Real estate investment trusts (REIT) have become a hot topic among income-oriented investors. REITs offer attractive income in a low-yield environment, and that has enticed yield-hungry investors to pile into the sector with almost reckless abandon. We recently spoke with Damon Andres, vice president at Delaware Investments and senior portfolio manager of Delaware REIT Fund (DPREX), to find out his perspective on the REIT market and learn where the best opportunities can still be found. He also offered several examples of some counterintuitive plays in the asset class.
Ben Shepherd: REITs have had a lot of new money flowing into the sector lately.
Damon Andres: The capital flows have just been unbelievable over the last several quarters; whether it’s IPOs or secondary offerings, there’s just a lot of money absorbing the liquidity in this sector. REITs have refinanced, strengthened their balance sheets, and even secured equity financing. Since the market’s bottom in early 2009, REITs are up by more than 175 percent.
Ben: Investors have been really starved for income over the past few years. Do you think that’s led to yield chasing in REITs?
Damon Andres: There’s clearly been a quest for yield that’s reaching across all sectors, and some investors are getting reckless by not performing the due diligence on what they’re buying.
But I don’t think REITs are trading far beyond their fundamentals. Admittedly, I do occasionally get frustrated that REITs are a little ahead of themselves in terms of valuation. But the average REIT yield is a little over 3.5 percent, while 10-year Treasuries yield 2.25 percent. Additionally, the implied cap rate—the inherent yield that a REIT’s properties generate—is just over 6 percent. So when you take those figures into account, REITs are still trading close to their long- term historical averages on a spread basis.
Ben: Regional mall REITs are your top sector allocation. How wise is that considering the recent bankruptcy of General Growth Properties?
Damon Andres: Our favorite sector right now is regional malls and we do own General Growth Properties (NYSE: GGP), which just emerged from bankruptcy. General Growth was the third- largest owner of regional malls globally when it went bankrupt, but there wasn’t anything broken with regional malls or the retail mall format. General Growth was a highly leveraged company that had a very aggressive balance sheet. It went into the financial crisis with ridiculous amounts of debt. When that market dried up, it couldn’t refinance its assets and spiraled out of control, ultimately ending up in bankruptcy.
The irony of that whole saga was General Growth’s asset quality was actually pretty solid. It owned well-situated malls and had a skillful operating team. And the cash flow from those malls actually held up well too. Since its bankruptcy, General Growth strengthened its balance sheet and recently spun off some of its underperforming, lower-quality assets. Those weaker properties are now trading as a separate company, while the asset quality of the real estate that General Growth retained is in the top tier. Its overall asset quality isn’t quite as high as Simon Property Group (NYSE: SPG) or Taubman Centers (NYSE: TCO), but it’s probably the third- or fourth- highest quality regional mall REIT at present.
In the regional mall space, Simon Property Group is the flagship company because of its absolute size. When you review its fundamentals, it barely even had a hiccup during the financial crisis, as the malls it owned still performed quite well.
Simon Property Group provides the most visible cash flow generation in its sector and its malls have occupancy rates in the mid-90 percent range, which is pretty close to historical highs. And it still has room for meaningful rental rate increases. Consumer and retail demand are driving its growth, as a significant number of retailers are in store expansion mode.
We’re taking a barbell approach to the sector as we watch it recover. Some of the hardest-hit malls were the lower-quality malls, so it tends to be a bit of a higher-risk sector. But we think there’s opportunity there. CBL & Associates Properties (NYSE: CBL) has lower-quality malls and definitely felt the impact of the financial crisis and the pinch that put on the midmarket consumer. Over the past three quarters, CBL has really turned its occupancy rates and leasing velocity around, and that speaks to the recovery that’s underway.
Ben: Apartment REITs are your next largest allocation, but I noticed your holdings are higher-quality names such as AvalonBay Communities. Why focus on the higher end rather than on midmarket names like Home Properties?
Damon Andres: The long-term trend has been toward higher demand in gateway markets, and AvalonBay Communities (NYSE: AVB) is an example of a well-positioned REIT.
We don’t own Home Properties (NYSE: HME) because it has significant exposure to the Washington, DC market, which had been very hot but is now one of the softer markets.
The industry as a whole has limited supply, which solidifies our belief that real estate is still a safe investment. Over the last several cycles, the real estate market got into trouble whenever development and supply exceeded demand. That scenario is not in evidence in any of our favored markets at the moment. The one caveat, however, is that in Washington, DC, for example, development is starting to ramp up and it will eventually happen elsewhere too.
When that occurs, it will be in the secondary- and tertiary-type markets, and higher asset quality plays will get hit hardest by additional housing supply. AvalonBay is reasonably well insulated and—this will sound counterintuitive—it has one of the biggest development pipelines in terms of value-add going forward than any of the other apartment companies. So it controls its own destiny with development. AvalonBay has a high-quality management team and a long track record of successfully executing its development strategy.
Ben: Are there any corners of the REIT market that should be avoided?
Damon Andres: We’re concerned about the health care sector. Government reimbursements are a significant source of income for tenants of health care REITs. As the government reins in its spending, it’s unclear how that will affect the health care sector. Additionally, health care REITs are not particularly cheap on a valuation basis, so we’re underweight in that area.
With regard to industrial REITs, the market has gotten too aggressive in its belief that there’s a global shortage in supply and logistics capacity. The industrial sector has always been somewhat volatile, so we’re underweight there as we await more compelling values.
The lodging sector had a great run last year as investors started buying into the economic recovery story. Although there may be a few good years of upside left in terms of EBITDA (earnings before interest, taxation, depreciation and amortization) generation, valuations have gotten ahead of themselves and aren’t pricing in the economic risk that’s still out there. So while we believe we’re well into a recovery phase, it’s somewhat tenuous given all the global macroeconomic headwinds.Ben: What’s your best piece of advice for investors?
Damon Andres: Don’t get too aggressive when seeking income. Look for asset classes or companies that can provide income growth that is driven by increasing cash flow rather than just a bump in the dividend rate.