Morgan Stanley: 5 REIT Stocks To Underweight For Q4

As we enter the fall season, investment bank Morgan Stanley foresees some headwinds for the REIT sector as a whole. Morgan Stanley designated these five REITs as Underweight: CBL and Associates Properties, Inc.

, Government Properties Income Trust

, Home Properties, Inc.

, Mid-America Apartment Communities, Inc.

, and Realty Income Corporation

. Large, liquid, interest-rate sensitive REIT sectors which have outperformed YTD, have the potential to be under the most pressure as 2014 winds down. REIT Sector Risk Factor Review 1. Rising interest rate risks. 2. Stretched valuations after strong YTD performance. 3. Slowing internal and external growth outlooks for 2015 and 2016. 4. Pipeline of new equity paper creating a potential oversupply: $2 billion of secondary offerings and $4 billion of IPO's were identified by Morgan Stanley in the near term. Institutions may choose to sell some winners to book profits and recycle capital to invest in new issues. These risk factors were previously reported in a recent Benzinga article: • Morgan Stanley's Top 5 REIT Picks For Q4 A Closer Look at Five Underweight Picks

Regarding these five Morgan Stanley Underweight picks for the balance of 2014, if this was a horserace, Mr. Market appears to have two "favorites," or stocks which have not performed well YTD; and three "dark horses," or REITs which have performed fairly well YTD. Underweight Favorite: CBL and 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 which own mall assets which are commonly referred to as Class-B and below. In a recent retail panel, one of the few things that all of the participants agreed upon was that Class-B malls presented the greatest challenges and risk of underperforming over time. • http://www.benzinga.com/real-estate/reit/14/10/4898453/bricks-mortar-vs-internet-sales-retail-experts-recently-debated-the-t However, a trend of consolidation in this sector has begun spurred by the recent announcement of the acquisition of Glimcher Realty Trust by Washington Prime Group, itself a recent spin-out of industry leader Simon Property Group. • http://www.benzinga.com/real-estate/reit/14/09/4854724/simon-property-group-inc-and-recent-wpg-spin-billions-bet-on-glimcher Underweight Favorite: Government Properties Eponymous Government Properties Income Trust primarily owns office buildings which 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. However, 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 controversial REIT Management & Research LLC, (RMR). In general, REITs that are externally managed 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 which 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. Mid-America Apartment Communities and Camden Property Trust with 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 with all four of these multi-family REITs down between 7 and 7.5 percent since the end of August. Home Properties dividend yield is now up to 4.9 percent, with Mid-American paying out a 4.4 percent yield. Dark Horse: Realty Income When it comes to paring down on the REIT sector, perhaps the biggest surprise for many investors would be that Morgan Stanley included triple-net lease stalwart Realty Income -- so dependable it is also known as The Monthly Dividend Company -- on its Underweight list. However, this sector is perceived to be at greater risk from a rising interest rate environment than most of its REIT peers due owning a portfolio of assets with long-term leases. 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 also pointed out that the rate of FFO growth in the triple-net sector has slowed tremendously compared to 2013 and is expected to continue to decelerate based upon 2015 estimates to just under 4 percent. Due to the Realty Income track record of excellent performance during both good and bad economic times, there are many investors who would welcome a chance to initiate or add to a long position. This should act to dampen downward pressure on valuation, assuming interest rates were to increase at a relatively modest rate. Final Thoughts Morgan Stanley "wildcards" which could change the playing field included: Federal Reserve actions or comments, unusually strong Q3 earnings, as well as merger and acquisition activity. In the event the Fed were to signal what is interpreted to be 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 should help to mitigate the drop in its shares relative to its newer peers.