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Ky Trang Ho Contributor

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INVESTING

12/18/2015 @ 10:01AM

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Why 2016 Should Be An Awesome

Year To Invest In REITs
Investors in real estate investment trusts, REITs,
are basking in a reversal of fortune after lagging
the stock market the past year. REIT stocks
climbed to the top of the leaderboard in the
fourth quarter
despite worries that a Federal
Reserve interest rate hike will slam profits as
their borrowing costs would increase.
2016 should be an awesome year to invest in
REITs. Analysts at Credit Suisse and Bank of
America Merrill Lynch expect REITs to see
decent returns in 2016 thanks to limited new
supply across the country, strong economic
growth, and attractive valuations. Rising interest
rates may be both a blessing and a curse for the
real estate industry. It increases borrowing costs
for homebuyers and developers, making
purchases less affordable. At the same time, it
could boost demand for apartment rentals.

Stanford Shopping Center, a Simon Property Group (SPG) property in

Palo Alto, Calif. Simon Property Group, a real estate investment trust,
REIT, is the nations largest shopping mall owner. (AP Photo/Paul

Sakuma)

Vanguard REIT exchange-traded fund (VNQ)

the flagship REIT ETF surged 4.7% the past
three months, ending Dec. 17, while the SPDR
S&P 500 ETF (SPY) added 2.6%. But VNQ lost
1.0% over the trailing year, underperforming
SPYs 2.0% gain.
%

Total

Total

Total

Return Return

Total
Return Total

Return

Name

Ticker

First Trust
S&P REIT
ETF

FRI

iShares
Cohen &
Steers REIT

ICF

iShares
Mortgage
Real Estate
Capped

REM

iShares
Residential
Rel Est
Capped

Month

Month

3.66

5.79

4.59

Return
12

YTD

Month

3 Year

0.92

1.9

10.94

7.53

4.54

4.89

12.06

0.1

-6.2

-9.64

-9.55

1.05

6.43

8.04

9.6

10.17

13.64

2.77

5.28

0.72

1.72

9.53

-0.2

-5.79

-10.72

-10.27

2.41

3.4

4.91

-6.87

-5.96

9.61

3.91

6.8

3.33

3.9

12.17

3.89

6.61

3.06

3.75

11.95

3.48

5.72

1.37

2.1

11.48

-0.3

3.11

1.13

3.58

14.84

REZ

iShares US
Real Estate

IYR

Market
Vectors
Mortgage
REIT Income
ETF

MORT

PowerShares
KBW
Premium Yld
Eq REIT ETF KBWY
Schwab US
REIT ETF

SCHH

SPDR Dow
Jones REIT
ETF

RWR

Vanguard
REIT ETF

VNQ

SPDR S&P
500 ETF

SPY

Source:
Morningstar

Earnings and Share Price Outlook

Credit Suisse analysts are betting REIT shares

will rally 17% over the next 12 months
as
dividends increase nearly 10% in 2016. They
forecast 8.6% earnings growth in 2016.
Bank of America Merrill Lynch strategists
forecasts REITs will see earnings growth of 5.4%.
Thats on par with the S&P 500 (SPY) earnings
growth projection of 5.0%, but lower than 2015
growth of 7.7%. They forecast S&P 500 (SPY)
dividend growth of 10.0% in 2016 versus 5.4% for
REITs. But the S&P 500 (SPY) growth is off a
lower base. The S&P 500 yields 2.1% vs. 3.8% for
REITs.
The market may view slower growth as a
negative inflection point, Jeffrey Spector, a
research analyst at BofA ML, wrote an equity
report Dec. 9. But we would argue REITs offer
strong earnings visibility in a volatile market and
would be a good defensive play.
High Demand, Limited Supply
Theres strong demand for office space across the
country and in the top five office REIT markets:
Boston, New York City, Washington D.C., Los
Angeles, and San Francisco, notes Credit Suisse
analysts. In a Dec. 6 equity research report, Ian
Weissman and Derek van Dijkum cited five
leading causes:

1. Employment growth, the main driver for office

leasing demand, continued its steady pace upwards
(211,000 jobs added last month), Weissman wrote.
Private office-using employment growth is now up
5% over the previous peak in 2007.

Economists at Credit Suisse project the U.S. will

add two million jobs next year after creating two
million in 2015. U.S. gross domestic product on
track to grow 2.7% next year as wages expand
3%, which supports consumer spending.
The four other drivers for office space are:

2. Despite densification headwinds, U.S. leasing

fundamentals are strong with vacancy down to 13.9%
and net absorption as a percentage of inventory at
1.3%, 30 basis points above the long-term average.
San Francisco and San Jose have been clear leaders
in rent growth (up 90% and 60%, respectively), with
NYC a distant third (up 30%).
3. New supply in most markets is still muted at 0.9%
of inventory, below the peak in 2007 at almost 1.4%.
4. Office pricing is up over 55% since the beginning
of 2010, which is below 200%+ increase at same
point in the last cycle.

Rents on the West Coast have grown by 8.25%

year over year on average thanks to Google
(GOOGL), Apple (AAPL) and Amazon (AMZN)
eating up space in Silicon Valley. On the East
Coast, rents grew 2.5% year over year.
Office pricing has rallied 55% from their 2010
low but remains well below their 2007 levels. The
caveat is that debt capital markets the main
driver of the last boom have not been as crazy
this time around.
Global economic uncertainty especially in
China coupled with global economic stimulus
should support foreign buying in U.S. real estate
as a means to store cash.
As the Fed begins raising interest rates, a key
point to monitor will be the tug of war on cap
rates between higher capital costs and the wall of
capital looking to invest in core U.S. real estate,
particularly foreign flows, say Jeffrey Spector, a
research analyst, and his colleagues at BofA ML.
Foreign buyers are less price sensitive and more
driven by capital preservation needs given the
macro uncertainty outside of the U.S.
Commercial real estate transactions totaled $429
billion in 2015, according to BofA ML. They have
climbed steadily since their 2009 low. But theyre
far from recovering their pre-recession peak. By
contrast, the S&P 500 (SPY) surpassed its prerecession high in 2013.

Commercial real estate transactions totaled $429 billion in 2015,

according to BofA ML.

Attractive Valuations
REITs are trading at attractive valuations on
some measures while yielding more than riskfree bonds, but less than junk-rated bonds.
REITs traded at 90% of net asset value, below
their long-term average of 101%, as of Dec. 10,
according to BofA ML.
REITs traded at an adjusted funds from
operations (AFFO) multiple of 20.9 times vs. the
long-term average of 15.7 times, according to
BofA ML. The distribution rate for REITs is
3.85%, +161 basis points (1.61%) above the 10year Treasury yield (2.24%) and -155 basis points
(1.55%) below the BAA Corp Bond yield.
The distribution rate spread versus the S&P 500
dividend yield is +178 basis points (3.85% versus
2.07%), below the spreads long-term average of
+366 basis points (3.66%).

Real estate investment trust share prices relative to net asset value (Bank
of America Merrill Lynch)

Investment Risks
Weissman and van Dijkum of Credit Suisse are
cautious on REITs because of bearish signs in the
capital markets and worries in the tech sector,
especially in San Francisco.
San Francisco is almost entirely leveraged to
tech, and given the disconnect between private
market tech valuations (high) and the lack of
liquidity (initial public offerings, mergers and
acquisitions, and buyouts), we will likely see an

increase in down-rounds, especially with the

larger (i.e., unicorn) venture-capital, venture
capital, funded tech companies, they wrote.
We believe an increased number of downrounds will have a chilling effect on VC fund
flows, which will, in turn, affect office demand by
tech companies. Keep in mind that VC
investments are driven by valuation, not cash
flood.
In the wake of the Great Recession, companies
have cut costs by squeezing more workers into
their offices by reducing office size and
increasing the number of cubicles. The average
square foot per employee is now 200 versus
about 250 square feet per employee in 2009.
Companies are increasingly letting employees
work outside the office. The number of mobile
workers is expected to double from 2009 to 2016.

REITs are likely to underperform the stock

market if interest rates increase significantly.
Over the past 20 years, there were six periods in
which interest rates rose 1% or more, with an
average increase of 1.5%. Over those six periods,
REITs lagged the stock market by 13%, according
to Credit Suisse. But REITs experienced positive
returns in four of those six periods.
A strong dollar may dampen foreign demand.
The waters are clearly more choppy than they
were 12 months ago, with several risk factors that
could mute, or even derail the real estate
recovery, Credit Suisse analysts wrote in a 75page report Dec. 11.
Other potential risks to their bullish view
include: 1) anemic, 2.5% gross domestic product
growth in 2016 makes the group more
susceptible to potential demand shocks; 2)
supply pipelines are increasing; 3) increased
global macro uncertaintyworld economies
rarely sneeze without the U.S. catching a cold;
and 4) real estate assets are largely full, with
occupancies at/above prior peaks. Internal
growth will, therefore, need to be entirely rate
driven, tougher to achieve with the U.S. macro
backdrop what it is.