REITS 101 AN INTRODUCTION TO REAL ESTATE INVESTMENT TRUSTS A Real Opportunity While they have been around for over fifty years, real estate investment trusts (REITs) have been slow to move into the mainstream. This was partially a by-product of only a moderate number of REITs existing prior to the 1990s, but also a result of REITs characteristics, which are different from stocks and bonds and require specialized analysis. However, the low interest rate environment that has prevailed since the global financial crisis has introduced a new wave of investors to REITs. We believe a continuation of low rates, coupled with the addition of REITs as a new GICS sector at the end of August (they previously were a subgroup of financials), will likely result in continued growth for the asset class. In this paper, we provide an overview of REITs: what they are, their characteristics, what drives their performance, how to value them, as well as how to allocate to them within a diversified portfolio.
2 What Is a REIT? In simple terms, real estate investment trusts or REITs are investment vehicles that offer exposure to real estate. They are corporate entities that own, operate, develop, manage, acquire, or finance real estate. By filing as a REIT, a company avoids taxation at the corporate level in exchange for passing on 90% or greater of its taxable income to shareholders. This has historically resulted in significant and reliable income streams for investors. While there are different types of REITs, this paper will address those that are listed and publicly traded. A REIT typically falls into one of two categories. Equity REITs, which make up approximately 90% of REITs, generally own and operate real estate. Mortgage REITs lend to owners and operators or acquire real estate-related debt or mortgage-backed securities. Growth of an Asset Class REITs were first established in the United States in 1960 as a means to provide retail investors access to larger and more diversified portfolios of commercial real estate, similar to mutual funds. Originally REITs, like mutual funds, were designed as passive investment vehicles. However, over time, reforms were made to allow REITs to actively manage and operate their portfolios. At first, the REIT model was slow to catch on, with just over 50 equity REITs formed from 1960 to 1990. However, due to the savings and loans crisis and the closing of some tax loopholes, growth accelerated in the early 1990s, with 113 equity REITs launched from 1991 to 1995 and total market cap expanding from $9 billion in 1991 to $50 billion in 1995. 1 Today, have a market cap of $972 billion and own more the $1.8 trillion of commercial real estate (including non-listed REITs) (Exhibit 1). 2 There are 219 REITs in the FTSE/NAREIT All REIT Index and 26 REITs in the S&P 500 Index. More than 193 trade on the New York Stock Exchange. In addition, the average daily trading volume has nearly doubled over the past five years, from $3.3 billion in 2011 to $6.0 billion in 2015. Exhibit 1 Equity REIT Market Cap ($B) 1,200,000 800,000 400,000 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 As of 30 June 2016 Source: NAREIT
3 A Diverse Asset Class REITs own and/or manage a variety of property types, or sectors, though the majority of specialize in a specific sector such as office buildings, regional malls, or apartments. As the real estate market has matured in the United States, specialty sectors such as data centers, timber, or infrastructure have developed. Each sector has its own unique economic drivers and lease terms (Exhibit 2), which can enhance diversification within portfolios. Due to the potential variance of performance among different property sectors, the average spread between the best- and worstperforming sectors over the last five years has been 40% (Exhibit 3). As such, it is critical to understand how each sector is impacted by both economic and real estate cycles. Exhibit 2 REIT Sectors' Different Economic Drivers and Lease Terms Real Estate Sector Market Cap ($B) % of US Listed Market Economic Drivers Key Tenants Lease Duration 98.2 9.8 Corporate Profits, Business Segment Growth, GDP 58.4 5.8 Consumer Spending, Sales Corporations, Professional Service Industries Logistics, Manufacturing, ers 5 10 yrs 3 5 yrs Regional 117.1 11.7 Disposable Income, Consumer Sentiment Soft Good ers, Jewelry, Department Stores 7 10 yrs (in-line) Shopping Centers 79.3 7.9 Consumer Spending, CPI, Population Grocery and Drug, Local Necessity 3 5 yrs (in-line) Single Tenant 37.7 3.8 Consumer Spending, CPI, Population Restaurants, Banks, Gas/Convenience 10 15 yrs Multi-Family 113.4 11.3 Age Cohort Growth, Interest Rates 21 35 yrs and 65+ Age Cohorts 9 12 months Manufacturing Housing 12.0 1.2 Interest Rates, Population, Age Cohort Growth 55+ Age Cohort, Lower Middle Class Families Various Diversified 54.2 5.4 Various Various Various Lodging 41.8 4.2 Business Spending, Disposable Income, Consumer Sentiment Business and Leisure Travel Daily (consumer); 10 15 yrs (management contract) 104.9 10.5 Aging Population, Government 65+ Age Cohort 9 12 months (resident); 10 15 yrs (management contract) Self 66.4 6.6 Population Adults Monthly Timber 27.3 2.7 Construction, New Home Sales Construction Industry Various Mortgage REITs 55.9 5.3 Interest Rates, Health of the Financial System Real Estate Owners 3 10 yrs a As of 30 June 2016 a Maturity duration Note: Not every sector and subsector are represented. Source: Lazard, NAREIT
4 Exhibit 3 US REIT Sector Performance Is Diverse 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 46% 42% 3 34% 31% 30% 24% 21% 51% 2 16% 16% 15% 13% 12% 8% 8% 1% 4 43% 42% 38% 36% 35% 26% 24% 2% 2% 1% -15% -15% -1-20% -24% -24% 25% -12% -19% -26% -35% -38% -39% -60% -60% -6 75% 64% 39% 38% 31% 29% 25% 9% 2% 4 43% 39% 36% 30% 29% 19% 19% 19% 36% 21% 15% 14% 9% 0% -2% -5% -5% -13% % Difference between Best/Worst Sectors 31% 29% 25% 20% 18% 18% 13% 13% 9% 6% 4% 2% 0% -6% - 40% 31% 2 26% 21% 10% 41% 16% 6% 5% 4% 3% 3% 0% - -24% 25 50 23 27 73 73 28 49 24 35 30 65 As of 31 December 2015 The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. Source: FTSE NAREIT All Equity Total Return Index Why Own REITs? can offer investors attractive risk-adjusted returns, a potential source of income, diversification benefits, and a hedge to inflation. Attractive Long-Term Returns: Since their inception, REITs have historically outperformed stocks and bonds over every long-term time period except the last five years, where they lagged by only 70 bps (Exhibit 4). Strong Relative and Absolute Income: Due to the underlying property leases and requirement that they pass through 90% of their taxable income, REITs have generated attractive and consistent income. Enhanced Diversification: Real estate has historically had a low correlation to other asset classes (Exhibit 5). Inflation Hedge: REIT dividends have historically grown faster than inflation as stronger economic growth increases the demand for real estate (Exhibit 6). Exhibit 4 REITs Have Historically Outperformed Stocks and Bonds Annualized Returns (%) Years US REITs S&P 500 BofA/ Merrill Lynch Corporate BofA/ Merrill Lynch High Yield 5 11.9 12.6 3.5 5.0 10 7.4 7.3 4.5 7.0 15 11.1 5.0 5.0 7.6 25 12.1 9.8 6.2 9.0 30 10.7 10.4 6.8 8.3 40 13.7 11.4 7.6 N/A As of 31 December 2015 The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. Source: FTSE NAREIT All Equity Total Return REITs Index, S&P 500 Total Return Index
5 Exhibit 5 Real Estate Has a Lower Correlation to Other Asset Classes Correlation of Listed US Real Estate to Other US Asset Classes, 1997 2016 REIT Correlations Decline over Long Holding Periods Correlation of Returns on Publicly Traded Equity REITs to the S&P 500 Index (%) 60 (%) 60 40 40 20 20 0 0-20 S&P 500 Nasdaq Barclays Corp. BofA Corp. US Agg. Treasury -20 12 Month 36 Month 60 Month As of 31 January 2016 Correlations with financials may decline. Source: FactSet As of 31 January 2016 For all periods from April 1995 through January 2016. Source: FactSet Exhibit 6 REIT Dividend Growth Has Exceeded Inflation Listed Equity REIT Dividend Growth vs. CPI, 2005 2015 (%) 70 REIT Dividend Growth Consumer Price Index 35 0-35 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 As of 31 December 2015 Source: Bloomberg
6 Drivers of Performance Economic growth: Economic expansion is one of the primary drivers of commercial real estate, typically increasing demand for space, rents, and ultimately growth in net operating income (NOI). Resulting job creation and wage increases reverberate throughout all property sectors. Additional office space is required to house new employees; warehouse and distribution space is needed to address increased inventories; retailers, many with leases tied to a percentage of sales, pay higher rents to landlords as consumers spend more; new households are formed, increasing demand for apartments; and business and leisure travel accelerate, raising hotel occupancy and room rates. Demographics: Population change, immigration, migration patterns, and household income are significant contributors to the growth, development, and consumption of real estate. Equally important are the trends and preferences of large age cohorts. Millennials for example have put off getting married, having children, and buying a house, which has fueled multi-family housing and urban densification. As demand and space requirements change, buildings may be at risk of becoming obsolete, and once-popular neighborhoods or destinations can experience a decline (Exhibit 7). Supply and demand: Excess demand and tight supply will favor landlords, whereas a prolonged, favorable environment can lead to a glut of new construction and downward pressure on occupancy and rents. A cycle of oversupply, equilibrium, and undersupply has historically been the norm for real estate. However, the global financial crisis was unique for the slow pace of new development prior to the crisis. Coupled with a near shutdown in new construction post-crisis, landlords have benefited despite a less-than-robust economic recovery due to constrained supply. Exhibit 7 Millennials Have Preferred to Rent over Buy Share of under 35-Year-Old Households That Rent (%) 68 58 48 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 As of 30 June 2016 Source: US Census Bureau
7 Valuing REITs While REITs share a number of valuation metrics with equities such as multiples, growth, and yields, other metrics are particular to real estate: Funds from Operations (FFO): Like most companies, REIT net income is reduced by depreciation expenses. However, unlike assets such as equipment, property generally appreciates. As a result, FFO adds back certain real estate related deprecation expenses and is akin to EPS for equities. Adjusted Funds from Operations (AFFO) or Cash Available for Distribution (CAD): As FFO can overstate income, certain items like recurring expenses (e.g., tenant improvements, leasing expenses) and capital expenditures are subtracted and rent increases are included. P/FFO: Price to FFO can be thought of as a price to earnings (P/E) equivalent used to calculate relative value. However, as a result of different property sectors and individual companies having different ranges, the metric is better suited to top-down analysis. While some third-party research firms may provide P/Es on REITs, they treat depreciation as an expense, resulting in significantly higher ratios than P/FFO. Net Asset Value (NAV): NAV is one of the most important valuation metrics because the value of a REIT is mainly derived by the assets it owns. This is also why NAV doesn t apply to companies that don t own hard assets. Determining NAV requires calculating a REIT s 12-month projected net operating income (NOI) and dividing by an appropriate cap rate. This results in an estimated value of a REIT s properties. After including additional income sources, cash, and land and subtracting liabilities, we arrive at the NAV. Capitalization Rates: Capitalization rates (cap rates) represent the rate of return, or yield, based on the income that a property is expected to generate in its first year. It is calculated by dividing the property s projected 12-month net operating income (NOI) and dividing by the current market value of the asset. The lower the cap rate, the higher the multiple on the asset. Dividend Yield: Due to the significant contribution to a REIT s total return (on average around 60%), comparing yields among REITs as well as bonds (the 10-year Treasury and corporate bonds being most relevant) can provide investors as useful relative valuation tool. Not every property or portfolio is created equal and, as a result, qualitative factors should be accounted for when valuing real estate. These factors include portfolio quality and location, development pipeline, pending acquisitions, lease term and structure, and management quality. Investing in REITs What allocation should REITs have in a portfolio? We believe REITs offer a hybrid of equity and bond characteristics, along with some distinct features of their own. Some have viewed real estate as akin to equities due to their strong total returns and volatility. Others equate REITs to bonds due to their high yields. In reality, real estate is a distinct asset class warranting a separate allocation within an investor s portfolio, depending on one s investment goals and risk tolerance. An appropriate allocation to real estate can improve a portfolio s potential to generate higher returns at lower volatility. Institutional investors have historically allocated strategically to real estate and at higher levels than other investors. Generally this is a result of better understanding the asset classes characteristics by employing dedicated analysts. While US institutions who choose to invest in real estate generally allocate between 10% of their portfolios to commercial real estate today, others have held significantly higher levels.
REITs: A Real Opportunity While some may consider REITs to be similar to either stocks or bonds, what makes them a distinct asset class is their differentiated source of returns. Through the contractual lease obligation of the tenant to the landlord (REIT), a stable income stream is generated. And through occupancy growth, rent growth, or redevelopment of properties, REITs have the ability to grow their income stream. So, whether through attractive potential total returns, stable and significant income, enhanced diversification, or a hedge against inflation, we believe REITs can serve most investors objectives. Up until recently, listed real estate has not enjoyed the same wide-scale adoption as stocks or bonds. But through organic growth, strong results, and industry changes that formalize REITs as a separate asset class, that will likely change. As a result, investors who haven t previously invested in real estate would be well served by taking a more in-depth look at the asset class. Notes 1 Source: NAREIT, ULI 2 As of 29 April 2016 Important Information Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in emerging markets countries. An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal payments. Certain information included herein is derived by Lazard in part from an MSCI index or indices (the Index Data ). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom. The MSCI Index Data may not be further redistributed or used as a basis for other indices or any securities or financial products. Published on 22 August 2017. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) based upon information believed to be reliable as of 23 August 2016. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates ( Lazard ) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard s local regulatory authorizations. Please visit www.lazardassetmanagement.com/globaldisclosure for the specific Lazard entities that have issued this document and the scope of their authorized activities. HB27092