Why REITs Have Outperformed During Wild October Trading

The first two weeks of October have taken investors on a roller coaster ride erasing most of the gains in the S&P 500 YTD. While the financial sector as a whole has seen weakness recently, U.S. real estate has held up quite well.

Investing in publicly traded real estate investment trusts, or REITs, has been a safe haven for investors.

REIT Basics

REITs are not a new fad. The legislation authorizing REITs was signed into law by President Eisenhower in 1960.

The law allows companies who qualify under IRS regulations to avoid taxation at the corporate level. In return for this privilege, REITs must pay out at least 90 percent of their taxable income to shareholders in the form of dividends.

Related Link: Self Storage REIT Sector Continues To Outperform: Hits 52-Week Highs

A Twist On Familiar Advice

Warren Buffett does not believe in investing in fads or in businesses which are overly complex or hard to comprehend. A classic tongue-in-cheek quote often attributed to both Mr. Buffett and Peter Lynch is: "Go for a business that any idiot can run -- because sooner or later, any idiot is probably going to run it."

The quote is inapt when it comes to REITs, in that when it comes to picking blue-chip REITs, quality of the management team is a critical component to consider.

REITs that are externally managed should be carefully researched to make sure that the board of trustees and management incentives are aligned with shareholders. REITs that are internally managed and focused on a single asset class often have the highest valuations based upon Funds From Operations (FFO) multiple per share, the REIT equivalent to P/E ratio.

Thus the core of the classic advice does apply to REITs: simpler is better.

Large Cap Blue-Chip Equity REITs

Unlike companies designing the latest "killer app," the next wonder drug or technology breakthrough, the largest REITs by market cap are easy to understand:

• Simon Property Group Inc SPG is a $51.6-billion cap REIT that owns Class-A regional malls and outlet malls across North America, as well as joint-ventures in Europe and Asia.
• American Tower Corp AMT is a $36.5-billion cap REIT that operates 70,000 communication towers located across the globe leased to wireless network providers.
• Public Storage PSA is a $29.3 billion cap REIT that owns more than 2,200 self-storage locations across the U.S. and Europe, as well as holdings in PS Business Parks -- commercial and office/industrial properties.
• Equity Residential EQR is a $24.3-billion cap REIT that owns almost 400 properties containing ~111,500 units concentrated in key metropolitan core markets including Los Angeles, Boston, New York, Washington D.C., Seattle, Denver and South Florida.
• Health Care REIT, Inc. HCN is a $22-billion cap REIT that owns a 1,224-property portfolio of senior housing, medical office, life science and hospitals located across the U.S., Canada and United Kingdom.

4 Reasons REITs Have Performed Well YTD

1. Supply: A lack of new development since the Great Recession has resulted in more space being absorbed in most REIT classes than is being created.

However, construction of certain product types such as apartments and industrial facilities has accelerated in some markets. (The real estate business at the margin is dependent upon local market conditions, regardless of national trends).

2. Demand: The U.S. economy has been improving steadily for the past few years and continues to grow at a steady pace.

Well-located shopping centers and regional malls are performing well. Businesses that had delayed hiring decisions and facility expansion have been leasing offices, warehouses and R&D facilities. The sharp increase in wireless data and cloud computing has been a boon to REITs that lease out cell towers and data centers.

3. Available Equity and Debt: During 2013 and 2014 there has been an abundance of REIT IPOs and secondary equity offerings. Well-managed REITs have been able to replace higher interest rate debt and/or floating credit facilities with lower cost debt. This contrasts with the environment in 2008-2009 when capital markets shunned real estate.

4. Better Leasing Spreads: The lower cost of capital has allowed REITs that typically sign long-term leases -- such as the single-tenant triple-net REIT sector -- to lock in a higher spread between cost of capital and revenue per square foot.

Strong Performance Across Most REIT Sectors

In the face of weaker U.S. retail sales forecasts, economic weakness in Europe, and Ebola concerns that have dominated recent headlines, investors have seen almost all REIT sectors outperform the S&P YTD.

However, there has been weakness in the new single-family home rental asset class -- a new business model -- and recent weakness in the lodging sector that has been attributed primarily to fears regarding Ebola.

Bottom Line

Investors who are not currently invested in this alternative asset class may want to consider researching REITs or discussing the merits of including them as part of a diversified portfolio with their investment advisors.