the US 10-year Treasury yield has pressured some of the equity prices of REITs as of late. As the yield spread between the Treasury and the yields on these equity REITs narrows, and what the bigger question is whether or not that pressure is going to become significantly more as the federal funds rate approaches more historic levels.
Brian Nelson, CFA:
That’s a really good point Kris — that the 10-year Treasury right now is about 1.8%, and the average dividend yield for S&P 500 REITs, or even looking at the Vanguard REIT ETF (VNQ), the dividend yield on the VNQ is about 3.5% versus the 10-year Treasury about 1.7% or 1.8% [at the time of this podcast]. So investors are still enamored by REIT dividend yields.
The big question is what happens when the yield on a riskless security like a 10-year Treasury, or even a longer duration US Treasury, becomes higher than the dividend yield on a real estate investment trust dividend-paying equity. Do investors fly out of those dividend paying stocks and into more riskless securities for that yield? That is one of the areas we are really concerned about — what happens when that tipping point occurs? These REITs are not trading at attractive valuations, per say.
When we look at the earnings multiple across the REIT sector, for example, the forward P/E ratio is at 17 times which is slightly a premium to the forward P/E ratio of the average S&P 500 company. As investors are flocking to steadily-rising income dividend-paying REITs — case in point Federal Realty (FRT), a REIT that has raised its dividend for the past 48 consecutive years — that REIT is trading at 40 times 2017 earnings and 23 times 2017 funds from operations guidance. Now Federal Realty has already fallen from $170 in July and August to $140 in November. But those valuation metrics are as of November.
So the frothiness of the REIT sector even a few months ago was tremendous, and now we have seen some REITs come back in, but still things are a little pricey. But that being said, there are areas within REITs that are fundamentally strong, wouldn’t you say Mr. Araos?
Christopher Araos:
Yes, currently data center REITs are doing very well such as Digital Realty Trust (DLR). They are leveraged for long-term secular demand in markets such as the ‘Internet,’ which has a compound annual growth rate of 23%, ‘Cloud’ has a CAGR of 33%, ‘Video’ has a CAGR of 27%, and ‘Mobile’ has a CAGR of 45%. As an example of how much this demand is starting to exceed supply, a new data center is going to open up in Chicago, being made by Digital Realty Trust in order to accommodate this anticipated demand.
Brian Nelson, CFA:
…one anecdote is locally where we are based in the Chicagoland area is that the supply of data centers isn’t enough for a lot of the demand there. The CAGR’s that you mention, the growth rates that you mention as this economy evolves, are forward looking, too — and when we think about ‘Internet’ growth potential, think about ‘Mobile’ and ‘Video.’ Looking at the ‘Cloud’ going out to 2019, these are growth rates that are very, very strong — and so Digital Realty is a REIT that is exposed to that area.
But when we think about other areas that are really strong, the healthcare REITs. A few of them that come to mind are Ventas (VTR), HCP (HCP), and Omega Healthcare (OHI). These REITs are levered to the long-term demographic trend of the aging population in need for increased healthcare spending as a percentage of GDP. So the data center area is an area that is very strong in terms of long-term secular demand drivers and also the health-care REITs as well.
But that being said, not every REIT has the benefit of having these strong end markets.
Kris Rosemann:
Yes, that is right Brian. The office space REITs are an example of a group that are struggling to find that long-term driver. However, there are some pockets of strength in the near term. For example, New York is experiencing a significant boom in office demand, and construction is expected to pass the $40 billion dollar mark in 2016 alone in New York City.
But the overall office market has been much slower to recover and expand, and there also been a significant shift in trends of the way we work. The Internet has really enabled companies to allow their employees to work from home such as IBM (IBM), Xerox (XRX), United Health (UNH), Dell, and the increase in Internet-based companies like WebMD (WBMD) is not only pushing out more office jobs, but it’s also proliferating ecommerce.
Brian Nelson, CFA:
When you are thinking about the mall REITs in particular, we have department stores like Sears (SHLD), J.C. Penney (JCP), and even Macy’s (M) as of late that have really seen their business models come under significant pressure. These are anchor stores for the malls. The teen-retailing space has been an area that continues to be fickle. As you mention, the trend is for wearable technology which is a form of fashion to some degree. So that’s impacting the overall health of mall REITs. But that being said, offices aren’t going away — just companies are using their space more efficiently. Malls aren’t going away — people are just becoming more comfortable buying things online.
When we look at the overall REIT space, there’s plusses and minuses. There is this asset allocation dynamic that we’re looking at if the US Treasury yields continue to rise under contractionary Fed policy. Just want to bring attention, too, the fact that the forward P/E ratios across the REIT industry aren’t all that attractive. Some of them with very long dividend track records are trading at frothy multiples.
The very idea that a REIT pays out 90% of its taxable income in the form of shareholder dividends each year means that the REIT itself cannot hold a lot of cushion on the balance sheet in terms of having a lot of excess cash to handle exogenous shocks to its business, and that’s why a lot of the real estate investment trusts don’t score as highly in terms of their Dividend Cushion ratios — because it is a function of their business model and having to spend all of their taxable income and distributing that in the form of dividends.
Thank you very much for joining us today. I am Brian Nelson for Valuentum.