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Sullivan: Biggest Threat to REITs is Balance Sheet Complacency

Sullivan: Biggest Threat to REITs is Balance Sheet Complacency

Jim Sullivan manages Green Street's North American REIT research team. At different points during his 17-year Green Street career, he has been lead analyst for a variety of property sectors including malls, strip centers, healthcare, office, industrial, self-storage and manufactured home communities.

Newport Beach, Calif.-based Green Street Advisors has been offering real estate and REIT research for more than 25 years to help investors make the best investment decisions.

REIT Insider sat down with Sullivan to get his 30,000-foot perspective on the entire REIT industry.

An edited transcript follows.

REIT Insider: According to Green Street’s latest report, commercial property values seem to have plateaued. Do you expect this trend to continue, and if so, what impact will it have on REIT valuations?

Sullivan: Real estate operating fundamentals range from good to terrific in just about every property type. That, combined with a near absence of new development, should help prop up commercial real estate values. Green Street Advisors publishes a monthly Commercial Property Price Index revealing that values are holding steady after a robust two-year rally.

Property values have been drifting upwards at an inflationary-type pace for the better part of a year now. Historically low return hurdles continue to support valuations, but prices have been held in check for now. Green Street’s Commercial Property Price Forecast combines signals from the bond market with signals from the REIT market to gain insight about the direction of property prices over the next six months. Signals from both markets seem to suggest that the next leg for property values is up.

REIT Insider: Multifamily has been on a terrific run—in fact, some reports suggest the sector is getting overheated. What are your thoughts on multifamily REIT valuations—is there still room for growth or are they at peak pricing?

Sullivan: The supply/demand picture in the apartment business makes it a great time to be a multifamily landlord. However, rent growth has dramatically outpaced income growth, so some slowing of the torrid growth pace is to be expected. What happens in the single family market over the next two to three years could have a major impact on apartment operating fundamentals and values.

REIT Insider: Most REITs have cleaned up their balance sheets significantly and are in pretty decent financial shape. What do you see as the biggest threat to REITs today?

Sullivan: The biggest threat to REITs today is balance sheet complacency on the part of management teams. While REITs are generally in strong financial shape, some companies still have far too much debt on their balance sheets. In several studies levered REITs consistently fail to deliver higher returns to justify their added risk.

Surprisingly, this was even true in the ten years leading up to the market peak. Our valuation approach explicitly adjusts for variables that matter, such as balance sheet strength, while ignoring variables (e.g., dividend yield) that get undue attention from many investors. Eighty-one percent of our sells have high leverage!

REIT Insider: Green Street is a vocal critic of non-traded REITs. Has your opinion of the vehicle changed with the introduction of daily valuation non-traded REITs?

Sullivan: While daily valuation NTRs are an improvement over their highly flawed predecessors, most investors are much better off under most circumstances investing in publicly traded REITs rather than even the “new and improved” NTRs. Green Street Advisors, recently authored a report that evaluates the new breed of non-traded REITs and compares them to public alternatives.

The report explains that investors in non-traded REITs start in such a deep hole after 10 to 15 percent of what they invest is taken out upfront for commissions and selling fees, it is close to mathematically impossible for the performance of the underlying real estate to make up the gap. By contrast, investors in public REITs do not face this economic headwind

REIT Insider: Two of the main reasons why REITs are widely considered attractive investments –a hedge against inflation and their low correlation to the equities overall – seem to be less evident in today’s market given the low inflation environment and the volatility that REITs have experienced. What are your thoughts on this statement?

Sullivan: All investors should have five percent to 20 percent of a well diversified portfolio in commercial real estate, and publicly traded REITs provide a terrific way to achieve that investment goal.

Real estate has historically proven to be a decent inflation hedge and REITs indeed have been more highly correlated to the stock market over the past couple of years than they had been previously. But the real goal should be portfolio diversification, and REITs should be a part of that.

REIT Insider: When you look at the entire REIT sector, do you see any major disconnects between REIT operating metrics/fundamentals and the valuations they are seeing? In this instance, by disconnect, I mean certain sectors or certain REITs that are perhaps not appropriately valued.

Sullivan: Self-storage is a sector that has pleasantly surprised investors consistently in good times and bad. Hotels, by contrast, are a volatile sector where the rewards during strong economic conditions always seemed to be outweighed by the hits delivered during downturns.

REIT Insider: In your recent discussions/conversations with REIT executives/management, how do they feel about the current economy—are they encouraged or discouraged?

Sullivan: “Cautiously optimistic” is a common comment. The present is pretty good for real estate landlords, yet there is plenty of angst regarding future events including Europe , the presidential election, tax policy, and the overall economy.

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