REITs: Providing Visibility in an Age of Uncertainty
Franklin Equity Group portfolio managers Daniel Scher and Blair Schmicker make the case that REITs are more than just a “collection of assets,” as they were once viewed, and instead offer exposure to quality business models and professional management teams with long track records of value creation.
The modern real estate investment trust (REIT) era began in the early 1990s, and their initial appeal was quite simply as a means of participating in the benefits of ownership of commercial real estate without the pitfalls of illiquidity and weaker disclosure. The asset class has matured over the last 30 years into what many may regard today as the benchmark for quality, capital stewardship, transparency, and governance within the overall real estate landscape. Lessons learned from challenges gone by have certainly played a role in the evolution of the REITs sector over the past three decades. For example, the global financial crisis (GFC) of 2008/2009 altered the way many listed REITs operated with respect to financial leverage (debt); today many REITs operate with debt ratios at historic lows. The more recent COVID-19 pandemic introduced an unprecedented set of challenges, but in the aftermath, many listed REITs improved their internal practices and disclosure.
Another outcome has been rapid technological and behavioral change affecting how people live, work and play, with massive implications for utilization of retail and office space. In turn, the underlying composition of the REIT sector has shifted away from those traditional uses toward categories such as industrial, residential, self-storage, health care, data centers and cellular towers, each with strong secular underpinnings.
We believe this bodes well in the age of heightened uncertainty that engulfs the world we live in. Here we focus on four characteristics that pertain to the REIT sector and that can provide much-needed visibility amid these turbulent times: (1) reliable revenues, (2) compositional change, (3) top-tier transparency, and (4) financial flexibility.
REITs derive the majority of their revenue as rental income from tenants who sign leases on the space the REIT owns. While there are exceptions such as lodging, self-storage and residential, these leases are largely multi-year contracts, thereby providing for good visibility of top-line income. The portfolios themselves tend to be highly occupied, and the consistency of this metric over time evidences the quality proposition for the REIT sector as a whole. Importantly, even in the severest of downtowns, e.g., the GFC, same-store net operating income (NOI) growth for the US REITs was modestly negative for just a few quarters before recovering strongly in subsequent years, underpinned by solid rent growth as well as high occupancy (See Exhibit 1).