REITs Are Solid Investments, But They’re Looking Pricey

Technology shares have reclaimed leadership on a YTD basis returning 27.5% according to the Technology Select Sector SPDR ETF (XLK), whose largest holdings include Microsoft (MSFT), Apple (AAPL) and Mastercard (MA), all of which have returned more than 35% YTD. But with the market becoming increasingly volatile and yields hitting all-time lows – again – investors have also gravitated towards more defensive sectors like REITs, which have been the second-best performing sector this year at 25.8%.

Of it’s largest holdings, the best performers were Equinix (EQIX), SBA Communications (SBAC), and Prologis (PLD). Not surprisingly, all three have been beneficiaries of an insatiable demand for data and the infrastructure that is required to feed that demand. But REITs in general have done well overall, namely because of their improving fundamentals and defensive characteristics. My biggest issue with them right now is valuation.

As I will point out in the next few moments, fundamentally, there isn’t much not to like about REITs, but after strong returns YTD, they are trading at a fairly high multiple and NOI growth seems to have peaked. I will still hold them in my portfolio for income, but their price appreciation potential has diminished. 

Source: Author Prepared

Debt to Total Assets

Despite a slight increase in debt to total assets, REITs have maintained very conservative balance sheet leverage during the most recent Fed tightening cycle. For companies that must continuously raise new capital to keep growing (unless they are selling assets to raise cash), having a strong balance sheet is important not only for being able to service interest payments, but to qualify for lower cost of capital based on financial strength.

Interestingly, but not surprisingly, there seems to be some correlation between stock performance and the strength of balance sheets, although we haven’t really run any statistical analysis to confirm this. For example, Industrials have one of the lowest debt ratios among REIT sub-sectors, as do data centers and infrastructure REITs, which happen to be three of the best performing sub-sectors YTD. Now, their outperformance is driven by the fundamentals in the industry they operate in but weak balance sheets would likely deter investors regardless of the industry prospects.

Meanwhile, Regional Malls have a debt ratio of 64% and they are the only group with negative performance YTD and are down 12% over the past year. Whether debt is scaring investors off we don’t know, and it’s hard to tell considering Retail REITs face specific challenges that have been difficult to overcome. The correlation of debt and performance could just be a coincidence, but certainly, as investors, we prefer less debt to more debt.

Source: NAREIT

A recent article found on the NAREIT website also touched on the change in debt to book assets in REITs overall and how they have improved from 2007 to Q2 2019. Notice the overall shift to the left in the chart below, indicating lower debt to book ratios – with less than 25% of REITs with leverage ratios above 60%, compared to 50% in 2007. This should give investors some confidence that their REIT investments are on solid financial footing on average, but I caution that there are still some REITs with leverage above 80%.

Interest Coverage

One of the benefits of a low interest rate environment is that REITs have been able to issue debt at historically low levels while growing net operating income in the process, and this trend has continued throughout the current tightening cycle.

Even with the slight upward trend in debt/assets, interest expense to NOI has declined, owing to refis and lower rates, as well as increasing NOI.

Now that rates have declined and are expected to fall further, I expect this ratio to continue to improve, or at worst, remain at current levels. Compared to the last Fed tightening cycle and the previous recession, REITs should be able to hold up well with interest expense only slightly above half the levels reached in 2004.

Like debt ratios, the interest coverage ratios have also improved since 2007, with only 10% of REITs currently with an interest expense to NOI ratio of greater than 40%. In 2007, a whopping 81% of REITs had over 40% interest to NOI ratios.

Not surprisingly, the weighted average interest rate on long-term debt continues to decline and is now at an all-time low.

Interest coverage, meanwhile, has ticked up this past quarter, yet another improvement in the financial stability of REITs that makes investing in them even more compelling.

As REITs refinance their existing debt and extend maturities, the weighted average term to maturity continues to set new highs not reached since 2002.

Funds from Operations

Funds from operations or FFO, is a better indicator of a REIT’s performance than the more traditional earnings per share reported by most other companies. The reason for this is the high amount of depreciation inherent in a portfolio of real estate that depresses earnings and doesn’t really reveal much about the underlying performance of the REIT. So for all intents and purposes, FFO is to REITs what EPS is to other companies.

FFO growth has slowed across all sub-sectors except a few. For example, Manufactured Homes and Specialty REITs FFO growth accelerated. Both sub-sectors were impacted by one or two companies, however. In the case of Manufactured Homes, there are only 4 companies in the sub-sector and it is a relatively new sub-sector that has benefited from low housing affordability and higher rental rates. On the other hand, Specialty REITs have been driven by the rapid growth of Innovative Industrial Properties (IIPR), on the back of strong interest in Cannabis stocks and the landlords that own properties where cannabis is grown.

Two other notable sub-sectors are Lodging/Resorts, whose FFO declined in the TTM period, and Healthcare, whose FFO turned positive. Whether these sub-sectors are heading in opposite directions now is something we will be looking into. Lodging REITs have been the second worst performing sub-sector YTD and are down almost 13% over the last year. They have recovered 6.4% MTD in September, making them one of the top three performers so far this month. Contrarian play? Perhaps.

Net Operating Income

Net operating income accelerated to 4.7% in Q1 compared to the same period one year earlier. This was a pickup from the 3.7% last quarter. Interestingly, performance was more consistent across sub-sectors this quarter compared to last quarter. SFH REITs slowed considerably compared to last year, consistent with the slowdown in FFO, but all other sub-sectors were fairly consistent.

Most of the FFO growth on a trailing twelve month basis was driven by Infrastructure REITs, with 17% NOI growth over the last 12 months and a 15% NOI increase among Specialty REITs.

Regional Malls, Shopping Centers, and Healthcare REITs continue to struggle and they were joined this past quarter by Timber REITs, which had a 10% decline in NOI as they were impacted by a slowdown in homebuilding and lower lumber prices.

Same Store Net Operating income

SS NOI remains strong across the entire Residential REIT space with Manufactured Homes showing a 6% growth in SS NOI and Single Family Homes at just above 5%. We have also seen Office NOI increasing while Industrial REITs continue to show strong performance due to demand for warehouse space.

Lodging and Free Standing NOI growth are not reported by NAREIT.

Source: NAREIT, The Income Strategist

Comparing SS NOI growth of Residential REITs to the broader REIT universe, we can see from the chart below that the gap widened again.

Source: NAREIT, The Income Strategist

A further breakdown of the Residential REIT space shows consistency across all three sub-sectors with with Apartment REITs reaccelerating over the last two quarters. We expect this to reverse next quarter as mortgage rates have come down and we are likely to see a slight uptick in homebuying – although I have my reservations about how robust homebuying will be. In any case, lower rates will put a ceiling on rental growth rates, which should show up in the next few quarters.

Source: NAREIT, The Income Strategist

Acquisition/Disposition Activity

Acquisition activity has slowed down in some sub-sectors such as Data Centers and Infrastructure, which happen to be the best performing sub-sectors YTD. I also want to point out, however, that despite the very low net acquisitions within certain sub-sectors, activity has been robust. Take the Office REIT sector for example. Overall, the sub-sector hasn’t grown much despite a high level of acquisitions because it has had almost as much activity on the dispositions front. The same holds true for Residential, although acquisition activity has exceeded disposition activity this past quarter.

Retail REITs have been the most active net acquirers with approximately $2.5 billion in acquisitions this past quarter, followed by Industrial and Diversified REITs, while dispositions were the dominant theme among Lodging REITs.

Source: NAREIT, The Income Strategist

Despite the increase in retail net acquisitions, however, as we mentioned before, it continues to be driven entirely by Free Standing acquisitions, and that means Realty Income (O) and other larger REITs. With this quarter’s $1.25 billion acquisition, Realty Income will likely drive this figure higher on the next data release.

This is a continuation of the trend we have seen over the last few quarters, particularly as Shopping Center REITs were repositioning their portfolios. We did, however, see positive net acquisitions in the Shopping Center REIT space, a reversal in activity since the sub-sector has been in disposition mode for several quarters.

Source: NAREIT, The Income Strategist

Within Residential REITs, there was a considerable slowdown in acquisition activity among SFH REITs after their initial buying spree in 2017, but Apartment REIT acquisitions seem to be reaccelerating and are now at levels near the Q2 2017 peak.

Source: NAREIT, The Income Strategist


With all this good news you might think you’d be jumping head first into REITs, but there are one or two factors that dampen my enthusiasm. For starters, the Price/FFO of US Equity REITs are rich. They are not extremely overvalued, but after a nice run YTD, the multiples are as high as they were back in 2016. In fact, the highest multiple REITs have reached in recent years was in Q3 2016, when the multiple reached 17.96. The Vanguard Real Estate ETF (VNQ) then dropped over 11% through early 2018, when the multiple was slightly below 16. In other words, be very cautious about valuation.

Furthermore, while occupancy rates are holding up well and balance sheets are strengthening (as I mentioned), both the growth of same store NOI and overall NOI growth have been on a downward trend (although SSNOI improved this past quarter). NOI growth was essentially flat this quarter and Non-SS NOI growth was negative. The last time there was a decline in non-SS NOI was in 2009-2010.

The key to investing in REITs is understanding the underlying drivers of performance for each sub-sector and allocating to those sectors facing tailwinds and avoiding those with challenges and or less financially stable balance sheets.

The good news is that overall, REITs are fundamentally sound and a broadly diversified strategy would likely perform quite well as the weaker names and challenged sectors would be more than compensated for by sectors with the wind at their back and strong companies with competitive positioning.

According to NAREIT, however, REIT share prices are currently trading at a premium over NAV of 12%. This premium allows REITs to issue new equity at a lower cost, which drives investment for future growth. It also reflects a strong outlook for the sector, but also means that investors buying in now are buying in at a premium AND they are likely to be diluted by new issuance.

As I mentioned earlier, there are certain sub-sectors that are taking advantage of cheap capital to aggressively grow through acquisitions, but just like REIT stock prices are at a premium, so are property values, and there is the risk that REITs will overpay to try to grow.

I have a hefty allocation to REITs and still like them for their dividend and dividend growth potential, but lately I’ve become more cautious about any additional share price appreciation. It is important to choose sub-sectors and individual companies wisely or simply invest in a diversified vehicle like VNQ.