In the wake of the subprime mortgage crisis, real estate has been a taboo sector. Still, even as some investors continue to associate real estate with the worst of the downturn, shares of real estate investment trusts (REITs) have been on a roll recently.
After a strong third quarter, the Dow Jones Composite All REIT Index is up 11.85 percent so far this year, and as the Wall Street Journal noted recently, REIT stocks are trading at a premium to their underlying assets for the first time since the real estate downturn began.
Optimists say REITs are benefiting from a bottoming in the real estate markets plus a healthy amount of access to funding that has remained elusive for many rivals. Notably, REITs brought in $28.6 billion in capital this year through September. Belying investors' enthusiasm, though, is a market that still faces a number of roadblocks, including struggling tenants and a tarnished image.
U.S. News recently sat down with Joel Beam and Ian Goltra of Forward Funds to discuss the future of this latest run in REITs. Beam is the manager of Forward Select Income, a REIT mutual fund that distinguishes itself through its focus on preferred stocks, which are first in line for dividend payments. The fund is up 62 percent so far this year. Goltra is a senior analyst and a member of Forward's real estate portfolio management team.
There have been concerns about a bubble in the commercial real estate market. Do you think that prediction is accurate?
JB: The commercial side of the business is clearly in a difficult time right now. There's a lot of debt that needs to roll over. But it's nowhere near the scale of the challenge in the residential market . . . I do think that prices were inflated relative to current values when you look back toward the '06, '07 time frame, and I think those people that bought properties then—which was really the top of the market—to the extent that they need to refinance sooner rather than later, they're going to have a problem. The commercial-property sector has a cycle. Things do appreciate in price, and the valuation of those properties will come back in periods of tight liquidity and in a recessionary time frame, but that doesn't mean that there's a widespread bubble in the same way that there is in the housing space.
An estimate from earlier this month indicated that REITs were trading at a 24 percent premium to their net asset values. Does your team feel that there is too much short-term expectation built into the market?
JB: I think it's fair to say we do.
So what should investors do?
JB: When things are cheap, I tend to buy more of them. When they're more expensive, maybe I'll look at some other alternatives and another place to put a little bit of money. As we make decisions with respect to a whole portfolio of securities, we have levers that we can pull, like we raise a little bit more cash, or we might put some money into a more conservative but higher-security kind of investment. So I think for folks, certainly for maybe a retail investor, the decision is really about the time horizon of their investment and what they want out of the stock. I'm not a big believer in trying to time things.
How has the recession affected the image of REITs?
JB: I think the downturn has created more of a challenge for REITs because anytime you say real estate, people think residential real estate. We've always fought that battle, and I think the downturn has made our work harder in the sense that we really have to cleave those two, and it's very difficult to do. Residential is totally different than commercial real estate investments.
How do you go about separating them for investors?
JB: We try to part the Red Sea. We really try to say, "Look, it's night and day." . . . Residential real estate is driven by financing, by household formation, by household income levels, by things that are really just very different from the value drivers in commercial real estate. Commercial real estate is driven by the rental income that those properties generate. That is the underpinning of value on that side. And so we literally just try to use expressions like "night and day," "black and white," and just "separate it because it's not the same." . . . [But] there are ways that it does touch.
JB: It's apartments, and it's the overall economy. The single-family blowup, it's affecting the apartment sector . . . And so apartments have had a tough time for a few years now. It's hard for them to grow rents and maintain the credit quality of their people. And now their next challenge over the next few years is going to be to keep all of their decent people, because now rates are low, and there's a tremendous incentive to get people into homes as a way to try to revive the residential market.
How has access to capital helped REITs compared to their competition recently?
JB: We spend a lot of time trying not to be Pollyanna-ish. It's a tough market out there. Fundamentals are rolling down. It's an alley fight for tenants and for a lot of folks. And having the money to pay for tenant improvements, having the money to pay brokers to make sure that the brokerage community stays your friend and not your enemy—these are elements of the business that folks are executing on a day-to-day basis within the universe of all real estate companies. And REITs are poised to outcompete because they have great people but also because they have access to capital. It's a real differentiator.
What is the ideal type of diversification for a REIT portfolio?
JB: Any individual REIT has tremendous diversification typically within it. Some are more regionally focused, but a lot of them have national footprints. Some even have international exposure. So you get a tremendous amount of diversification within a portfolio.
IG: Really, at the end of the day, it's interesting: It comes down to people. You have folks like at Corporate Office in [Maryland] who run a great business, essentially working very closely with the Defense Department and contractors and having security clearances and building buildings that are appropriately outfitted to the needs of those special tenants. They have a very narrow market focus and essentially one property type: the suburban office . . . . But Corporate Office runs a great business. So we really have to look at it by entrepreneur and by manager of the business.
Are there any sectors within real estate that you'd recommend?
JB: In tough times, what you want to focus on as a real estate investor is longer-duration leases. And in particular, in the fund that I run where I'm focused on senior securities, I sleep well at night owning senior securities of companies that don't have a lot of lease rollover exposure. What that translates into is net lease companies, companies . . . for instance, in the healthcare sector, where they tend to own a lot of nursing homes and otherwise pretty boring properties, but where I have great assurance that they're going to pay the rent and that the company in turn is going to pay our dividends. Broadly speaking about real estate, it's toughest to feel good about hotels and apartments, really because of the fact that those [involve] daily and monthly lease turnover, and it's tough having visibility about how that's going to work out for you.
What countries are looking attractive?
IG: If you look around the world, some of the best value is interestingly in places like Asia, like in Hong Kong. Six months ago, part of that answer might have included Japan. In Japan, landlords don't insist that tenants pay the top rent when their leases roll over in very strong markets, and conversely, tenants don't expect landlords to drop the rent to the floor in tough times. And so there's a more long-term relationship approach in Japan. But Japan's in a very difficult period.
Traditionally, a strong selling point for REITs has been that they are not correlated with the rest of the market. Has the downturn exposed this as a myth?
JB : I think over the near term, everything's been correlated, or more highly correlated. Long term, I think that it will hold up. Once we get past what is obviously the crisis of two generations—really unprecedented movements in the market—I do think that long term, the statistical profile of the REITs is going to return to something more uncorrelated.