Sector report by Tan Shing Yee and Claire Willemse, 27 November 2020
The fallout of the Covid-19 pandemic has impacted all sectors of financial markets, albeit in different ways. Considering that real estate is considered an alternative financial instrument in contrast to the more well-known bond and equities’ markets, it should have provided diversification and helped mitigate any direct negative impacts to those markets. However, REITs are available in many different subsectors, themselves exposed to different industries. Therefore, the performance of REITs between these subsectors (as well as geographies) and between each other where different amounts of risk and leverage are involved has varied greatly.
In this report, the will be an overview of different real estate industries and its current outlook which thus contributes to the performances of REITS. 2 REIT ETFs are also explored in depth as potential investments and compared to individual investments in specific Real Estate Funds. Note that as REITs are an alternative financial instrument, not all of the usual financial metrics used to value stocks and bonds are applicable or even suitable.
OVERVIEW OF SECTOR
The real estate sector, a part of the alternatives sector, comprises investing in physical property or land. This can be through buying the actual property or through financial instruments called REITs, which pool together investors’ funds to invest in companies which invest in income-producing real estate. Real estate can produce income via rents, making for a stable long-term income, as well as capital gains as property values rise over time and from mortgage interest repayments.
Real Estate Investment Trusts (“REITs”) vs Real Estate Funds (“REFs”)
Real Estate Investment Trust and Real Estate Funds are not the same.
- A Real Estate Investment Trust (“REIT”) is a corporation, trust or an association which invests directly in income-producing real estate which are commonly traded like a stock.
- A Real Estate Fund (“REF”) is a type of mutual fund primarily focused on investing in real estate securities offered by public real estate companies such as (i) securities of REIT(s), (ii) shares of open and/or closed-end real estate funds, and (iii) mortgages or interest securities of real estate.
Key differences between REIT(s) and Real Estate Fund(s):
|Real Estate Investment Trusts (“REITs”)||Real Estate Fund (“REFs”)|
|REITs commonly invest in REITs and real estate related stocks.||REFs invest directly in real estate and owns, operates or finances income-producing properties.|
|REITs can be traded publicly on major exchanges, publicly registered but non-listed, or private. (However, in this report we will be focusing on publicly traded REITs). Prices of REITs fluctuate throughout the trading session with most of them being very liquid and thus trade only in substantial volumes.||Real Estate Funds do not trade like stocks. Share prices are only updated once per day and can only be bought directly from the company that created it or through an online brokerage.|
|90% of a REITs taxable income is paid out as dividends to shareholders which is how investors generate their income.||REFs provide value through appreciation so they may not be the best choice if you are looking for passive income or short-term gains.|
To sum it up, REITs and REFs offer investors a way to access real estate without the need to own, operate or finance properties. In general, REITs can provide a steady source of income through dividends. REFs on the other hand produce most of their value through appreciation, which makes them attractive to long-term investors.
What qualifies as a REIT?
The business model of most REITs is that the REIT leases space and collects rents on the properties, then distributes that income as dividends to shareholders. To qualify as a REIT, a company must comply with certain provisions in the Internal Revenue Code (“IRC”). Requirements a company has to meet to qualify as a REIT varies between countries. As we are focusing on the US, the major requirement for the US is that a company must pay out >90% of its net income in the form of dividends. But for example, UK-REITs are limited to investing in the UK and cannot be open-ended investment companies and similarly distribute at least >90% of their exempted rental income to shareholders to avoid income taxes.
Breakdown of REITs
REITs offer investors income potential as well as the liquidity of traditional stocks. The three main type of REITs are:
|Equity REITs||Owns and operates income generating real estate. Companies must pay shareholders at least 90% of their income in the form of dividends. Major revenue: from real estate property rent.|
|Mortgage REITs (“mREITs”)||Lends money to real estate owners/operators by either (i) directly through mortgages and loans, or (ii) indirectly by acquiring mortgage-backed securities. Major revenue: from interest earned on mortgage loans (financial real estate).|
|Hybrid REITs||A combination of Equity REITs and Mortgage REITs|
In order to invest in a variety of assets such as real estate funds to diversify a portfolio, there are three structures which REITs adopt, which are REIT ETFs (electronically traded funds, UCLIF’s focus), REIT Mutual Funds (such as OEICs) and REITs Private Investor Funds (companies that are exempted from SEC registration and are not listed; commonly only sold to institutional investors).
Global Real Estate Investment
A total of 40 countries in the world have adopted the US-based REIT approach to real estate investment offering all investors access to portfolios of income producing real estate across the globe. Mutual funds and exchange-traded funds (ETFs) offer the easiest and most efficient way for investors to add global listed real estate allocations to portfolios.
Incorporating global-listed REITs in a portfolio has evidently produced higher annualized returns, by almost 10%, and lower risk compared to a portfolio without global-listed REITs through analysing risks and returns of various asset classes (stocks, bonds, real estate and cash) for the period 1976 – 2014.
What is a REIT ETF?
REIT ETFs are exchange-traded funds (ETFs) that invest the majority of their assets in equity REIT securities and related derivatives. REIT ETFs are passively managed around an index of publicly-traded real estate owners. Two frequently used benchmarks are the MSCI U.S. REIT Index and the Dow Jones U.S. REIT Index, which cover about two-thirds of the aggregate value of the domestic, publicly-traded REIT market. Many investors are planning to move their investments from mutual funds into ETFs due to the rather consistent share insurance it also provides.
FUNDAMENTAL QUALITATIVE SECTOR ANALYSIS
REITs invest in the majority of real estate property types, including offices, apartment buildings, warehouses, retail centres, medical facilities, data centres (a rising sector due to the increasing demand of technology as well as cloud spaces for storage), cell towers, infrastructure and hotels. Most REITs focus on a particular property type, but some hold multiple types of properties in their portfolios, called diversified REITs and lastly speciality REITs (the ones that do not fit into any category).
Office REITs have seen most of their rents paid as many companies are able to continue trading or benefitting from government support schemes. Furthermore, there is still a lot of uncertainty as to how long this pandemic is likely to continue and whether working from home will become a more permanent fixture, leading many firms to keep their office space in the interim. However, there are pressures on landlords to ensure offices are COVID-proofed for if workers do choose to return at some point, albeit likely at reduced capacity.
Retail REITs have been badly affected by the lockdowns globally, as shops and restaurants alike have had to shut. Many of them have been unable to stay afloat despite government aid, as they are unable to be carried out from home and have had to cease trading indefinitely. Therefore, rental payments have been poor resulting in poorer REIT performance. Lodging REITs have performed similarly, as they are very dependent on the leisure and tourism industry, which essentially halted to a stop when lockdowns were imposed. There has been some respite as lockdowns eased, however, this did not last long as fears of a second wave spread through large parts of Europe and the summer holidays finished. Many however are skewing more towards a positive view amidst the development of COVID vaccines and their release starting at the end of 2020.
In direct contrast, Industrial, Infrastructure and Data Centre REITs have somewhat benefitted from the lockdowns, as it was seen to accelerate the rate of digitalization in economies. Speciality REITs have similarly performed well when they were focussed on digital advancements such as 5G, the Internet of Things, big data enterprise and cloud computing, and is predicted to only further rise from here as the top ten of the fastest growing industries revolves around the usage of software implementation and automation – heavily reliant on technology. Other speciality REITs that have performed well are Timberland and Supermarket REITs, as housing demand increased and supply decreased due to forest fires in the US, and as people have increased the proportion of their income spent on food during the various lockdowns. Certain shifts towards sustainability have also created growth opportunities for some of these subsectors.
Self-storage REITs have also outperformed the general market, as they have seen a high percentage of rental due paid and have therefore, been relatively recession proof this time. With a potential reduction in supply on the horizon, this is likely to further boost existing self-storage REITs’ performance. Residential REITs have been very unevenly impacted, with certain geographical regions benefitting more so than others (such as with people moving to the country with an increased focus on homes during lockdown).
Many investors are moving towards higher ESG rating investments. In terms of the environment, working from home has actually resulted in reduced carbon emissions, as people reduce commuting and offices are left closed. However, a lot of previously non-disposable and reusable items have been moved away from, in the attempt to comply with social distancing and new hygiene standards. The developments in technology may also have moved closer towards digital cities, which has room for growth in the real estate sector, however, the pandemic may have discouraged city-living to an extent. Overall, the environment is also more focused upon in developed countries compared to developing countries, as it is yet to become as viable a consideration in consumption decisions for individuals.
Changes in other legislation, such as in planning regulations and in terms of what securities are available to the public (especially the case in developing economies, where REITs are starting to become an investment option) could also affect the performance and popularity of REITs.
FUNDAMENTAL QUANTITATIVE ANALYSIS
The key ratios to look out for here are therefore, the AFFO pay-out ratio, FFO pay-out ratio, the price-to-FFO-multiple, debt-to-EBITDA ratio, interest coverage (FFO over interest) and capitalization rate.
Expense and Debt Ratios
Here we can see that between 2007 and 2019, the interest expense as a percentage of NOI has decreased significantly. This means that a lower percentage of REITs were willing to take on as high costs. This reflects an overall shift towards a more cautious stance for REITs, as debt to book assets and debt to market assets ratios have also decreased overall over this same time period. This could be partially explained by poor performing REITs who had too much debt failing, but also by fewer REITs using highly leveraged, higher risk strategies in the wake of the 2008 Financial Crash.
The average price-to-FFO multiple can range between 3 and 24, depending on the size of the REIT and which subsector it focuses on. TTM figures are used (trailing 12 months). Below is a summary of REIT performance up to August 2020. Small cap REITs outperform larger REITs during the pandemic, likely due to their propensity to have higher pay-outs to make up for the higher leverage involved. However, it seems that money did flow away from them and towards larger REITs, as they were seen as less risky to weather the pandemic.  
This also filters through to 2020 performance with micro and small cap REITs having suffered a larger fall in performance than mid cap and large cap REITs, who may have had more diversified portfolios and stronger balance sheets. Considering that some of the largest REITs by capitalization are also in the technology (or a sector heavily dependent on technology and recent technological advancements) sector, they may also have been naturally skewed towards the better performing sub sectors through the pandemic. Considering that the pandemic has also accelerated the speed of digitalization in the economy, it has also boosted existing trends and therefore, benefitted already stronger companies and sectors in the economy.
A look into the various subsectors demonstrates that performance really does vary between them. As analysed later on, retail and hotel real estate have struggled badly in terms of price, lowering their Price/FFO ratios, while others have continued to provide strong growth, albeit with less of that growth filtered into prices perhaps, as uncertainty remains.
U.S. Equity REIT Average AFFO Payout Ratios
The leftmost graph is from Mar 31, 2020, with high payout ratios for the majority of subsectors (due in part to the regulation of high payouts in order to fall into the REIT legal classification). There were significant falls in payout between Q1 (chart on the left) and Q3 of 2020 (chart on the right), as the effects of the pandemic heavily impacted some subsectors, however, this did not correspond directly with the AFFO Payout Ratios, as some continued to pay out high percentages to keep investors’ fears at bay, as long as they were able to receive some form of income.
Economic uncertainty is rife throughout not just the real estate sector, but across all sectors. Many real estate subsectors are cyclical-i.e. retail REITs perform well when macroeconomic indicators are positive. This is because higher consumption by consumers would lead to higher occupancy rates as more businesses come in to profit from this, as well as higher rental payments, as retail businesses are able to thrive on higher spending. Although arguably, in the UK, the high street was already suffering with the increase in e-commerce growth, and even in years of positive economic growth, these businesses may have been struggling. Residential REITs are also potentially cyclical, with people struggling financially unable to pay rents during times of economic turmoil. However, considering that having shelter is a necessity, people tend to be quite likely to try to pay these rents in contrast with other items and therefore, it can still be considered more defensive.
The performance of many subsectors is dependent on how long the Covid-19 pandemic lasts, as while many REITs and other real estate companies have reserves of cash in order to weather a sudden economic crash or a poor economic outlook for a while, these strong balance sheets will start to deteriorate. Also, as the lockdown increases in duration, the economic fallout to individuals and businesses is also worse as those who have seen their incomes reduced and livelihoods taken away are unlikely to be able to find alternative income streams to keep them functioning. Furthermore, government support schemes will likely be reduced as the pandemic draws on, with increased pressure on government finances and pressure to ensure that any assistance reaches those who need it most dearly. This also brings about the issue of political risk, in terms of the US election, where expectations may or may not be met, leading to potential turmoil in markets overall. Furthermore, government policies towards affordable housing for younger people may change-perhaps to something that tackles the issue better or alternatively, worse. Alternatively, considering that some housing markets are fuelled by investors, many of whom may be from overseas, political events such as Brexit and the implications of that, may dampen the market. Taxation policies, not just on Stamp Duty (as in the UK) and inheritance as for residential real estate, but also in terms of a potentially more progressive system or a system that reclassifies how REITs should work, could affect the performance and fees for REITs.
Brexit would also affect economic growth in the UK in other areas, and therefore, not just reduce the amount of cross-border investment, but also reduce performance of UK assets by poorer rental incomes and price growth. Differences in regulation may also further affect trade and change the demographics involved in the real estate market, potentially changing performance between the different subsectors. Currency fluctuations could also affect performance, however, since currencies are highly dependent on speculation, it is often just a risk that is taken when investing in foreign assets, that can be hedged against.
These are the two suggested REIT ETFs I would suggest to invest in after an overall analysis and risk evaluation.
1. SSGA SPDR ETFs Europe – Plc Dow Jones Global Real Estate (GBRE)
Since its inception in October 24 2012, it now has a current market cap of $165.78m. It’s REITs and REIT Securities makes up 83.93% and 11.89% of the portfolio respectively, which includes equity REITs and REOCs from emerging and developed markets around the world. This fund is expected to increase in price as its fundamentals remain strong and with the predicted economic recovery, it should benefit. Top companies in their portfolio consist of industry sectors such as Healthcare, Data Centres and Residential (senior focus) which are currently a high demanding market. With the rise of senior citizens (60+ y/o) predicted to be 1.3b by 2030, demand for home care will be increasing in the near future; in which COVID patients will also contribute to that growing number as more sickbeds are demanded. Given the rise in technology and cloud computing, the storage needed for those software systems are 3 times the amount of traditional computing hence the surge demand for data centres. Following that however, as e-commerce increases, retail REITs will be affected due to the potential decrease in physical stores to reduce cost and engage a wider network of consumers. Simon Properties, a retail REIT and the second largest component within this portfolio, may have an overall effect on this ETF Ticker, although it only has a weighting of 1.73%.
Overall, I believe this GBRE is well positioned to benefit from the current economic trend. It is currently trading in GBP, eliminating FX rates and with an indicative spread of just 0.3%, it is a strong buy for a mid-length investment. Momentum indicators seem to be pointing towards a gradual increase and analysts also predict a U shape recovery of the stock price post-pandemic. However, there is an ongoing charge fee of 0.4% which may be relatively high compared to other ETFs but with the strong fundamentals and promising growth outlook, the small fees paid would not affect much of the investor’s returns – a quarterly yield of 3.0%.
2. SSGA SPDR ETFS Europe – PLC FTSE EPRA Europe EX UK Real Estate UCITS ETF (EURE)
Incepted in August 10 2015, EURE has some pretty strong growth drivers which makes this another good investment. Firstly, it has a strong expansionary fiscal stimulus in Germany (38.63% weightage), part of the G7 countries, whereby it’s real estate market is classified as one of the best in the world – concrete gold. Due to the budget surplus from the pandemic, the government injected large fiscal stimulus into the economy such as providing state subsidies which led to a sharp increase in the prices of houses in Germany affecting the residential REIT which EURE has a 19.99% dip into Vonovia, with a current market cap of €32.02b. With 10-year mortgage rates falling to as low as 0.6% and banks increasing their lending, the price of houses will continue to experience a rapid increase in Germany.
The rising demand for care homes further strengthens this ETF as it has a 98% exposure to Deutsche Wohnen SE, owning a €14.75b market cap of the industry. Given Germany has seen a +21% YoY between Jan-Sep 2020, this strongly flags a potential growth driver. Lastly, with vaccines available as early as Christmas, the aggregate demand will be set to resemble pre-Covid normality with the rise of purchasing power of consumers. Overall, with 73.95% being invested directly in real estate, the expected appreciation in the German real estate market will have an immediate increase in the ETF’s performance, and further proves why EURE is a strong investment.
REITs are compared using different valuation metrics compared to stocks, to take into account the differences in structure, as mentioned above. Some common metrics are detailed as below.
- FFO (Funds from Operations) refers to net income (compliant with GAAP, the generally accepted accounting principles) + depreciation and amortization – gains from property sales. This gives a more accurate depiction of the operating cash flow of REITs and how stable dividend payments will be. Considering that REITs are required by regulation to pay out a high percentage of their income, a healthy FFO pay-out is generally in the range of 70-90%. If it is much higher, this may be a sign of trouble, as it may signify that management is too focused on short term returns.
- AFFO (Adjusted Funds from Operations) is FFO -capex + straight line lease revenue (when a REIT gets paid rent up front) + amortization + debt + equity issuance costs. It is similar to free cash flow for a stock.
- Capitalization rate = net operating income/current market value
- Debt to equity ratios are used to ensure that a REIT is both efficient in its use of leverage and not over-leveraged. REITs have an average D/E ratio of around 366%.
- Interest coverage ratios (EBITDA or FFO/interest expense) of 3x are considered a benchmark for REITs to be able to cover fixed costs. However, as of 2019, 80% of REITs had coverage ratios above the benchmark, part of a shift towards higher coverage ratios in the sector since the Financial Crisis in 2008.
Healthcare REITs can be split into five subsectors, including senior housing, skilled nursing, hospital, medical office and research/lab space. The senior housing sector has fared particularly badly, with care homes struggling immensely (record-low occupancy) as they suffered from Covid-19 outbreaks.
Many nursing and care homes saw falls in revenue as a result and therefore, rent payments are likely to fall in the near future, reducing dividends from REITs with exposure to this sector. However, this is unlikely to continue past the pandemic, as the baby boomer generation is expected to fuel high demand for such facilities. This is, however, dependent on the levels of supply in this sector, as it has historically stifled rent growth here. In skilled nursing REITs, the pandemic has added strain on operators, but government assistance has somewhat mitigated this. Hospitals have seen layoffs due to the suspension of elective surgeries and other less urgent services, putting further strain on hospitals. However, the latter two sectors are very dependent on government policy and if it changes significantly, such as with the upcoming election in the US, they may see a large fall in government funding or from private health insurance, as people are perhaps being encouraged to utilise lower-cost healthcare options available. Medical office REITs have stayed relatively robust with close to 100% of rents (based on pre-Covid-19 levels) being paid. However, they may be at permanent risk though, as there has been an increase in the uptake of telemedicine. Research and lab space have also remained less tumultuous as these functions carried on throughout the pandemic, becoming perhaps more valuable. Their strong fundamentals have also factored into this. 
Overall, healthcare REITs have outperformed other real estate subsectors, as rent averaged about 96% throughout the lockdown through to August. They are also considered more defensive generally. Healthcare REITs have been trading at a discount to other REITs, in terms of lower Price-to-FFO multiples of 15.8x to the overall REIT sector average of 20.7x. It is also trading at a 10-20% discount to Net Asset Value.
Another impact of the pandemic to note is the exacerbation of wealth inequality globally. This is because those who were on lower incomes to begin with were more likely to lose their jobs when the lockdown began, as their jobs tended to come with lower job security and a lot of those jobs were in retail sectors or other sectors where the daily tasks could not be performed virtually nor would they have been of as much use if they had. Furthermore, it has led to increased gender and racial inequalities, such as many women having ended up leaving the workforce in order to take care of children, rather than their male counterparts. This could also lead to future changes in the socio-economic landscape and the structure of the economy.
Another factor to note is the acceleration of digitalization in the economy, as the pandemic has encouraged a much larger demographic to embrace certain aspects of digitalization. This involves the increase in working from home, the increase in e-commerce (as people have been unable to go out and shop) and the increase in the usage of contactless payments. This has benefitted some REITs as discussed earlier. However, whether this will have a longer-term impact, depends on whether this has reached people who otherwise would not have adapted to these technologies, or whether it has only sped up adoption by those who would have joined in the next few years, reducing growth in that time period.
Certain technologies have also benefited and seen increased investment as sales have soared. This may have resulted in further development of new technologies, increased ease of usage for some products and improved home working capabilities for many firms. However, this does potentially bring about regulatory issues and social issues, such as in terms of monitoring and in terms of a daily fall in face-to-face interaction. Whether the pandemic will result in a permanent shift in social habits is yet to be seen, depending on to what extent alternatives are created and adopted during this time and for how long the pandemic lasts for. The long-term effects of this to different demographics is also yet to be seen, potentially paving the way for new businesses and opportunities in the future.
Longer Term Trends
Alternatives are also gaining increasing popularity where more traditional securities have failed to provide satisfactory returns, or simply be it due to the increased awareness and short-term trends involved. This may also have in turn spurred the increase in these sorts of products and alternative vehicles, which in turn boost the popularity of the sector further. While the pandemic has impacted REITs, due to regulations on the proportion of income to be paid out, REITs are likely to be able to provide some sort of income through these turbulent times, provided they are in a subsector which has not been too badly hit. Longer term trends do include that residential property prices have increased on aggregate and that there is not another housing crisis expected. Certain subsectors also have strong growth prospects, such as data centre REITs and senior housing as Boomers hit those ages.
Some key risks to note is that while the underlying asset of real estate tends to be quite illiquid, the security itself is not so and thereby, when investing in ETFs or OEICs this risk is mitigated. There is also the risk that the underlying asset will not perform well due to the non-repayment of mortgages and over-leveraging (more of an issue with m-REITs, especially with those which rely on risky mortgages, such as New Residential Investment Corp). Economic uncertainty such as in the current economic climate, may also affect the performance of some sub sectors negatively, however, others have not suffered nearly as much. Technological advancements could also render some REITs less profitable as new ideas take their place. However, by buying a fund and gaining diversification through it and other asset classes, these risks are mitigated to acceptable levels. One last thing to note is that fees can affect the performance quite greatly over time and once again, by choosing certain ETFs or OEICs, this issue is also mitigated.
For data centres, it is as the amount of data grows and companies move their data storage off their own premises and into data centres. This is because of the increased reliance on technology to perform daily tasks (including commerce) that were previously completed face-to-face. It also accelerated the adoption of technology into the home, as many workers who previously did not have such technology in their homes received it in order to work from home; even in some developing countries where this was considered less common. However, there are of course geographical discrepancies here as not every company in every country was able to shift to working from home. Furthermore, some diversified REITs may have benefitted from the strong performance in these subsectors, depending on the relative proportions of these subsectors to worse performing ones.
In the UK in particular, fewer downsizing purchases have occurred since the start of the pandemic, yet the overall residential market remains strong. Mortgage approvals have reached highs not seen since 2007, to the point that banks have had to raise mortgage interest rates to try to combat this rise in demand. The longer-term outlook may be slightly less buoyant though, as factors such as Brexit may limit foreign investors interest in UK property and working from home potentially becoming a more permanent fixture, as this would reduce the demand for property in cities.
Furthermore, the pandemic has unevenly affected different demographics, such as with young people being left worse off, both in terms of lost income and career prospects. While this may impact REITs dependent on rental income, young people have struggled to get onto the property ladder even before the pandemic and therefore, this is unlikely to make as much of an impact on housing sales in the short term. Healthcare REITs saw mixed performance as nursing homes struggled while medical office REITs benefitted with close to 100% of rental payments.
These subsectors themselves could be split into different types of properties and therefore, the figures may be skewed by certain elements of those sub sectors which did benefit, i.e. with medical REITs doing well under healthcare whereas nursing homes suffered. The worst impacted industries, i.e. hotel and shopping centres and malls, saw large falls in AFFO Payout Ratios, as they were immediately impacted when lockdowns resulted in their tenants having to shut, stopping their income stream entirely and thereby, stopping rents. Even with government assistance in certain geographies, the uncertainty these businesses faced for the long-term as a vaccine has still yet to be developed, has resulted in much lower rental payments as a percentage of the total owed. This was much lower than in say, office sectors, where firms were able to continue operating with staff working from home. The summary of the YTD performance of the different subsectors is included above.