By Raymond Mathis
After the one-two punch of stronger-than-expected readings from the Institute for Supply Management's manufacturing sector gauge on Apr. 1, and the March employment report on Apr. 2, bond yields marched higher as Wall Street wondered if signs of a strengthening economy will prompt the Federal Reserve to hike interest rates sooner rather than later.
Rising rates, of course, are anathema to investors in real estate stocks. Shares of real estate investment trusts -- a widely used vehicle for investing in the sector -- sold off sharply in the wake of the reports, before staging a partial rebound on Apr. 7. Nonetheless, Standard & Poor's Equity Research remains bullish on select REITs.
Although we think real estate fundamentals remain relatively weak for most property types, the S&P REIT composite index outperformed the S&P 500-stock index year-to-date through Apr. 2, posting a 7.9% total return, vs. 1.3% for the 500. We think it's notable that, on a total-return basis, REITs have outperformed the S&P 500 over the past 1-, 3-, 5-, and 10-year periods. However, we expect the industry to perform more in line with the broader market over the coming 12 months.
WHERE TO FOCUS.
Because REITs have historically been economic laggards, we see same-property revenue as likely to be flat across the broader industry for the near term. But we also expect differentiation among property types, with hotel and retail properties likely to lead apartment and office space.
Also, many REITs aim to boost earnings via other means. Some have engaged in merger-and-acquisition activity. Others are goosing earnings by refinancing debt and preferred issues, while many are divesting noncore holdings, unlocking substantial capital gains in the process.
What should investors look for in a REIT security? In our view, they should focus on the stock's current dividend yield, its long-term dividend growth rate, and the ratio of dividends paid out from funds from operations (FFO), a widely used measure of REIT financial performance.
Investors should also consider fundamentals for the REIT's dominant property type, net asset value (NAV) per share, and, on a macro level, the anticipated direction of interest rates.
The possibility of rising rates could limit the appeal of REITs with dividend yields about equal to those of the benchmark 10-year Treasury note (recently at 4.14%) -- why invest in a REIT if you can get the same yield from a risk-free security like the 10-year note? -- or those concentrated in real estate segments with little prospect of growth. As of Apr. 6, the median REIT yield was 5.44%.
But the broad sell-off has provided an enhanced buying opportunity for selected REITs that carry wide positive yield spreads vs. the 10-year note, such as Hospitality Properties (HPT ; recent price, $42; recent yield, 6.85%). Also attractive: REITS whose dividend growth should outpace an interest rate hike, like Vornado (VNO ; $56; 5%), or that are leading a segment recovery, such as lodging company La Quinta (LQI ; $7.60; doesn't currently pay a dividend, but S&P expects it to pay one in the next 12 months). Each of those stocks carries S&P's highest investment opinion, 5 STARS (buy).
Analyst Mathis follows stocks of real estate investment trusts for Standard & Poor's