Keith Mills, Senior Vice President, Head of Research: July 2013
What is a REIT?
The REIT (Real Estate Investment Trust) structure, signed into law in September 1960 by President Eisenhower to enable individual investors to own income-producing commercial real estate, is unique in the corporate structure and investing world.
Per Internal Revenue Service rules, REITs do not pay federal corporate income taxes but are required to pay out 90% of their taxable net income in the form of a common stock dividend, which is then taxed at the shareholder level (ordinary income), avoiding the double taxation of dividends. As of July 11, U.S. equity REITs had an average dividend yield of 3.4% per the FTSE NAREIT All Equity REITs Index.
REITs are typically dedicated to owning assets in predominantly one commercial property type. So, REITs that own office buildings typically own just office buildings, those that own apartment communities normally just own apartment communities, etc. This specialization requires investors seeking diversification to own a basket of REITs across multiple property types or allows them to have exposure to only certain property types at different points in the business cycle. Most REITs are allowed under IRS rules to operate their own properties, with the exception of lodging and healthcare REITs that must enter into leases or property management agreements with third-party operators.
As the saying goes, real estate ownership is all about location, location, location. Well-managed properties located in the markets with the highest barriers to entry—from new construction and most favorable demand characteristics—are expected to achieve higher rental-rate and operating income growth over the long-term, all else being equal.
New property supply growth, or completions, as a percentage of existing stock, for most U.S. commercial real estate property types, has been on a steady decline in recent years or is at a low level relative to historical averages. The one exception is apartments/multifamily, which started to realize an increase in new construction starts during 2012. Demand for U.S. commercial real estate space has gradually recovered following the 2008-09 economic recession, resulting in higher occupancies and stable-to-increasing rental rates across most property types, particularly in urban locations.
What Does Trillium Look for in REITs?
Trillium’s approach to investing in REITs is to focus on well-managed and governed companies with business strategies that embrace efforts to improve the company’s environmental impact. Real estate development and utilization is a tremendous natural resource and energy hog during both their initial development and ongoing use. According to the U.S. Energy Information Administration (EIA), “Roughly 41% of total U.S. energy consumption in 2010 was used in buildings, or about 40 quadrillion Btu.” Moreover, when considering the commuting costs for travel to and from work and retail stores, the impact on the environment is even greater.
As a result, our environmental analysis of REITs includes the EPA’s ENERGY STAR rating, the U.S. Green Building Council’s Leadership in Energy and Environmental Design (LEED) certification, and proximity to public transportation. Energy Star ratings focus on energy and water consumption, or building operating performance, and were first awarded to office buildings by the U.S. Environmental Protection Agency (EPA) beginning in 1999, followed by retail, lodging, and industrial properties in the early to mid part of the last decade. According to Energy Star’s website, “to qualify for the ENERGY STAR, a building or manufacturing plant must earn a 75 or higher on EPA’s 1-100 energy performance scale, indicating that the facility performs better than at least 75% of similar buildings nationwide.” So, only buildings ranking in the top 25% of energy performance receive the Energy Star rating. Per Energy Star’s website, as of December 2012, there were nearly 20,500 Energy Star rated buildings in the U.S.
The U.S. Green Building Council’s Leadership in Energy and Environmental Design (LEED) program began in 1998 and as of November 2012, over 15,000 commercial buildings were LEED certified globally. About one-third of new building development in the U.S. today is LEED certified versus about 2% in 2005. LEED certification designations are Platinum, Gold, and Silver. Most new developments or existing property refurbishments aim for achieving the Gold or Silver certification as the cost/return-on-investment to achieve the Platinum rating versus the Gold is significant.
Trillium’s governance analysis across all sectors, including REITs, focuses on the separation of the Chairman and CEO roles, our opinion of the likely true independence of independent directors, executive compensation structure, and diversity. In terms of REITs, we are also concerned with their unique equity ownership structure. Board-member independence also warrants special focus stemming from the fact that most REITs are small or mid-capitalization companies that completed their initial public offerings in the early- to mid-1990s with long-time industry contacts, associates, etc. of the REIT’s founders/principals being those categorized as “independent” directors.
Based on our review of many REIT 2012 Proxy statements, a number of REITs still have independent directors who have been part of their Board since their IPO in the early- to mid-1990s or shortly thereafter. As a result, we focused on those companies that had the best relative board make up. For example, we only considered REITs whose directors are elected annually and serve for a maximum of one-year at a time. The primary area of focus in our executive compensation analysis was incentive compensation make up and overall compensation alignment with shareholders’ long-term interests.
From a social perspective, property access to public transportation is important for many property types, particularly apartments, office, and retail. Many of the REITs that are on our internal Buy List have favorable access to transportation, mainly due to their properties being in urban locations.
Trillium’s internal Buy List, or the list of approved securities that our Portfolio Managers select from to build and manage our different investment strategies, includes the following REITs by property type:
Apartments/Multi-Family: AvalonBay Communities (AVB), Camden Property Trust (CPT), and Home Properties (HME);
Healthcare: HCP (HCP) and LTC Properties (LTC);
Industrials: EastGroup Properties (EGP) to go along with Prologis (PLD);
Lodging: Host Hotels & Resorts (HST) and LaSalle Hotel Properties (LHO);
Office: Boston Properties (BXP) and Brandywine Realty (BDN);
Retail: Acadia Realty Trust (AKR) and Federal Realty Trust (FRT); and
Self-Storage: Extra Space Storage (EXR).
How have REITs performed since 2009?
Between 2009 and 2012, the FTSE NAREIT All Equity REITs Index outperformed nearly all major equity indices, including the S&P 500, S&P 500 Utilities, Russell 2000, and NASDAQ. However, year-to-date thru July 11, REIT stocks have underperformed these indices and were quite volatile during May and June. We believe this was for three reasons, but primarily related to an expectation of higher U.S. interest rates.
First, as noted, REIT stocks had performed very well during the past several years in the low U.S. interest rate environment, as investors craving yield/income piled into REITs to collect their dividends. The hint of higher U.S. interest rates after Federal Reserve Chairman Ben Bernanke’s comments in late May about a potential tapering of Quantitative Easing spooked the investment market and suggested the potential for higher long-term interest rates. Thus, one of the primary catalysts for the REITs’ 2009-12 outperformance was unwound.
Second, the slow, but steadily improving U.S. economy of the past few years reduced the interest rate spreads to U.S. government debt that REITs and other commercial real estate investors paid on their borrowed debt. Like lower interest rates, lower interest rate spreads also contributed to REIT valuations becoming extended after private real estate buyers began to pay increasing multiples/prices for acquired properties in recent years. Think of it as a magnet effect, as private payers pay higher prices due to low interest rates/spreads, the public REIT valuations are pulled toward these higher values. This is particularly true for REITs owning properties in the markets where the private buyers are acquiring, such as major, urban markets. During May andJune, the market also viewed the unwinding of Quantitative Easing as a potential threat to U.S. economic growth. Lower economic growth often results in higher interest rate spreads, which negatively impacts prices paid for commercial real estate properties and REIT equity values.
Finally, REITs often underperform in an environment of low inflation, which characterizes the current U.S. market and the forecast for the coming quarters. Since the equity market has “digested” the U.S. Federal Reserve’s intentions as it relates to the tapering of Quantitative Easing and remains comfortable that the Fed is unlikely to take actions that will increase interest rates in the near-term, REIT share prices have rebounded. However, REITs share-price actions during the past two months are indicative of their heightened sensitivity to higher interest rates and interest rate spreads at this time.