This article originally appeared on institutionalinvestor.com on 12 June 2014.
In the years since the global financial crisis sunk property and related investments to tremendous depths, the U.S. commercial real estate (CRE) sector has regained strength and is well on the way toward recovery. Values for institutional quality properties are up roughly 70% from the 2009 trough and in fact are 5%–10% higher than the prior 2007 peak (see Figure 1).
Going forward, while further broad-based gains in CRE values will be more limited, we believe several factors point to a sustained and prolonged recovery. These include low supply growth, pent-up household formations, availability of capital across a variety of sources and strong demand from sovereign wealth funds and foreign investors. Additionally, while rising real interest rates represent a potential headwind for CRE capitalization rates and values, any sustained rise in rates would likely be accompanied by an improving U.S. economy, which in turn could create incremental demand and rent growth for well-located properties over longer time horizons.
However, not all real estate is created equal, and investors with bottom-up fundamental research capabilities and industry knowledge can target subsectors likely to provide superior long-term outperformance.
REIT unsecured debt: a clearer view into real-time value
Bonds issued by REITs – real estate investment trusts – are a vehicle for credit investors to participate in the commercial property sector or specific subsectors. REITs are unique within the corporate sector because calculating nearly real-time values for a company’s assets and liabilities is achievable with a reasonable amount of certainty; this is due to highly detailed disclosure best practices (in some cases down to the individual property level) as well as a generally active transaction market that provides reliable sales comparisons. Accordingly, performing reliable stress tests on REIT portfolios gives credit investors a valuable framework in assessing credit risk and the REIT’s ultimate ability to make timely payments of interest and principal at maturity.
In the average REIT capital structure (see Figure 2), CRE asset values would have to fall by over 60% before the value of a REIT’s unsecured debt exceeded the value of its assets and recovery on the debt dropped below par (see Figure 3). To put this in context, institutional quality real estate values fell by “only” 40% peak-to-trough during arguably the most severe financial crisis in recent history. Accordingly, we believe REIT unsecured bonds can provide significant equity cushion to weather an inevitable downturn in the current cycle.
Additionally, our research suggests nearly all of the REIT unsecured bonds currently outstanding contain meaningful debt covenants, which serve to prevent REIT management teams from over-leveraging balance sheets.
Specific covenants come in several forms, for example:
- Total Debt to Assets < 60%
- Secured Debt to Assets < 40%
- Interest Coverage Ratio > 1.5x
- Unencumbered Assets to Unsecured Debt > 150%
Other positive attributes that make the probability of default low and recovery value high for REIT unsecured debt in the event of default in our view include 1) the ownership of higher-quality assets that have a much broader buyer base than lower-quality assets, 2) the effective cross-collateralization of those assets, 3) the ability to issue subordinate equity and preferred equity as well as to sell or encumber assets in order to raise cash if needed and 4) the recent laddering and terming out of debt maturity schedules. By way of example, there has been only one default in the 20+ year history of the modern REIT era; these bonds did not have the standard REIT covenants and ultimate recovery was still 100%.
Attractive and less attractive real estate subsectors for the long term
While this strong track record lends support to REIT investing, we are always mindful of the cyclical nature of commercial real estate. PIMCO views the following subsectors as the most attractive over longer time horizons and better able to withstand downturns. All of these sectors share the same themes, including high-barrier-to-entry geographic footprints, below average capex (capital expenditure) requirements and solid cash flow generation.
High-barrier apartments. Since the financial crisis, household formation growth has been well below the long-term average. In the current environment, we believe the apartment rental market and the single-family housing market can co-exist comfortably. While the single-family housing market should continue to improve and home prices should continue to rise modestly on a national basis, we think demand for apartments will remain solid due to pent-up household formations and a growing younger cohort that is now more averse to homeownership due to high student debt levels, lack of down payments, strict mortgage underwriting standards and the desire for job mobility. Additionally, many of the jobs being created in today’s economy are in areas where single-family housing is unaffordable for the average person, making renting the only option.
Self-storage. The self-storage sector has a track record of posting consistent net operating income (NOI) growth during periods of both economic strength and weakness, thanks to broad-based demand: marriage, divorce, relocation, etc. Self-storage also features barriers to new supply given “not in my backyard” politics and limited availability of attractive land sites near population centers. Most importantly, owning and operating self-storage facilities requires very low capex, which drives significant and consistent cash flow generation.
High-productivity malls and outlets. The threat of further anchor box stores going dark remains elevated as e-commerce retail sales continue to take market share from traditional retail sales. While re-tenanting underperforming anchor boxes with higher-quality tenants could be a positive for lower productivity malls over the long term (assuming the rest of the mall is still viable), store closures hurt near- to intermediate-term results. Power shopping centers (those anchored by stores like Best Buy, Bed Bath & Beyond, Barnes & Noble, OfficeMax, Staples, etc.) will be more affected by the growing prevalence of e-commerce than centers anchored by grocery chains because most products sold in power centers can be ordered online and shipped the same day.
Winners in the shift toward e-commerce will likely be REITs that own well-located industrial and logistics facilities, as well as REITs that own retail centers in centralized locations that can act as showrooms, store pick-up locations and distribution hubs.
Hotel C-corporations. Hotel C-corps such as Starwood, Marriott and Hilton have all shifted toward an asset-light operating model, whereby an increasing percentage of EBITDA (earnings before interest, taxes, depreciation and amortization) is generated from highly scalable management and franchise fees, which require very limited capex. While hotel demand is still highly sensitive given daily “leases,” these companies generate significant free cash flow and carry very low levels of debt.
High-barrier office. New supply risk is more limited in high-barrier-to-entry markets such as New York City and San Francisco due to land constraints and lengthy permitting processes. Additionally, demand from foreign investors for iconic buildings in marquee cities has been strong and focused on long-term capital appreciation and storing wealth outside of their home countries. However, this strong foreign bid may be somewhat more vulnerable to a rise in global real rates given the more limited cushion between cap rates and interest rates on these assets.
We tend to avoid the following subsectors, as they generally do not possess favorable long-term investment dynamics:
- Suburban office centers face significant supply risk, and re-leasing vacant space is extremely difficult and costly. Additionally, the rationalization of work space per employee is a long-term secular risk that affects overall demand for office space.
- Data centers have decent near-term demand, but long-term capex is high due to obsolescence and technology risk, while new supply is looming in select markets.
- Low-barrier industrial warehouses face both new supply and obsolescence risk. These types of assets also have a track record of generating below-average rent growth.
- Hotel REITs are currently in the sweet spot of a multi-year recovery, but owning and maintaining physical hotel assets over the long term is one of the most capital-intensive sectors due to daily turnover and requirements to maintain brand standards. Long-term capex are typically 2x–3x the level of other property sectors.
- Low-barrier strip centers are the most at risk to the e-commerce threat and new supply risk over the long term.
Implications: look long-term at REITs
PIMCO’s longer-term approach to real estate credit leverages the firm’s significant resources, bottom-up analyses and proprietary valuation models to identify opportunities with attractive risk profiles and the potential for credit spread tightening and ratings upgrades. The outlook for REIT credit remains encouraging, specifically in companies with above-average exposure to high-quality assets in high-barrier-to-entry markets, relatively lower capex requirements and management teams with solid capital allocation and balance sheet management track records. We expect these attributes can drive consistent and reliable cash flow generation, as well as preservation of capital over the long term.