UPRETS INSIGHT | Real Estate Investments Trusts (REITs) Analysis
Through years of development, REITs has gradually become an indispensable part of investors’ asset allocation process. After experiencing the global economic fluctuation in the second half of 2018 and the adjustment in the first quarter of 2019, the performance of the US real estate market and REITs has gradually stabilized.
According to the prediction of Thomas Bohjalian, head of the real estate department of Cohen & Steers asset management company, the U.S. real estate market will continue its steady growth trend in 2018 in 2019, and the industry as a whole is still in a stage of healthy development. At present, real estate holders still have some advantages in pricing power, which also supports the stable growth of REITs yield from the side. Even if the Federal Reserve will adjust interest rates in the foreseeable future, the real estate industry will remain stable.In addition, because REITs’ main source of income is the rental of real estate properties, REITs are less affected by the international economic situation than other assets such as stocks.
To sum up, we think REITs is a very noteworthy sector for investors. Next, we will make a brief analysis of the current situation of the market from various aspects.
Cohen & Steers report address：
https://www.cohenandsteers.com/insights/read/video-u.s.-reits-2019-outlook
I. Classification of REITs
The classification method of REITs is not complicated. First of all, REITs can be divided into two types: publicly listed and privately owned. Later, REITs can be further divided into two types: Equity REITs and bond REITs
Private REITs are not SEC registered entities, but they must also comply with SEC (506) (Regulation D) and enjoy the same preferential tax treatment as publicly listed REITs. Private REITs can be opened to “qualified investors” in the United States and sold directly through private placement.
Private REITs can also be subdivided into “private REITs” and “non-publicly traded REITs”. The above two kinds of REITs are both open investment instruments and are not traded on public stock exchanges. However, there are some key differences between the two in terms of selling methods, valuation methods and commissions and fees that may be involved in the purchase process.
In addition to the above categories, REITs can also be subdivided into 12 different trust funds according to their main business areas. The specific classification is shown in the following figure:
Among the above types of REITs, special attention should be paid to the special category of mortgage REITs. This type of REITs uses real estate as collateral for loans, but generally does not own or operate real estate.
Mortgage REITs need a special analysis method, because this type of REITs will use a variety of hedging instruments to manage interest rate risk exposure, and the main income of this type of REITs does not come from operating or real estate leasing. Although a small number of hybrid REITs will also operate both real estate and mortgage businesses, most REITs are still focused on “hard asset” businesses, and such REITs are called Equity REITs. Generally speaking, equity investment trust funds tend to hold certain types of real estate, such as apartments, regional shopping centers, office buildings or accommodation facilities.
· Office REITs: Hold and manage office-type real estate, lease the space in the held real estate to tenants, and focus on specific types of markets, such as CBD, etc. Other companies emphasize specific tenant categories, such as government agencies or biotechnology companies.
· Industrial REITs: Generally, hold and manage industrial facilities and lease the space in these facilities to tenants, focusing on specific types of properties, such as warehouses and distribution centers. This type of REITs plays an important role in e-commerce and meets the needs of logistics development.
· Retail REITs: Hold and manage retail real estate, focusing on retail real estate operations such as large regional shopping centers, direct selling shops, grocery shopping centers, etc.
· Lodging REITs: Hold and manage real estate such as this hotel and resort and rent space for these properties to guests (or companies).
· Residential REITs: Hold and manage all kinds of residential houses, specializing in such businesses as apartment buildings, student apartments, industrial houses and single-family houses. In the market segments, some residential REITs also focus on specific geographic markets or real estate categories.
· Timberland REITs: Hold and manage various real estate related to logging industry, focusing on logging and selling timber.
· Health Care REITs: It holds and manages all kinds of real estate related to medical care, including advanced living facilities, hospitals, medical office buildings, etc.
· Self-storage REITs: Hold and manage storage facilities and lease storage space to individuals or businesses.
· Infrastructure REITs: Hold and manage infrastructure real estate. Relevant real estate may include optical cables, wireless infrastructure, telecommunication towers, energy pipelines, etc.
· Data Centers REITs: Hold and manage customer facilities for secure storage of data. Data Centers REITs provides a range of products and services to help keep servers and data safe, including uninterruptible power supplies, air-cooled coolers and physical security.
· Diversified REITs: Hold and manage various types of properties. For example, Diversified REITs may hold a portfolio of office and industrial properties at the same time.
· Specialty REITs: Manage a unique mixed property type. The assets held by such REITs are generally special, including cinemas, casinos, farmland and outdoor advertising websites.
According to the data of the first quarter of 2019, the breakdown REITs in the top five market values are:
1. Residential REITs
2. Infrastructure REITs
3. Retail REITs
4. Health Care REITs
5. Industrial REITs
The five types of REITs with the highest YTD (Year to Date) returns rate are:
1. Industrial REITs
2. Data Center REITs
3. Infrastructure REITs
4. Timberland REITs
5. Residential REITs
The top five types of REITs in 2018 are:
1. Health Care
2. Infrastructure
3. Residential
4. Self-storage
5. Industrial REITs
II. REITs Analysis Methods
From the perspective of rating, REITs is an investment-grade industry. REITs with credit rating by Moody’s and Standard & Poor’s account for 70% of the total market value of the industry.
From the fundamental analysis, REITs may be affected by any factors that affect the supply and demand of real estate. For example, population and employment growth tend to benefit all types of real estate investment trusts. Rising interest rates also tend to benefit apartment REITs because the rental market will grow. It should be noted that the judgment and demand of the capital market and large financial institutions for REITs will also directly affect the trend of the industry. Even in the short term, this relationship between capital supply and demand may overwhelm fundamental analysis. The analysis of REITs also needs to pay attention to other factors, such as the growth prospects of income, the value of related service income and Funds from Operations (FFO), and whether the REIT has a unique strategy to improve occupancy rate and rent.
Continuous acquisition is one of the ways for many REITs to seek performance growth and realize economies of scale by absorbing poorly managed real estate. However, if the acquirer cannot effectively raise occupancy rate and rent, it may encounter a failed acquisition, resulting in potential losses. Since mortgage debt plays an important role in the valuation of REITs, it is also necessary to make a simple analysis of the balance sheet of each REIT. Measuring the ratio of fixed interest rate debt to floating interest rate debt is one of the important analysis data. For example, in a low interest rate environment, REITs that only use floating interest rate debt will suffer potential losses if interest rates rise. Therefore, analysts need to pay close attention to macroeconomic developments, especially the recent interest rate cut by the Federal Reserve. However, in practice, some data indicators need to be judged in combination with reality. For example, it is difficult for analysts to judge the leverage ratio and P/E value with a single standard.
From the angle of leverage ratio, REITs’ overall leverage ratio has dropped to the lowest level in at least 20 years. In the first quarter of 2019, the ratio of debt to book assets was 50.6%, compared with 58.3% before the financial crisis. REITs reduced leverage by raising a large amount of equity and saving debt to fund its portfolio. The lower debt ratio and correspondingly higher capital buffer have provided a solid foundation for resisting future market events and opportunities for acquisitions. More and more financing channels help REITs reduce financing costs, improve the health of their balance sheets and improve the flexibility of future operations.
At present, REITs has shifted its capital structure from mortgage loans (guaranteed debts) to bond issuance (unsecured debts), gradually reducing its reliance on secured debts. The increased use of unsecured financing reflects to a certain extent the improvement in the overall financial situation of the real estate investment trust industry. For REITs with investment grade bond rating, the possibility of obtaining unsecured bonds is the greatest. By the first quarter of 2019, the number of investment grade REITs had increased to 68.
III. U.S. REITs Market Performance in the 1st Quarter of 2019
Commercial real estate is one of the most common asset categories in real estate investment, and REITs are mostly distributed in this market. According to data from Nareit, a professional real estate trust research institution, the total assets of US commercial real estate in the fourth quarter of 2018 were about US$ 16.0 trillion, and the upper and lower valuation limits were US$ 14.4 to US$ 17.0 trillion respectively. Among them, more than one-third of commercial real estate is located in the first-tier cities (east and west coasts) market in the United States. According to the analysis of total assets, the largest segments are Multifamily, Office, Retail and Health Care, which also account for more than half of the total value of commercial real estate in the United States. The following figure shows the situation of the segments.
Overview of American commercial real estate in 2018
In addition to understanding the total scale of commercial real estate, investors also need to analyze the recent development of REITs in the industry. According to Nareit analysis, by the fourth quarter of 2018, REITs currently hold about 10% of all commercial real estate in the United States. It is worth noting that, due to its own nature, REITs’ real estate is mainly commercial real estate at the institutional level. Compared with the uneven age, quality, location or other characteristics of ordinary real estate projects, institutional real estate is generally located on the east and west coasts of the United States and has higher quality and returns. If the data of REITs in 2018 are separately compared with the total scale of institutional commercial real estate, REITs accounts for about 20.4% of the institutional real estate market.
REITS’ Share in the Total Scale of Commercial Real Estate
In the first quarter of 2019, Funds from Operations (FFO) of REITs in the United States increased to $15.9 billion. FFO data increased by 1.8% over the same period last year, and the growth rate of 5%-20% in recent years has slowed down, which is consistent with other indicators showing a weak commercial real estate market in early 2019.
At the beginning of 2019, the global macro-economic situation experienced a series of changes and adjustments. The global stock market fluctuated greatly. The suspension of the U.S. federal government also exacerbated the macro-economic uncertainty. Investors’ worries about the economic recession were also rising. In the above macro environment, on the one hand, some enterprises and individuals will hesitate to sign new commercial real estate leases, on the other hand, investors will become more cautious. If the above external factors are taken into account, the weak performance of US commercial real estate and REITs will not surprise too many investors.
With the recovery of macroeconomic data in the first quarter of 2019, the fundamentals of the commercial real estate market are gradually stabilizing. U.S. GDP exceeded expectations in the first quarter of this year. Strong employment growth in March and April provided strong support for the demand for leased commercial land. In the first quarter of 2019, U.S. gross domestic product (GDP) grew 3.2% year on year. The growth of net exports and private inventory investment boosted the overall economy, but consumer spending contributed only 0.8%, lagging behind the performance of previous quarters. In April 2019, non-agricultural employment increased 263,000, higher than expected, while the unemployment rate also fell to 3.6%, the lowest level since 1969. The well-performing labor market has supported the increase in average wages, with the average hourly wage in the United States increasing by 3.2% in the past 12 months. As demand for most types of real estate lags behind new supply, rental growth slowed in the first quarter of 2019.
Judging from the gradual recovery of GDP growth and the rising employment rate, the correction in the real estate market at the beginning of this year is only temporary stagnation, and there may be some rebound in the next few months. Although the fundamentals of the U.S. real estate market tend to be stable, investors still need to pay attention to the deviation of market performance from fundamental analysis in the short term.
An Overview of the Growth of Rental Income from Real Estate in the United States
After half a year of economic adjustment, the economic growth and employment market in the United States have gradually stabilized, while commercial real estate has shown a new momentum of growth. According to the data of the first quarter of 2019, the fundamentals of REITs industry have gradually stabilized. REITs’ occupancy rate is about 93.8%, approaching the historical high of 94.1% set in the second quarter of 2018.Same-storenet operation income (ss-noi) grew 2.7% in the past four quarters, up from 2.2% in the fourth quarter of 2018.SS-NOI for single-family and industrial houses grew strongly, at 6.7% and 6.0% respectively, while SS-NOI for industrial REITs grew to 5.1%. The above growth data provided impetus for REITs industry’s growth in the second half of 2019.
Overview of REITS’ Property Occupancy Rate
IV. Issues Worth Attention in US REITs Market
In the first half of 2019, the global economic situation began to stabilize gradually, while the U.S. economic data also returned to stable growth, with strong employment growth rate. Rising consumer spending and increased business activities boosted demand for almost all types of commercial real estate. However, the global real estate market, including the United States, is still facing many challenges under the macro background that the global economic recovery is weak and the stance of the Federal Reserve is stronger than expected.
First of all, in terms of macroeconomic prospects, the US GDP growth rate accelerated in 2018, from 2.5% in 2017 to 3.0% in the third quarter of 2018. As the economic boost brought by the U.S. tax reduction policy gradually fades, and higher interest rates lead to a cooling of the real estate market and corporate investment, GDP growth in 2019 is likely to be flat or slightly slow, and the current economic situation and the stability of consumer power can withstand moderate interest rate increases. Since 2018, employment growth in the United States has been strong, with non-agricultural employment increasing by 215,000 people per month on average, which is quite close to the average of 210,000 people in the past five years. However, even though the unemployment rate in the United States has fallen to its lowest level since 1969, the decline in the labor force participation rate has left millions of potential workers in the United States without or looking for jobs.
From the perspective of financial markets, Federal Reserve’s short-term interest rate policy objective provides an anchor point for the entire yield curve. Recently, several Federal Reserve officials have said that inflation data may cause the Federal Reserve to suspend interest rate hikes rather than accelerate the pace of interest rate hikes, especially when Federal Reserve Chairman Powell recently said interest rates were “slightly below” neutral levels. Although the Federal Reserve has more direct control over short-term interest rates, long-term interest rates have a greater impact on the economy and the commercial real estate market. U.S. 10-year Treasury bond yield has dropped to about 2% from about 3% in the fourth quarter of 2018. In the long run, U.S. Treasury bond yield is still at a historical low. In addition, economic growth in other parts of the world will also affect the long-term interest rate in the United States. Even if it is slightly raised, such financing interest rate will still be low, which will be beneficial to investment in real estate.
From the perspective of commercial real estate market and REITs market, according to CoStar’s data, the average apartment rent in the United States accelerated from 2010 to 2015, with the increase in effective rent reaching a peak of about 5%. The reason behind this is that the housing crisis continues to stimulate rent elasticity. However, rent increases slowed in 2016 and 2017, raising concerns among investors that large-scale construction investments may lead to oversupply in the market. In 2018, the average rent growth in the United States picked up again. In the third quarter of 2018, the rent increased by nearly 3.5%. There is a shortage of houses for sale in almost every major city and in serviced apartment. In such a tight market environment, the main obstacle to the continuous rent increase is the current insufficient rent affordability, as household income is hardly able to keep up with the rent increase. In the coming period of time, whether the employment market can maintain strong growth and raise the average wage level will be an important factor affecting the sustainable growth of future rents.
Compared with the increase of employment rate, the demand for office space has been weak in recent years. According to CoStar’s data, since 2012, the total number of office rentals in the United States has increased by about 1%, while the employment in the office industry (finance, professional and commercial services, information services) has increased by 2% annually. Changes in the office work environment and more shared workspace have led to weak demand.
Summary
Investors are paying more and more attention to REITs because their risk is lower than that of stocks, but they can contribute more than 5% of the annual yield. In the three years from 2016 to 2019, the S&P 500 index in the United States rose by about 14.64%, while REIT under Morningstar, Inc also rose by about 7.09%. Vanguard Real Estate Index also rose 12.25% in the first quarter of 2019. It is worth investors’ attention that REITs also have a good history of performance in the late period of the economic cycle. According to Cohen & Steers, an asset management company, since 1991, US REITs have outperformed the S&P 500 index by more than 7% at the end of each economic cycle. In addition, Cohen & Steers believed that REITs “provided effective downside protection in a recession”.
According to the above analysis, for investors who are uneasy about the current economic situation, using REITs as an effective supplement in their portfolios will help to resist the risks of macroeconomic recession.
About UPRETS: UPRETS is a one-stop solution platform for security token offering founded in November 2018. Partnered with a publicly listed real estate conglomerate (NYSE: XIN), we currently focus on providing a cost-efficient, compliant and advanced tokenized real estate investment platform for property developers and investors globally by our patented blockchain technology.
Using this platform from UPRETS, the developers can provide liquidity for their property investors and the investors can benefit from the rent dividends and returns of properties in world-class major cities, such as New York, London and Dubai.
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