In early May we interviewed Eric Rothman, of Urdang Securities Management and the portfolio manager for the Managers Real EstateSecurities Fund. Below are his responses to our questions about the current state of the REIT market.
What is the average dividend yield for the portfolio? How does this compare to a historical basis?
As of May 10, 2013, the dividend yield, based on the weighted average dividend of the stocks in the portfolio, was approximately 3.1%. Like yields across the globe, the absolute level of the REIT dividend yield is currently very close to the lowest levels ever reached. On a relative basis, however, REIT dividend yields are squarely in line with their historical averages. Over the past 20 years REITs have carried an average yield spread to the 10-year U.S.Treasury yield of 120 bps. Today REIT dividend yields are almost exactly 120 bps above the 10-year U.S. Treasury. REIT dividend yield spreads relative to BBB-rated corporate bonds are quite attractive. In fact, they are one standard deviation higher than their 20-year historical average.
From a geographic perspective, what are some hot and cold market areas? What opportunities are you finding within these markets across the U.S.?
Today we are finding the best relative values in select smaller markets outside of the primary, traditional gateway markets (New York City, Washington DC, San Francisco, Los Angeles, Boston and Seattle). Middle market asset prices are better than primary asset prices while the fundamentals of the two market segments at this stage are approximately equivalent. Gateway markets still good markets long-term, but today we see the best relative opportunity in well-located assets in secondary markets like Houston, Dallas, Denver, Philadelphia, Minneapolis or Atlanta where higher initial yields more than make up for lower appreciation assumptions.
In some secondary markets, fundamentals are still recovering whereas in some primary markets much of the easy improvement in fundamentals has already occurred. Energy-focused markets like Houston and those near natural gas fields are faring the best. Government-intensive markets the least well. Additionally metros with high concentrations of technology and media industry are also performing well. Phoenix which had been one of the worst hit markets this cycle is recovering. Las Vegas is the among the last major markets to experience material recovery.
By quality of asset, a similar phenomenon is beginning to occur. "Core" asset pricing has gotten heated, better risk-adjusted opportunities exist in "value-add" projects. From a property-type perspective, we like industrial and regional malls the most. Industrial assets should benefit from an improving economy and the shorter leases typical of industrial building should provide for faster income growth in a recovering economy. Regional malls should fare well as consumer spending rises. Conversely, we are concerned about health care given the high proportion of government reimbursements health care operators typically receive.
The apartment sector has garnered a lot of attention lately with the rebound in the housing market and the growth of supply. What is your outlook for the sector and how do you think an ongoing recovery in the housing market will impact apartment REIT valuations?
We are bullish on apartments. Apartment vacancy rates have never been lower and rent and net operating growth is far superior to any of the major property types today. Contrary to popular myth, single family homes do not directly compete with apartments. Apartment households are their own distinct population. Renters are younger, more urban, have smaller households, and often demand more flexibility. Single family homes are not an attractive alternative to these individuals at their current stage in life. Rather than competing, the two can complement eachother. Data shows that there is a high correlation between rising home prices and rising rents. Demographics are favorable for apartments as more people are entering their prime renting age than have at any point in the past few decades. During the Great Recession the total number of households in the under-35 cohort actually declined despite that cohort expanding as a portion of the population because the poor job market caused renters to double up or move in with their parents. As such, we believe there is a high degree of pent up apartment demand that could be unleashed by an improving job market. Lastly, while apartment construction is increasing, it is needed. The absolute level of new construction is well below historical levels and is only two-thirds of the average level over the past 30 years.
Specific to Urdang's investment process, how do you differentiate relative to competitors who are buying the same type of REITs? What pricing inefficiencies are you able to exploit relative to competitors?
We do a number of things differently. At our core we are real estate investors. Urdang began as, and remains, a real estate investment firm. We only invest in real estate both in direct property and in securities. We bring a different mindset. At their heart REITs are securities in the real estate asset class. REITs are traded daily like stocks, but the returns and fundamentals behave like real estate. Conversely, there are a lot of investors out there who are generalist investors. For example, they might have followed insurance companies or banks last week, and now they have been charged with following REITs, which are a whole different animal. In our opinion, generalist investors who lack a real estate background are at a significant disadvantage to a company like Urdang, where real estate-focused investors are applying their knowledge real estate stocks.
Equally important is our experience. We have been investing on behalf of clients for over 20 years. We know the companies and management teams intimately. We spend a lot of time in the property market looking at assets, understanding management's vision for the project, and how they're going to change it and improve the building. If one is not exclusively dedicated to REITs and real estate, one simply does not have the time or ability to do that.
How you believe REITs will do in a rising-rate environment, given that a rising-rate environment doesn't necessarily accompany inflation or vice versa? Are REITs a potential hedge to an inflationary environment, and what have you seen historically?
Rapidly rising interest rates, in the absence of an accompanying economic expansion, would be bad for many asset classes, but particularly so for real estate which is a capital-intensive industry. If interest rates are gradually rising in response to an improving economy, real estate and REITs can fare quite well. REITs have used the current low interest rate environment to lock-in very attractive, long-duration financing. REITs have well-laddered maturities and use little floating-rate debt. As such, their balance sheets should be insulated from the immediate impact of rising interest rates. Rather, they will be strongly advantaged with in-place interest rates that are meaningfully below market interest rates. As interest rates rise, risk free rates, discount rates and capitalization rates should correspondingly rise. While the value of REITs' assets will be negatively impacted by an increase in required yields, yields on new investments will similarly rise. When married with REITs' low in-place cost of capital, such new investment could be very accretive to REIT earnings and net asset values. The majority of academic research on the subject suggests that there is very little correlation between REIT performance and market interest rates over long periods of time where interest rate increases are expected.
REITs own hard assets. In an inflationary environment we would expect REITs and real estate to perform reasonabl ywell. As prices rise, replacement cost rises, thereby bolstering real estate values. Rents are often tied to increases in CPI, thus protecting landlord's cash flow by ensuring rents rise as prices rise.
The commercial real estate market has held up reasonably well. Do you think this area is in the clear, generally? If not, what potential issues do you see on the horizon?
Commercial real estate is well past the bottom of the cycle. There has been very little new supply added in the past five years and demand has been slowly but steadily recovering for much of the past five years. Occupancies are approaching pre-recession levels and market rent growth is broadly accelerating. Capital values have responded favorably to the strengthening fundamentals, low-interest-rate environment, and improving availability of financing. In our opinion, the capital appreciation that has occurred since the bottom is fully warranted. Although the value recovery has been substantial, it is important to recognize that values for the vast majority of most real estate outside of nation's top prime markets are still below peak levels From a fundamental perspective we see little that would disrupt the current cycle. If new supply were to suddenly increase- which it does not appear to be doing- it would be years away from posing any material threat to market fundamentals. A recession could suppress demand, but that would likely harm the broader stock market more because real estate is generally insulated from short-term economic volatility by grace of their long-term leases. The biggest risks we see to real estate and REITs today come from the capital markets. A surprise increase in interest rates would be negative. Similarly, a shift in investor sentiment away from yield-oriented and hard asset investments would likely be harmful to REIT capital values.
Can you address where REIT current cap rates are compared to where they've been historically?
Over the past two decades or so the cap rate for all classes of real estate has ranged between 9% and 5%. Today cap rates for all classes of real estate are in the low-6% range. Implied cap rates for REIT are currently in the mid-5% range. Owning the best quality assets in the nation's best market, the market has usually awarded REITs with a 50-100 basis point lower cap rate relative to real estate assets broadly over the past 15 years. The current spread between REIT and broad real estate assets is no higher than usual. Said another way, REITs values represent a low double-digit premium to net asset value which is a little above the historical premium of about 5%.
This material is intended for investment professionals and institutional investors only and may not be suitable for retail investors. The views expressed reflect those of Urdang Securities Management as of May, 2013, and are not intended as investment advice or a forecast or guarantee of future results. It should not be assumed that any securities discussed were or will prove to be profitable. Past performance is not an indication of future results.
Comments discussed may reflect forward-looking statements. Forward-looking statements involve inherent risks and uncertainties, both general and specific, and risks exist that forecasts or other outcomes described or implied in forward-looking statements will not be achieved. We caution you that a number of important factors could cause results to differ materially from expectations, estimates and intentions expressed in such forward-looking statements.
Information has been obtained from sources believed to be reliable, but its accuracy, completeness, and interpretation are not guaranteed.
This information is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Managers Investment Group or Urdang. Investment recommendations may be inconsistent with these opinions. There can be no assurance that developments will transpire as forecasted and actual results will be different. Data and analysis does not represent the actual or expected future performance of any investment product. These opinions are subject to change at any time without notice.
Investment advisory services are offered by Managers Investment Group LLC, an investment adviser registered with the U.S. Securities and Exchange Commission. Managers Investment Group (MIG) is a subsidiary of Affiliated Managers Group (NYSE: AMG), and represents many of AMG's affiliated investment managers.
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