Rates Could Be Lower, Lower For Longer, Longer

In a recent New York Times article, Norm Alster wrote, "Past performance, we are repeatedly and rightfully reminded, is no guarantee if comparable performance in the future."

The writer was referring to real estate investment trusts (REITs) and his bearish argument was centered on the notion that real estate securities “faced lurking risks” and the “possibility of a recession” could “pinch business growth and consumer spending”.

He essentially argues that REITs could not sustain the successful record over the last decade because, in his words, “REITs are hostage to fears of a further Fed interest rate” and he concluded as follows, "You may not want to count on the returns of the last 15 years."

As the late Benjamin Graham, father of value investing, pointed out, past performance is useful in calculating the value of a stock only as far as it is indicative of what is to come in the future as it pertains to earnings.

Remember that REITs are much different from ordinary stocks because they are considered both equity vehicles and income alternatives. REITs, unique to most stocks, must payout at least 90% of their net income, so they pay investors high dividends. Also, REITs generate income from buildings with contractual leases that provide more predictable sources of earnings and dividend growth.

Think about like this.

Starbuck’s generates earnings by selling cups of coffee and the sustainability of the company’s profits is a direct function consumer demand. In other words, the earnings stream for Starbuck’s is not as predictable as a rent check from the coffee powerhouse .

Alternatively, a REIT that owns buildings leased to Starbucks has a much more predictable earnings stream because the lease contracts provide clarity as it relates to the future income that the REIT will generate.

This is a key point because REITs have a strategic advantage over most other equity alternatives in that these publicly-traded landlords can forecast future earnings with a greater degree of certainty. This also means that dividend growth is much easier to forecast - remember, REITs must payout at least 90 percent of net income (most payout 100 percent) and when rents grow, so do dividends.

So maybe you’re asking, “REIT dividends are so low today, why fool with them?”

First off, remember that REITs are securities but they own real estate. Marc Halle, managing director with PGIM Real Estate explains, "REITs have a reliable income stream derived from rent paid to the landlord. In today’s low yield environment, investors who often look no further than the bond markets for income should consider REITs. It’s important to consider fundamentals."

The current real estate supply in the U.S. is not keeping up with demand. The combination of the 2008 credit crisis and the subsequent liquidity crunch subdued global economic growth, and stringent banking regulations have sharply curtailed and inhibited new real estate development.

In other words, it’s hard to argue that a recession could jolt the REIT sector because supply and demand remain in-balance. Dean Sam Chandan, Larry & Klara Silverstein Chair in Real Estate Development & Investment, at NYU SPS Schack Institute of Real Estate explains,

The most recent spate of reports on the economy and jobs point to slow but sustained growth in the United States. Nonetheless, investors are clearly expressing greater concern about our position in the business cycle. In part, that is a response to the possibility of spillovers from instability in the world's anchor economies, including the likelihood of contraction in the United Kingdom.

It also reflects the longevity of the current expansion, which has now entered its eighth year. Barring an exogenous shock, we do not anticipate a recession in the near-term. However, a recession within the investment time-horizon for acquisitions and loans made today is a near-certainty.

In the current environment there are not a lot of inflationary factors on the horizon and for REITs the overall costs of capital keeps dropping, which means that profit margins are widening. In our view, there are really only two catalysts that could spark a REIT selloff: (1) a dramatic rise in rates, or (2) a recession.

The chart below provides evidence that a recession is not likely, GDP is well below average:

Dr. Brad Case, Sr. V.P. at NAREIT explains,

The parts of the economy that are most prone to cyclical extremes are still a smaller share than usual of the total economy.  Employment is continuing to increase, and the ISM Composite Index—one of the most important leading indicators of macroeconomic growth—is showing more strength than usual.  The economy looks more like one that’s on its way back up to normal growth, rather than one where we should worry about weakening growth.

There are plenty of economic events that are forcing yields to remain low and because REITs are both equities and yield vehicles, the income alternatives win out for now. The two possible catalysts (rate increases or recession) don’t appear likely so we are keeping our chips on the table, or as Marc Halle explains.

Rates could be be lower, lower for longer, longer .

Many of our favorite REITs are benefitting from rates that are lower, and accordingly, we seek out the best in class names that we hope will pay out dividends longer. In the healthcare REIT sector, we like companies like Omega Healthcare Investors (OHI), Ventas  (VTR), and Healthcare Trust of America (HTA).

In the retail sector, we like REITs such as Tanger Factory Outlets (SKT) and Taubman Centers (TCO). In the Industrial sector we like STAG Industrial (STAG) and Monmouth Real Estate (MNR).

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Disclosure: I own shares of  OHI, VTR, HTA, SKT and TCO.

I’m editor of Forbes Real Estate Investor, coauthor (with Stephanie Krewson-Kelly) of The Intelligent REIT Investor and author of  The Trump Factor: Unlocking the Secrets Behind the Trump Empire .

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