Morgan Stanley's 5 REIT Stocks To Underweight: A Close Look
Heading into fall, investment bank Morgan Stanley foresees some headwinds for REITs. Large, liquid, interest-rate sensitive REIT sectors which have outperformed YTD have the potential to be under the most pressure as 2014 winds down.
Morgan Stanley designated these five REITs as Underweight:
CBL & Associates Properties, Inc. (NYSE: CBL), Government Properties Income Trust (NYSE: GOV), Home Properties, Inc. (NYSE: HME), Mid-America Apartment Communities Inc (NYSE: MAA) and Realty Income Corp (NYSE: O).
Related Link: Morgan Stanley's Top 5 REIT Picks For Q4
A Closer Look
If Morgan Stanley's picks' future performance were a horse race, Mr. Market appears to have two "favorites" among the five, meaning stocks which have not performed well YTD, and three "dark horses," or REITs that have performed fairly well YTD.
Underweight Favorite: CBL & Associates
When it comes to bashing bricks and mortar retail, few asset classes get more negative press than regional malls with relatively low sales per square foot.
CBL & Associates is one of the REITs that own mall assets that are commonly referred to as Class-B and below. In a recent retail panel, one of the few things the participants agreed upon was that Class-B malls presented the greatest challenges and risk of underperforming over time.
However, a trend of consolidation in this sector has begun spurred by Washington Prime Group Inc's recent announcement of its acquisition of Glimcher Realty Trust, itself a recent spin-out of industry leader Simon Property Group.
Underweight Favorite: Government Properties
Aptly-named Government Properties Income Trust primarily owns office buildings that are leased to federal, state and local government agencies. The good news is that the credit profile for its tenants is one of the highest in the office REIT sector. The bad news is that this concentrated portfolio is subject to the whims of bureaucratic budgeting and agency downsizing or consolidation.
This REIT is externally managed by REIT Management & Research LLC, (RMR). In general, externally-managed REITs trade at lower valuations due to concerns regarding whether the interests of shareholders are aligned with management when it comes to corporate governance, management incentives and fees.
Back in July, Government Properties regained control of Select Income REIT by paying a premium to purchase the entire Equity Commonwealth stake at $31.50 per share. Select Income is a triple-net REIT that owns land leases in Hawaii as well as mainland single-tenant assets. Select Income shares closed at $23.98 on Oct. 6, or down ~24 percent since the July purchase by Government and RMR.
The combination of asset mix and management concerns has created a situation where Government Properties is now paying a dividend yielding ~8 percent, one of the highest yields of any equity REIT.
Dark Horses: Home Properties and Mid-America Apartments
Home Properties is a $3.4 billion-cap multi-family REIT, while Mid-America sports a market cap of $5 billion. The apartment sector had outperformed significantly during the first half of 2014, as reflected by this chart from August 26:
As reported on Benzinga, Mizuho initiated coverage of the apartment REIT sector on August 25, 2014. Mizuho gave Mid-America Apartment Communities and Camden Property Trust its Buy rating, while Home Properties and UDR Inc. were started at a Neutral rating.
However, during the third quarter, this REIT sector has been under pressure due to profit taking. All four of these multi-family REITs are down between 7 and 7.5 percent since the end of August. Home Properties's dividend yield is now up to 4.9 percent, and Mid-American is paying out a 4.4 percent yield.
Darkest Horse: Realty Income
Perhaps the biggest surprise for many investors would be Morgan Stanley's inclusion of triple-net lease stalwart Realty Income — so dependable it is also known as The Monthly Dividend Company — on its Underweight list.
Nonetheless, this sector is perceived to be at greater risk from a rising interest rate environment than most of its REIT peers due to owning a portfolio of assets with long-term leases.
Will it really underperform, however? Unlike the corporate bond asset class, these leases often include contractual increases in the rent. Additionally, the underlying real estate net asset value can increase to keep pace with higher costs for construction and entitled land stemming from lower unemployment and/or a growing economy.
Morgan Stanley strengthened its case by pointing out that the rate of Funds from Operations growth in the triple-net sector has slowed tremendously compared to 2013 and is expected to continue to decelerate to just under 4 percent, based upon 2015 estimates.
Due to the Realty Income track record of excellent performance during both good and bad economic times, many investors may welcome a chance to initiate or add to a long position. Such demand could act to dampen downward pressure on valuation — assuming interest rates were to increase at a relatively modest rate.
Morgan Stanley identified "wildcards" which could change the logic of its ratings, including Federal Reserve actions or comments, unusually strong Q3 earnings, and merger and acquisition activity.
If the Fed signaled a sharp upswing in rates, the entire REIT sector would be vulnerable moving forward. However, the quality and diversity of Realty Income's earning stream could help to mitigate the drop in its shares relative to its newer peers.
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