Nicholas J. Johnson, managing director and portfolio manager focusing on real return portfolios, and Ray Huang, credit analyst, address two key questions about investing in real estate investment trusts (REITs).
Q: Why should investors consider an investment in REITs?
A: We believe REITs are an attractive and efficient investment vehicle for investors to gain exposure to the commercial real estate asset class. REIT returns have historically been very much in line with the direction of returns in commercial real estate (see Figure 1).
While REITs are generally registered with the SEC and publicly traded on a stock exchange, making them susceptible to daily market fluctuations, they have unique features that favorably compare with other corporate sectors and private real estate investments. These features include:
- Highly detailed disclosures that provide transparency and transaction activities, sometimes down to the individual property level; as a result, the current value of a REIT’s underlying assets can be calculated within a narrow band of several percentage points.
- More liquidity and efficiency for investing in institutional-quality commercial real estate relative to private fund structures or non-traded REITs.
- Specialization in specific property types and geographies, which gives investors the flexibility to create their own portfolios of assets depending on their own views on future values and growth expectations.
- The potential for a stable earnings stream and growing dividends providing current yields in the 3% to 5% range.
It’s important to note that REITs will gain a higher profile this year when they get classified as their own sector in indexes instead of being part of the financial sector in the Global Industry Classification Standard (GICS) structure. We view the net impact of this reclassification, scheduled for August 2016, as a modest positive for REITs given the potential for increased buying activity from generalist mutual funds that have historically been underweight REITs within financials, as well as the increased visibility of the asset class.
Q: How does PIMCO assess REITs?
A: We take a two-pronged approach to valuing REITs.
First, the purchase of a REIT is similar to buying an ownership stake in a variety of real estate holdings, such as buildings. So one way to value a REIT is to compare its share price to the value of all the assets the REIT owns. We refer to this as a REIT premium or discount to its net asset value (NAV). We aim to make these estimates more precise and forward looking by also taking into account ancillary factors affecting relative valuation between companies and sectors, such as views on longer-term secular growth trends, efficient general and administrative (G&A) loads, capital expenditure requirements and management’s track record managing its balance sheet and allocating capital.
Currently, REIT values in the major property sectors are broadly trading at an average mid-single digit discount to where physical assets would trade in the private market, according to Green Street Advisors NAV estimates. The values range from discounts of 15% to 20% in apartments, malls, and offices to premiums of 5% to 10% in industrial and strip retail centers. This means investors can generally buy REITs more cheaply than they could buy the same ownership stake in the assets in the private market. We see that as an attractive cushion to the potential for some volatility in U.S. commercial real estate prices over the next 12 months as discussed in a recent paper by colleagues John Murray and Anthony Clarke. As such, investors are basically getting paid, provided the assets held in the REIT hold or gain value, to take on a more liquid commercial real estate investment than holding the assets directly. This fact – combined with the $245 billion raised, but not yet invested by private equity and foreign capital for commercial real estate, according to research firm Preqin – makes for a favorable technical backdrop for the REIT space.
The second way to look at REITs is relative to the valuation in other liquid financial assets. REITs are basically a long-term real asset. At a high level, REITs or buildings collect long-term streams of rental payments plus they are assets whose prices should rise with inflation. The expected yield should be a function of the real yield available in other financial assets, which can be benchmarked by Treasury Inflation-Protected Securities (TIPS). REITs on average are about a BBB credit, so it makes sense to adjust this real yield from TIPS to a similar credit quality; as a result, we add on the current BBB credit spread from the credit market. The purchase of REITs is an investment in the equity part of the capital structure, so there should also be an adjustment for this – an equity risk premium. Figure 2 shows the results of this valuation approach. The yield on REITs (adjusted funds from operations, AFFO yield) is shown in the gold line. The three components – TIPS yield, BBB credit spread and equity risk premium (a function of the S&P 500 forward earnings yield) – are shown in the solid bars. When the yield on REITs is below the sum of these three components, we view REITs as rich relative to broader financial markets. Vice versa, when the yield on REITs is higher, we view REITs as cheap to broader financial markets.
So we currently view REITs as fair to modestly cheap compared to both the physical assets that underlie them and other financial assets. Given that cheapness to physical assets has historically coincided with strong future returns, we find REITs attractive overall.