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REIT Industry Review & Stock Picks - March 2013

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The U.S. Real Estate Investment Trust (REIT) industry has carved a niche for itself and is now an important part of the overall economy. Amid the low interest rate environment following the financial crisis, the demand for REIT stocks has risen owing to their ability to deliver steady income. Moreover, they help investors benefit from their capital appreciation opportunities.

The U.S. REIT industry delivered a solid 2012 overall, with a relatively strong run in the first half of the year followed by a modest second half. Furthermore, REIT stocks have outperformed the broader equity market in 2012 for the 4th straight year.

For full-year 2012, the FTSE NAREIT All REITs Index reported total return of 20.14% and the FTSE NAREIT All Equity REITs Index returned 19.70% compared to 16.00% for the S&P 500. The robust results for 2012 comes after FTSE NAREIT All Equity REITs Index delivered returns of 8.28% in 2011, 27.95% in 2010 and 27.99% in 2009 compared with the S&P 500’s return of 2.11%, 15.06% and 26.46%, respectively.

A Closer Look

A combination of factors has helped the REIT sector stand out and gain strong foothold over the past 15 to 20 years, the most notable among them being a healthy dividend payout. As a matter of fact, investors looking for high dividend yields have historically favored REIT stocks. Solid dividend payouts are arguably the biggest enticement for REIT investors as U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends to shareholders.

The dividend yield of the FTSE NAREIT All REITs Index came in at 4.38% as of Dec 31, 2012 while the dividend yield of the FTSE NAREIT All Equity REITs Index reached 3.51%. Moreover, the dividend yield of the FTSE NAREIT Mortgage REITs Index was 12.93% as of that date compared with the S&P 500 dividend yield of 2.22%.

During 2007 to 2009, REITs took considerably less debt than private real estate investors, and many were able to sell at the top of the market when private equity investors were still buying. Importantly, during the downturn, REITs were able to acquire properties from highly leveraged investors at heavy discounts. This enabled them to add premium high-return assets to their portfolios.

Furthermore, REITs managed to raise capital to pay off debt, owing to a large inflow of funds as institutional investors allocated more ‘dry powder’ to the industry, making them an increasingly attractive investment proposition. In 2011, REITs raised $51.3 billion in public equity and debt, out of which $37.5 billion alone was raised though public equity despite a highly volatile market.

In 2012, REITs have surpassed the prior year figure and raised an aggregate of $73.3 billion in capital, which included $45.8 billion in secondary equity common and preferred share offerings, $25.7 billion in unsecured debt offerings and $1.8 billion in initial public offerings.

Moreover, according to data from NAREIT, debt ratio of equity REITs (total industry debt as a percentage of its total debt and equity market capitalization) by the end of third quarter 2012 was 33.8% -- significantly lower than about 51% prior to the collapse of Lehman Brothers in 2008.

In addition, REITs typically have a large unencumbered pool of assets, which could provide an additional avenue to raise cash during a crisis. These assets, in turn, have provided the requisite wherewithal to the REIT industry to make strategic acquisitions over time to fuel its inorganic growth engine.

Going forward, we believe M&A opportunities will increase in the current low interest rate environment. Particularly the REITs with a solid balance sheet and reasonably better accessibility to capital are expected to capitalize on such opportunities. In the latter half of 2012, we noticed an increase in such deals and we believe the trend will continue in 2013 as well. However, ambiguity in the market may limit the tempo of the deals.

The Current Scenario

The January data was a little disappointing as the FTSE NAREIT All REITs Index gained 4.28% compared to 6.24% for the S&P 500. There were minor hiccups in the GDP growth rate of late, but we noticed that households and business spending has been accelerating and unemployment rate has been declining.

The European crisis has yet to resolve and given the current fiscal conditions, the interest rate is expected to remain low for an extended period. This, ideally, increases the demand for the REIT stock that offers steady income.

Though the economic uncertainty and particularly the political situation have been major factors affecting the market, we believe that with the economic recovery gaining momentum, rents and occupancies for most types of properties would improve further.

While a sluggish growth rate in jobs as well as closure of chain stores is likely to pose a concern for the Retail sector REITs, limited supply of new ones is expected to help increase the demand for the existing ones and drive up their rental rates.

In the Apartment sector, though on the whole there have been improvements, yet minor hiccups remain with an increase in supply in certain markets. Industrial sector is projected to benefit from the improving economy while the Timber sector’s performance would gain from an increase in new construction. In a nutshell, the long-term prospects of the REIT industry look favorable with a mild cautionary note.

Sector Performance in 2012

In 2012, most of the sectors in the REIT market performed well and reported double-digit returns. The standout performance in the industry was that of the Timber REITs (a total return of 37.05% as measured by the FTSE NAREIT Equity REITs Index, followed by Industrial (31.28%), Infrastructure (29.91%), Retail sector (26.74%), Health Care (20.35%), Self-Storage (19.94%), Lodging/Resorts (12.53%) and Diversified REITs (12.20%). The relatively underperforming sector was Residential (6.94%).

OPPORTUNITIES

We are bullish on Simon Property Group Inc. (SPG - Analyst Report), the largest publicly traded retail REIT in North America, with assets in almost all retail distribution channels. Its international presence gives it a more sustainable long-term growth story than its domestically focused peers. The geographic and product diversity of this Zacks Rank #2 (Buy) company also insulate it from market volatility to a great extent and provide a steady source of income.

In addition, Simon Property generally enters into long-term leases with companies, which insulate it from short-term market swings that have weighed on other players in the industry. With a favorable supply/demand relationship, rising earnings estimates, robust growth projections, and a healthy dividend rise (announced simultaneously with its fourth quarter earnings release), Simon Property offers an enticing upside potential going forward.

We are also bullish on Taubman Centers Inc. (TCO - Analyst Report), which owns, develops, acquires and operates regional and super-regional shopping centers throughout the U.S. and Asia. This Zacks Rank #2 (Buy) REIT focuses on dominant retail malls that command the highest average sales productivity in the U.S., measured in terms of mall tenants’ average sales per square foot.

Furthermore, the shopping centers are located in the most affluent regions of the country, thereby enabling retailers to target high-end upscale customers and maximize their profitability. This, in turn, has enabled Taubman to command relatively premium rents for its portfolio, thereby ensuring steady top-line growth. In addition, Taubman has one of the strongest balance sheets in the sector with adequate liquidity. The company has also taken prudent steps to reduce its operating expenses.

Another stock worth mentioning is Ventas Inc. (VTR - Analyst Report), a leading healthcare REIT, primarily engaged in the business of financing, owning and leasing healthcare related and senior housing facilities.

Being one of the largest healthcare REITs in the U.S., this Zacks Rank #2 (Buy) REIT boasts a significantly diversified portfolio and exposure to nearly all types of facilities. Also, the healthcare sector is relatively immune to the downturn in the economy, and provides a steady source of income that protects the company from short-term market volatility.

We expect the company’s strategic move in acquiring Atria and other opportunities to provide significant upside potential to the stock going forward. Moreover, we remain encouraged with the recent dividend hike announcement at Ventas.

WEAKNESSES

A significant chunk of REITs are raising capital through property level debt and equity offerings. Although both debt and equity financings provide the much-needed cash infusion, they could potentially burden an already leveraged balance sheet and dilute earnings. Property level debt is also harder to obtain and more expensive as commercial real estate prices remain under pressure.

Although overall market fundamentals remain positive for Apartment REITs, we are a tad bearish on BRE Properties Inc. (BRE). This Zacks Rank #4 (Sell) REIT is one of the leading owners and operators of multifamily apartments with a strong portfolio of assets in supply-constrained premium markets of the Western U.S.

The company is currently restructuring its portfolio and targeting non-core markets for assets dispositions. Moreover, it expects to fund the current development pipeline with proceeds from assets sale. Notably, the key strategic motive is to remain focused primarily on the targeted
high-barrier markets and sub-markets in California and Seattle, WA.

Despite attempts to reposition its portfolio, much of the company’s portfolio still resides in some weak multi-family markets, which together make up nearly 41% of the company’s same-store portfolio.

Another bearish stock is UDR Inc. (UDR), an apartment REIT that owns, operates, acquires, develops and renovates middle-market apartment communities.

This Zacks Rank #4 (Sell) REIT faces intense competition across all its markets from real estate investors, including insurance companies, pension and investment funds, public and private real estate companies as well as REITs. This affects the top-line growth of the company and puts considerable pressure on maintaining its profitability through stringent cost-cutting measures.

Moreover, though the recent employment trends are improving, they are not yet back to pre-recession levels. The U.S. economy still continues to shed jobs in some sectors. This, in turn, might exert pressure on the occupancy rates, affecting the rental revenue of the company, thereby hampering its long-term profitability.

Conclusion

Moving forward, limited supply of new construction coupled with the growing demand for high-quality properties bode well for the earnings prospects of REITs, in particular for those that have assets in high barriers-to-entry markets. To sum up, we firmly believe that despite a few pitfalls, given the current recovery of the economy as well as the low interest-rate environment, REITs still offers a worthy investment proposition for 2013.

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