One year ago we discussed the case for active management in the US real estate investment trust (REIT) space during the late-cycle market environment. Our team view was that relaxed monetary policy implemented by global central banks had created a setting where both high-quality and low-quality US REITs could deliver respectable results for a defined period of time. At this stage in the market cycle, however, we have witnessed a widening gap in the corporate performance of US REITs we cover, with the lower-quality segment of the asset class showing further deterioration. With the US economic expansion and commercial real estate cycle moving into later innings, the Invesco Real Estate team continues to believe that active management is critical to finding opportunities in higher quality REITs while potentially avoiding companies which we believe will continue to face fundamental deceleration.
REIT earnings trends showcase the haves and have-nots
On a quarterly basis, members of the Invesco Real Estate securities team evaluate all 171 names in the FTSE NAREIT All Equity REITs Index, a universal and expansive index of domestic REITs. Every company is examined to evaluate its fundamental strengths and weaknesses. That evaluation includes each firm’s geographic footprint strength, real estate asset quality, corporate strategic plan, balance sheet strength and management track record. The US REIT universe is then ranked by these qualitative criteria, resulting in two groups of securities. Two-thirds of the names in the investable universe are considered to have passed our first set of fundamental screens and are potential investment candidates for our portfolios, while one-third of all names in our benchmark are considered to have failed our qualitative analysis. (Those companies cannot be considered for potential investment and are automatically sold if they are held in a portfolio.) By cutting off the left tail of the investment universe and avoiding names which have failed our fundamental analysis, we believe that we can create portfolios with better fundamental attributes versus our static benchmark while also potentially avoiding torpedo candidates.
The corporate performance of US REITs showcases a deepening divide between companies we see as fundamentally investable and those that we are seeking to avoid. Earnings growth has continued to moderate across the entire REIT sector as the economic expansion ages further into the later cycle. Earnings growth for companies which have passed our qualitative screens (higher-quality REITs) has remained respectable at 4.3%. This is a decent rate of growth, albeit slower than what was experienced in prior years. On the flip side, for the one-third of names that fail our fundamental analysis (lower-quality REITs), earnings growth has fallen to -5.1%.1
Figure 1: The widening earnings gap between higher-quality (passing) and lower-quality (failing) REITs
Balance sheet quality has shown a continued divergence
The difference in balance-sheet quality of companies which pass and fail our fundamental analysis suggests that the disparity between higher-quality and lower-quality REITs is even greater than what the earnings growth disparity implies. Companies which pass our fundamental screens have generally continued to de-lever during the period of 2015 to 2019, from an average of 32% to a current level of 30%. By contrast, companies failing our fundamental analysis have exhibited balance sheet deterioration and higher levels of leverage, from an average of 40% to a current level of 50%.1 While falling interest rates have recently given a reprieve to highly leveraged companies, our REIT investment team believes that the increase in leverage for many names in the failing universe will continue to be a signal of long-term corporate weakness.
Figure 2: Lower-quality (failing) REITs had significantly higher leverage than higher-quality REITs
Two sector examples of where active management may add value
Two US REIT sectors, retail and health care, have continued to show more broadly based fundamental deterioration. The retail sector has been in the crosshairs of investors and the media as e-commerce trends have hit the segment very hard. Questions remain about the viability of class B and C shopping malls, as well as lower-quality shopping strips. Our view is that malls and related shopping centers that have ample diversification may have a pathway toward success. Specifically, we favor those “work-shop-live-play” facilities that have grocery stores with a deeper portfolio of food and beverage options, as well as adjoining hotels or apartments. However, less experiential shopping malls and shopping centers with weaker demand drivers could continue to see additional fundamental deterioration.
Furthermore, the health care sector broadly has seen sluggish growth rates due to the overdevelopment of senior housing and assisted living units. We believe that demand may not catch up with heightened supply for a few years. However, the investment team believes that there are select names within the health care sector which will buck the trend and see positive growth rates in the next few years, but we continue to believe that selectivity will be essential.
The Invesco Real Estate team continues to believe in the merits of active management, particularly when it comes to the higher-risk portion of the US REIT universe. The reason why is that active management provides the team with the flexibility to overweight or underweight individual securities or sectors to potentially find growth or avoid risk. Our investment team believes that the widening disparities between higher-quality and lower-quality companies may allow active managers to provide more value to investors during the later stages of the economic and commercial real estate cycles.
About Invesco Real Estate
Invesco Real Estate has over 500 employees in 21 different markets worldwide with assets under management exceeding $80 billion as of June 30, 2019. Our focus areas include US real estate, global real estate, global real estate income, infrastructure, natural resources and master limited partnerships.
1 Source: Invesco Real Estate, as of June 30, 2019
Blog header image: Joel Filipe / UnSplash.com
The FTSE NAREIT All Equity REIT Index is an unmanaged index considered representative of US REITs.
Diversification does not guarantee profit or protect against loss.
Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.
The health care industry is subject to risks relating to government regulation, obsolescence caused by scientific advances and technological innovations.
The investment techniques and risk analysis used by the portfolio managers may not produce the desired results.