We met with UDR (NYSE: UDR), Essex Property Trust (NYSE: ESS), and AvalonBay (NYSE: AVB). Revenue growth for the sector has decelerated in 2017, but, there are signs that the outlook could be turning a corner, confirming the proprietary modeling we had previously done on the sector. Using UDR as a proxy, the current rent growth trajectory means that same store revenue growth could stabilize within the next quarter or two.
Additionally, most management teams are expecting new apartment supply to peak in 2017 and slowly decelerate thereafter. Rising land costs, lack of labor availability, and tougher financing for developers are contributing to the slowdown. For example, deliveries in UDR’s markets are expected to be down ~15% in 2018. However, there are a handful of major markets that will still struggle with new supply, namely Downtown/West LA, Washington DC, and New York City, to name a few. The apartment REIT sector as a whole has about 25% of net operating income (or NOI) exposed to these markets. Markets in the Southeast such as Atlanta, Orlando, and Tampa are also expecting elevated levels of new supply in 2018, but revenue growth should remain strong due to outsized job growth.
We also visited with Independence Realty Trust (NYSE: IRT) and NexPoint Realty (NYSE: NXRT), smaller apartment REITs that focus on more affordable Class B properties. Demand has been very strong for this product type, and organic NOI growth has been well above 3%. NOI growth has also been helped by the lack of new competition for the “B” quality units. Additionally, both companies supplement their organic NOI growth with accretive redevelopment projects such as adding new amenities, updating kitchens, and replacing carpet with faux wood floors.
We met with Public Storage (NYSE: PSA), ExtraSpace (NYSE: EXR), Life Storage (NYSE: LSI), and Cubesmart (NYSE: CUBE). Generally, expectations are for new supply to be slightly higher in 2018 than 2017. The increased competition has led to a bifurcation in operating results and highlighted the importance of portfolio location and quality, as well as operating expertise among the self storage REITs. However, despite the continued headwind from supply, many companies have noticed a moderation in the rent deceleration that they have experienced this year (though they are not yet ready to call a bottom). We felt cautious optimism from the management teams and believe same store NOI (or SSNOI) growth near the long term average of 3-4% could be back on the table over the next year or two.
Our meeting with LSI gave us confidence that reported results could bounce back in 2018 due to multiple catalysts. Houston (10% of SSNOI as of 3Q17), had been struggling due to the downturn in the oil industry and above average new supply. However, the company has been a beneficiary of the dislocation in Southeast Texas caused by Hurricane Harvey. Additionally, the Life Storage assets acquired in 2016 will enter into the same store pool in 2018 (a 16% expansion of assets). Included in these assets are stores located in California that were reassessed upon the transaction resulting in higher property taxes in 2017. As a result of easy operating expense comps, the addition of the assets to the same store pool should supplement SSNOI growth in 2018. LSI also revealed that revenue growth this year could have been impacted by up to 75-100 basis points (or bps) due to organic web search issues they were having with the company’s rebranding. For most of 2017, properties essentially disappeared, considering they were not found until page two on search engines. In October, 75% of properties finally made it onto the first page of the search results, and they expect the remaining 25% to follow soon.
We met with Vornado (NYSE: VNO), Boston Properties (NYSE: BXP), Cousins Properties (NYSE: CUZ), Hudson Pacific Properties (NYSE: HPP), and Kilroy Realty (NYSE: KRC). The Vornado meeting was eventful considering they provided an elaborate review of the Penn Plaza redevelopment in Manhattan. The company owns 9 million square feet (or sqft) of space, most notably 6.7 million sqft of office and the Hotel Pennsylvania, long considered an ultimate tear down for a higher and better use. The “economic” center of the city is moving from Midtown toward Penn Station, placing VNO at the heart of years of value add projects. The catalyst for this shift began with the massive Hudson Yards office development to the West of Penn Station and, more recently, definitive plans underway to completely renovate and expand Penn Station.
When originally built, it was designed for 150-200,000 passengers per day but recent counts are over 600,000. And, this number could rise to over 1,000,000 in the future. A massive public/private partnership called the Gateway project is now underway to improve infrastructure and build a new station encompassing the architecturally important, but vacant, Farley Post Office (Figure 1). In addition, the project will include the new Moynihan Office Building with 730,000 sqft and 120,000 sqft of retail in the new Train Hall, projected to open in 2020. This is a 50/50 joint venture with the Related Companies, the developer of the Hudson Yards.
Management has toured the campuses of all the major tech companies in California to get ideas of how to make space attractive to this group of potential tenants. Costs are estimated at $1,100 per sqft, and rents should be over $100 per sqft. Assuming operating expenses of $26 per sqft, the stabilized yield on the building would be over 7%, which compares to a capitalization rate of 4% on similar properties.
Longer term, Amtrak (the owner of Penn Station), NJ Transit, and the Long Island RR are working with New York, New Jersey, and the Federal Government to secure funding for two new tunnels across the Hudson River (2019 start of construction) and to repair the tunnels damaged during Hurricane Sandy. A significant expansion of Penn Station is included in a project that could take until 2030 to finish.
We met with GGP (NYSE: GGP), Simon Property Group (NYSE: SPG), Macerich (NYSE: MAC), Washington Prime Group (NYSE: WPG), and Penn REIT (NYSE: PEI). The fundamental environment for retail, albeit modestly improving due to fewer expected retail closures in 2018, continues to have plenty of doubters. Despite the seemingly “okay” fundamentals, mall REITs are selling at huge discounts to consensus NAV estimates due to the negative sentiment created by department store closures, retail bankruptcies, and market share gains by e-commerce.
The entire “Class A” mall universe was the most discussed topic of REIT World due to the unsolicited bid by Brookfield Property Partners (TN: BPY) to purchase the 65% of GGP that it does not own for $23 per share. At the same time, Macerich and Taubman (NYSE: TCO) attracted new activist shareholders, sparking all kinds of speculation about eventual outcomes in both names. These three REITs own roughly $75 billion in assets, and should all be considered in play.
Regardless, the activism and potential for transactions will demonstrate where the values of Class A mall companies are today. We view the bid by BPY has woefully low, and should thus be rejected by the GGP Board of Directors. In our opinion, the Board should hold firm until a price reaches at least $26 per share. While BPY is the only bidder as of the publication of this piece, one cannot rule out a club deal with SPG or other REITs entering into the equation. SPG, the largest retail REIT in the world, has thus far professed to have no involvement in any of the above REITs, but we believe they are simply too important in this property segment to sit idle. SPG made unsuccessful bids for MAC in 2015 and TCO in 2003, and could view the current environment as opportunistic to take another shot at one or both!
We met with American Tower (NYSE: AMT) and SBA Communication (NASDAQ: SBAC) at REIT World, but also met with Crown Castle (NYSE: CCI) in Houston a few weeks prior to the conference. Together, they own approximately 90,000 towers accounting for 60% of total macro tower count in the US. Despite all of the talk about 5G, the next generation of cell service expected to bring wifi speeds to wireless devices, none of the three anticipates any significant revenue increase due to the deployment of 5G in the near future.
One of the forgotten elements of cell service is the spectrum over which the data (and voice) must travel. In its current imagined form, 5G would be deployed on “high band” spectrum, meaning the signal loses strength after only several hundred yards (versus several miles for “low band” mHz spectrum) and cannot travel through walls or buildings. Thus, the amount of sites required for widespread service is uneconomical. Most likely, the near term use of 5G will be as a replacement for home wifi. Should their outlook prove too conservative and 5G becomes a widespread reality, it would be a huge boon for cell tower owners and investors.
Despite the lack of contribution to growth from 5G, all three stand to benefit from ‘densification’ of 4G and LTE in the US, the potential for a fifth US wireless carrier or a strengthened fourth carrier, and international data consumption growth (specific to AMT & SBAC). Notably, the tower REITs had a positive news event in early November when Sprint (NYSE: S) announced it was no longer pursuing a combination with T-Mobile (NYSE: TMUS). As a result, Sprint has been quoted as having to increase its spend on its network to $5-6 billion from $3.5-4 billion currently, a direct near term benefit for towers. In addition, the threat of non-renewals on towers where both S and TMUS lease space has been eliminated.
Seven years into the lodging up-cycle, revenue per available room (or RevPAR) growth has slowed significantly. With Smith Travel Research (or STR) projecting RevPAR growth of only 2.3% in 2017 and 2018, top line growth is going to be tough to come by for lodging REITs during the next few years. As such, the largest lodging REIT, Host Hotels (NYSE: HST), is focusing on growing the bottom line through margin expansion and shrewd acquisitions. Using its proprietary “Enterprise Analytics” program, the company is utilizing “big data” to optimize staffing decisions and drive margins at underperforming hotels. For example, the company is focusing on cutting room service and implementing a ”green choice” program so rooms are not cleaned if the guest doesn’t request it. In addition, the company has employed a third party to conduct “time and motion” studies which helps to optimize staffing efficiencies. For example, the company found that weighing silverware saves time and personnel versus counting the individual utensils needed for a large event.
These data points helped to identify inefficiencies at the Don CeSar, a recent acquisition in St. Petersburg, Florida. The company estimates it will add 150 bps in yield from the hotel by the end of its first year simply due to cost cutting. We believe the company is in excellent position to capitalize on this portion of the lodging cycle due to its pristine balance sheet and exposure to irreplaceable hotels that will be resistant to incoming new supply.
We met with all five of the US-based data center REITs, including Digital Realty Trust (NYSE: DLR), CyrusOne (NASDAQ: CONE), QTS (NYSE: QTS), CoreSite (NYSE: COR), and Equinix (NASDAQ: EQIX), as well as one Dutch non-REIT, Interxion (NYSE: INXN). Management teams remain enthusiastic about the balance of supply and demand in all large markets and data center types. Supply as a percent of existing inventory is approaching all-time highs, but occupancy and rental rates are holding firm and even improving as demand from enterprise tenants and cloud service providers continues to set new records nearly every quarter. Several REIT CEOs suggested that 2H17 total leasing may break the 1H16 record, with annualized net absorption remaining in the healthy 8-12% range.
Public cloud, interconnection, and network-dense colocation continue to grow faster than other services, but several companies mentioned that large global tenants are increasingly asking REITs to provide them services outside of their core competencies. We recognize the value of economies of scale in the data center business, but are somewhat skeptical of economies of scope. We favor companies that have had the discipline to turn down margin-reducing, “growth for the sake of growth” initiatives.
We sat down with all thirteen industrial REITs and had two primary takeaways. First, all but one REIT agreed that e-commerce and lean supply chain management had permanently altered the trajectory for long-term rent growth in last-mile and urban submarkets. Since the 1980’s, institutional-quality industrial rents have been laggards relative to other real estate sectors at around 1% for most markets and 2% for the absolute best urban submarkets. Every industrial REIT at REIT World said that they believed e-commerce and supply chain management should boost these numbers to 2-5% over the next 5-10 years, and urban market rent growth over 3% as higher rents are more than offset by lower total shipping costs.
Several REITs expressed concerns about the re-leasing prospects of suburban and remote big-box warehouses located on the edges of gateway markets, even those that are new. Such caution was unexpected given the backdrop of healthy demand globally. Several firms said that they were skeptical that such properties would be able to post positive releasing spreads when 2016-17 leases roll in the early 2020s. Their rationale for skepticism included: (a) tenants have leased space beyond current needs, (b) increased automation of picking and packing will result in smaller space requirements, (c) 25-75,000 sqft “last mile” warehouses will take a larger share of demand from >1 million sqft remote distribution centers, and (d) small tenants will need less combined space due to outsourcing to more efficient third party logistics firms.
We came back from REIT World meetings loaded with new ideas and other actionable information. However, there were no discussions calling for the immediate end of the current real estate cycle. Supply and leverage, the typical cycle killers, are currently both in-check. We also did not hear commentary concerning a collapse in asset pricing. Demand remains strong for most of the property types we met with, and even lower-quality retail assets are catching a bid (though the buyer pools are noticeably smaller). Lastly, rising interest rates remain a minor concern. Most of the REITs in the Chilton REIT Composite have stellar balance sheets and have taken advantage of the current low interest rate environment to fix their debt costs and extend their maturities. Dividend payout ratios are also at historical lows, which should allow for growing dividends even without outsized cash flow growth.
Bruce G. Garrison, CFA, firstname.lastname@example.org, (713) 243-3233
Matthew R. Werner, CFA, email@example.com, (713) 243-3234
Blane T. Cheatham, CFA, firstname.lastname@example.org, (713) 243-3266
Parker Rhea, email@example.com, (713) 243-3211
RMS: 2005 (11.30.2017) vs. 346 (3.6.2009) and 1330 (2.7.2007)
Previous editions of the Chilton Capital REIT Outlook are available at www.chiltoncapital.com/reit-outlook.html.
An investment cannot be made directly in an index. The funds consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use.
The information contained herein should be considered to be current only as of the date indicated, and we do not undertake any obligation to update the information contained herein in light of later circumstances or events. This publication may contain forward looking statements and projections that are based on the current beliefs and assumptions of Chilton Capital Management and on information currently available that we believe to be reasonable, however, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements. This communication is provided for informational purposes only and does not constitute an offer or a solicitation to buy, hold, or sell an interest in any Chilton investment or any other security.
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