I spent a lot of time last night studying real estate investment trusts (REITs) and real estate in general. The real estate markets have, of course, recovered nicely since 2008, and a lot of money has been made investing in REITs. Trailing only community banks in performance, it has been an important part of my returns for the past seven years.
Real estate has been a topic of great interest this past week -- driven by Ivy Zelman's comments on homebuilders and the three-way merger between Colony Capital (CLNY), Northstar Asset Management (NSAM) and NorthStar Realty Finance (NRF). I carry more real estate exposure than most. In fact, I am of the opinion that most individual investors have far too little real estate in their portfolios. In addition, real estate is the collateral for the loans made by small banks, so it's a subject to which I pay close attention.
It is a confusing time for investors in real estate securities. Yield seeking and index buying has driven many of the larger, publicly traded REITs to lofty valuations that make them a less-than-ideal investment. One of the greatest investors in the history of real estate is selling right now. Sam Zell recently said that it is hard not to be a seller of real estate at current prices -- and he has backed up his words with actions. He sold a portfolio of apartments for $5.4 billion to Starwood Capital Group, and Equity Commonwealth (EQC) -- a real estate opportunities trust (REOT) of which he is chairman - has sold around $2 billion worth of office properties in the past year.
Then I see an article in the New York Times saying that REITs have become a favorite target of activist investors -- which is usually a huge positive. According to the article, there were 26 activist campaigns against REITs last year. The piece quotes Adam Emmerich, a partner at Wachtell, Lipton, Rosen & Katz, as saying "REIT activism will become more frequent and more mainstream."
Earlier this year, Emmerich teamed up with colleague Robin Panovka to write Wachtell's real estate outlook for 2016. They wrote: "Merger and acquisition activity should continue at a steady pace, with a number of public-to-private and public-to-public REIT mergers already in the works. Hostile transactions remain viable in the REIT world, and we expect the same factors -- including institutional investor and activist support -- that have led to current record-high levels across all industries to result in more hostile REIT acquisitions." If that is correct, then we should see some strong returns from targeted REITS.
I read over the CBRE 2016 outlook for commercial real estate, and it was generally upbeat. The report said: "Moderate economic growth with low interest rates, punctuated with bouts of pessimism and volatility -- the factors that have characterized the world economy for the past few years -- are likely to continue in 2016, supporting moderate growth in commercial rents and investment sales volume globally."
The National Association of Realtors is also pretty positive in its recent outlook. It reported that "commercial real estate in smaller markets maintained its upward momentum during the first quarter, with REALTORS® reporting continued improvement in fundamentals and investment sales." Larger markets are also faring well, according to the NAR: "Demand for commercial leases continued rising during the first quarter of 2016. Construction has been growing across all property types, but the gap between demand and supply exerted downward pressure on availability."
That all sounds pretty good, but we also have a recent report from commercial real estate data and analytics firm, Real Capital. Its recent Big Picture report said: "For most property sectors... cap rates are either unchanged or down slightly from a year earlier. The combination of largely at cap rates and falling volume suggests a bit of a hung market."
Leading REIT research firm, Green Street Advisors, agreed with this outlook in a report of its own, saying: "So far, 2016 is shaping up to be the year when cap rates stopped declining."
Putting it altogether, it is obvious to me that the easy money in real estate and REITs has already been made. I don't think the ballgame is necessarily over, but it is getting late in the game. Prices are flattening out in many sectors, and when S&P moves REITs and real estate companies out of the Finance sector and creates a new Real Estate sector in the Global Industry Classification Standard, we are likely to see a new flurry of sector and index fund buying that stretches them further.
It is a time to be very selective. Not all the bargains are gone, but bargain real-estate assets are hard to find. Paying very close attention to net asset values, along with insider and activist activity, will be the key to making money as we get later in the game. Tomorrow, I will discuss a few ideas that I think can still bring in game-winning profits.
