Morningstar Advisor - August/September 2011 - 34

Sector Rap
Martin: It would be both. Location is important,
but the ability to execute a strategy certainly
cannot be discounted. If you're defining a moat,
it could be a niche. Alexandria Real Estate
Equities ARE, for example, leases space to
biotech and pharma companies. It's one of the
go-to providers when a GlaxoSmithKline GSK,
Johnson & Johnson JNJ, or Novartis NVS
wants specialized lab or R&D space. Alexandria
benefits from a unique expertise, competitively
advantaged locations in key lab space/biotech
clusters, and strategic relationships and
proximity with universities. Alexandria has a
business model that is very difficult to
replicate, and there are very few competitors.
Other differentiators might be a management
team with a full-service real estate skill set,
where there is an ability to acquire, develop,
redevelop, and manage properties. This ability
provides flexibility and growth options
throughout an economic, financial, or real
estate cycle. We are looking for REIT business
models that are not one dimensional and
are positioned to better manage risk through
the real estate cycle. Certainly, locations can
constitute a competitive advantage. I'm
thinking of Federal Realty FRT on the retail side;
it's been in the business of owning properties
for decades, and it has some of the best
urban infill locations for retail shopping centers
in the country, characterized by high incomes,
consistent population growth, lots of
traffic, and very few competing land parcels.
Lukasik: When we're talking about moats,
we're talking about the sustainability and
growth of long-term cash flows. The management
teams that have decided upon a strategy
that focuses on space-constrained markets
or areas with very favorable demographics are
the ones that have been able to build moats
around their property portfolios.
Ren: Underwriting can also lead to defensibly
growing cash flow to shareholders. In health
care, they're writing these leases that are cross
collateralized. If you're a tenant, and you're
locked into a 10- or 15-year lease, you can't
34 Morningstar Advisor August/September 2011
readily drop a poorly performing property, or
maybe you have a better-performing property
that's making up rent on a poorly performing
property. There are a lot of protections on these
leases that are hard to get out of.
Guziec: Where are the opportunities now?
Martin: There's real opportunity, even in a
slow-growth environment, for dividend growth
and for REITs to maintain dividend yields.
FFO dividend payout ratios average 69%-the
historical low is about 66%, and they've
historically averaged 70% to 75%-so REITs
are very well positioned from a cash-flowcushion
and balance-sheet standpoint to
maintain current yields and inflation " plus "
dividend growth. That's important because we
may see higher interest rates and inflation,
and equity REITs are well positioned to meet
these headwinds. Generally, our stance right
now is to be a bit more defensive, so we're
focused on equity REIT portfolios and business
models less dependent on the economic
cycle. We would also gravitate to longer leases,
where there is less cash flow volatility-for
example, health-care REITs.
I would also highlight multifamily. Despite there
being some valuation concern about share-price
multiples, as all of our apartment REITs under
coverage trade at least 30% higher than our
estimates of their fair values, the multifamily
REIT sector benefits from fundamental
tailwinds. Supply is healthy, and demand is
increasing; a combination that has resulted in
strengthening operating performance and cash
flows. Driving multifamily demand is a difficult
mortgage financing environment and singlefamily
home valuation uncertainty. On top of
this, home ownership can be expensive. Home
ownership attitudes are being reassessed.
Helping to fill the void has been multifamily.
Many of the equity REITs own high-quality
assets that are professionally managed and
offer numerous housing options and amenities.
Guziec: What's mispriced today? What can an
investor buy?
Lukasik: We think that the sector in general is
15% to 20% overvalued relative to what our
underlying fair value estimates are for the REITs
we cover. But we are finding pockets of
opportunity for investors that need to have
exposure to the space. We were talking earlier
about Alexandria-that's one that's trading at a
discount to our fair value estimate right now.
But in general it's difficult to find undervalued
REITs. In retail, for example, Realty Income O
is the only stock that trades below our fair
value estimate, and its discount is slight.
Choosing specific REITs will be very important
for investors who want to make money in the
space over the long term.
Guziec: What's driving the overvaluation
today? Is it as simple as yield-chasing?
Lukasik: I think it's a combination of a couple of
things. One is yield, as you suggested. As
traditional yield-type investments, like U.S.
Treasuries or corporate debt, have seen yields
go down, many investors are looking for
sources of yield, and the dividend yields on
REIT stocks have looked attractive. The other
factor is just a huge amount of capital that has
been allocated to commercial real estate.
We've seen it both on the transaction side for
individual properties and in the public markets
as well. There's been a huge sum of money
that's been raised to invest in commercial real
estate. And as that money flows into the
market, it drives down the cap rates and drives
up the values that people are able to get for the
assets that they sell.
Ren: There are quite a few motivated buyers
out there, but not as many motivated sellers as
one would expect given refinancing concerns.
The banks have still been playing a bit of
" extend and pretend " on commercial real
estate credits, so the availability of properties
on the market-there haven't been the
grave-dancing opportunities that people
prepared for. K
Philip Guziec, CFA, is a derivatives strategist for
Morningstar.
Morningstar Advisor - August/September 2011

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