Manager Q&A: Real estate funds can rebound

By Alex Veiga
AP Business Writer

LOS ANGELES (AP) — It’s a great time to be a landlord. You just wouldn’t know it by looking at how real estate investment trusts are faring this year.

Demand for apartments, storage space and other commercial real estate has grown as the economy adds jobs at a solid clip. That’s pushing rents and occupancy rates higher, which translates into more profits for companies that own and operate apartment buildings and other properties.

A benchmark of publicly traded equity and mortgage REITs — the FTSE NAREIT All REITs Index — is down 2.2 percent this year, while the Standard & Poor’s 500 index is up 1.2 percent.

It turns out that investors are worried about looming interest rate hikes.

REITs are attractive to people who want high yields. That’s because their tax structure requires them to pay out most of their income to shareholders. But REITs also require a lot of money to operate. When rates rise, so do borrowing costs, which can translate into smaller dividends.

REITs also become less attractive to investors if Treasury rates go up.

Even so, investors’ concerns about the impact of rate hikes on REITs are overblown, says Marc Halle, managing director and head of global securities at Prudential Real Estate Investors. Halle believes that real estate REITs are undervalued and will generate better returns in the aftermath of a rate hike.

The portfolio Halle manages is made up mostly real estate investment trusts that own or operate office, industrial, retail and storage space, as well as apartments. Among its holdings are Mitsui Fudosan Co., Simon Property Group, Avalon Bay Communities and Prologis. Half the REITs are in the U.S., while the rest are companies in Europe, Asia and Latin America.

Below are excerpts from an interview with Halle, edited for clarity:

Q: What’s the biggest challenge you see to achieving better returns for real estate REIT funds?

A: It’s the perception of where rates are going and the uncertainty within the markets.

REITs have done very well when rates have gone up. REITs have also not done well when rates have gone up. But it’s not the rate increase which is the cause, it’s the fundamental nature of the market. It’s supply and demand.

When rates go up it becomes an inflection point for people to reevaluate the assets and look at it and say, ‘wow, there are compelling valuations and these assets are trading at significant discounts.’”

And you’ve seen that. Blackstone came in and did a (leveraged buyout). Apollo came in and did an LBO the past couple of months. You just saw Cascade investments, which is Bill Gates’ private fund — they just announced a significant equity purchase in one of the REITs.

So what you’re seeing is lots of private equity money recognizing the valuation gap in the REIT market and starting to come into the market.

Q: Are some REITs more vulnerable to rising rates?

A: You probably have heard a lot of REITs in the news over the past year or two, and lots of companies going public as REITs, but they’re not real estate companies. You’ve seen infrastructure companies, prisons, net lease, health care companies. You’ve seen lots of companies utilize the REIT structure for solving financial problems for their business.

About a third of the REIT index, this is where the ETFs trade, is made up of these companies that are not real-estate-related companies.

Q: Are you betting that REITs will generate better returns after a rate hike?

A: Yes. It’s either one of two things. Either the REITs perform better or you start to see a wave of (leveraged buyouts) of the companies. There’s lots of capital available. From our
perspective, you don’t want to see stocks trading at a discount. On the other hand, it’s a great time because it is clearly a discount to the private market.

Q: Do you favor any sector of real estate or any funds that just focus on apartments or office properties?

A: We’re a value investor. When stocks trade at a premium we’re going to sell those and move on to different sectors. Today we really like the mall space. We think malls trade at a big discount to their underlying net asset value. There’s lots of negative sentiment around why would you ever shop in a mall when you can buy anything on the Internet? And yet mall sales continue to do well quarter after quarter.

If you think about the distribution and growth of the Internet, you’re buying things off the Internet but they have to get to you somehow and they have to get to you through an industrial facility. We like that play. We like “A’’-quality malls, we like industrial distribution and we like some of the central business district office companies.