REIT yields look attractive, but dependant on economic recovery
Given our expectations for a slowdown in GDP growth next year in developed markets, primarily due to weak labour recovery and fiscal consolidation, the outlook for property markets therefore seems somewhat bleak. However, our analysis of real estate investment trusts (REITs) suggests that even in a slower-paced recovery the sector in general is fairly valued and should remain underpinned. With a cautious approach, REITs offer opportunity to pick up some yield in what is likely to remain an environment of very low interest rates.
Dependant on continued economic recovery
Property values have historically been highly correlated and levered to any changes in GDP growth, and hence our outlook for the real estate market as a whole is heavily influenced by our outlook for economic growth.
The contraction in loans to the US commercial and industrial sectors that began in late 2008 has recently stopped, and if the trend continues this suggests lending could start to grow again. This is a potentially promising trend for the economy, although monthly growth in the commercial real estate component remains negative. The downward trend began in mid-2005 and moved into negative growth in October 2008. Monthly declines have recovered from their lows, but remain negative, falling 0.7% in May.
In the US residential real estate markets, the supply of housing has fallen from a peak of 11 months in early 2009 to 8, still above the normal historical levels between 4-6 months, according to the National Association of Realtors. Some of this fall is probably attributable to government tax credits, which incidentally expired at the end of April. There also is an underlying "shadow inventory" (foreclosed properties returned to the lender), which a recent report by Standard & Poor’s suggested is currently equivalent to 33 months’ supply. These properties will not result in a massive oversupply shock, as they are likely to re-enter the markets slowly, particularly as lenders hold properties until they can be sold at an agreeable discount. A point to note is that this slow drip-feeding of shadow inventory is likely to mute any rebound in property prices.
REITs have been the favoured vehicle for investing in property in recent years, particularly as they avoid paying taxes as long as they distribute 90% of taxable income to shareholders as a dividend. REIT valuations, usually comparing the premium or discount of net asset values (NAV, or total assets – total liabilities) to market capitalisation, suggest they are close to fair value. The deep value seen in early 2009 has dissipated due to a price appreciation prompted by anticipation of an economic recovery. We believe fair valuations coupled with little prospect of property price rises will leave less room for price appreciation. That said, investor demand for yield has helped support REIT shares, which have fallen less than 1% while the S&P 500 has lost 6% of its value so far this year.
The outlook for REIT yields
REITs have traditionally had high dividend yields, and currently trade at a yield of 5.4%, 3.2 percentage points above the S&P 500’s average dividend yield. However, there are risks to REIT dividends, which have fallen by an average of 19% from their levels a year ago and remain in a downward trend. Real REIT dividend yields, adjusted for inflation, have fallen back to levels not seen since 2006.
While we see yields in the sector as attractive, we acknowledge some individual REITs’ debt levels remain at alarming levels. There are sectors which have shown greater resilience during the downturn, such as care homes, where dividend growth has grown over the last year. In contrast, the retail sector has seen very large dividend cuts. A selective approach is therefore essential.
Rental income is traditionally a key source of dividend payments for REITs, and is particularly susceptible to decline during an economic slowdown and first stages of a recession. As we expect growth in the economy, albeit at below trend level, we believe rental income is likely to at least remain supported at current levels.
Rental income in the UK is still declining, according to the Investment Property Databank. There has been a marked slow-down in the pace of declines since mid-2009, with the trend suggesting quarter on quarter growth could turn positive over the next two quarters. However, our analysis suggests that given a forecast of 2% GDP growth in 2011, UK rental income will remain flat through next year.
The REIT sector in general has also been bolstered by a decline in aggregate net debt, having fallen 18% since its peak in the third quarter of 2008. Although it remains at historically elevated levels, we are encouraged by the steps taken in the industry to reduce this burden.
Conclusion
We see many headwinds to the property sector in both the US and UK, particularly in light of a continued decline in lending to commercial property, and oversupply and high debt in the property sector in general. However, property prices have historically been levered to economic growth, and as we expect growth in the economy, albeit at below trend level, we believe REITs should remain underpinned. They represent an attractive source of additional yield, although on a valuation basis we are neutral and recommend a selective approach given high debt levels and vulnerability to dividend cuts of some REITs.
Disclaimer
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