REIT Investors Find Bigger Returns in Alternative Property Sectors

Posted on September 19, 2017

Year-to-date returns on the FTSE NAREIT Index show that the REIT categories that are leading the pack this year are data centers and infrastructure.

Investors searching for alpha returns in a maturing real estate cycle are looking beyond the mainstream REITs to some of the outliers, such as data centers, cell towers and manufactured housing.

“We’re seeing a lot of non-core REIT sector outperformance,” says Haendel St. Juste, senior REIT analyst at Mizuho Securities USA. The core real estate sectors aren’t as interesting for a number of reasons, including slowing growth, as well as bigger headwinds facing some individual sectors, he says.

Year-to-date returns on the FTSE NAREIT Index show that the REIT categories that are leading the pack this year are data centers and infrastructure, with total year-to-date returns as of Sept. 8th at 31.9 and 31.3 percent respectively. Manufactured homes also have been strong at 19.0 percent and industrial at 19.8 percent. On the flipside, those sectors that are at the bottom of the pack include retail at a loss of 9.8 percent; lodging/resorts at a loss of 2.4 percent and office at a loss of 0.9 percent.

“Investors have had to migrate outside of those core sectors to create alpha returns this year,” says St. Juste. “That is a dynamic that will probably continue in the near term, because many of those sub-sectors continue to have a growth advantage.”

Some of the traditional mainstays have struggled this year. Office has been flat and there is not a lot of excitement from investors about that sector, notes St. Juste. “Retail is a subsector where people just don’t know what to make of it and are approaching it with a lot of apprehension,” he adds.

Retail REITs are getting hit by weaker performance, as well as a more negative perception of the space. “We are clearly over-retailed in the U.S. and the growth in e-commerce is really not helping brick-and-mortar stores,” says Joi Mar, an analyst at research firm Green Street Advisors. That being said, retail is a mixed bag in terms of performance. Top class-A malls and well-located grocery-anchored centers are out-performing the class-B and -C malls and big box-anchored power centers. “Particularly among the low-quality malls, we think several hundred malls will close over the next 10 years or become irrelevant retail destinations,” says Mar.

Industrial has benefited from the growth in e-commerce and more demand for the distribution and fulfillment of those online orders. Import activity is also up, which is driving more demand for industrial space, while new supply has remained in check, notes Mar. “We expect rent growth to exceed inflation over the next several years for industrial,” she adds.

According to the latest Green Street Commercial Property Price Index for August, the industrial sector has seen the biggest increase in values over the past 12 months at 10 percent, while malls, strip retail centers and self-storage all posted drops in values, with malls at -6 percent; strip retail at -5 percent and self-storage at -3 percent.

There could be some improvement in the multifamily sector with new supply that is being absorbed and a slowing development pipeline. “We like apartments, but it certainly seems like the edge continues to be in those non-core real estate subsectors,” says St. Juste.

One non-core sector that may see its stellar performance fading is self-storage, with a year-to-date return at 1.7 percent, according to the FTSE NAREIT Index. The category has enjoyed a strong run over the past several years. However, its recent decline in performance is due to a number of factors beyond just a sector that is nearing its peak and experiencing slower growth, notes Mar. Secular demand drivers are also weakening in terms of shifting consumer trends, notes Mar. People are buying less stuff and relying more on technology. For example, as people continue to embrace digital technologies, they have less need to store things such as books, photographs and documents.

The bigger picture points to slower growth for REITs in general. According to the FTSE NAREIT All REIT Index, the total year-to-date returns as of Sept. 8th averaged 8.0 percent, which is lagging the S&P and Dow Jones Industrials indexes at 11.5 percent and 12.3 percent respectively.

Investors are not abandoning the REITs, but they are being more selective, notes St. Juste. There are concerns about late-cycle decelerating growth and more issues popping up in specific real estate sectors. The silver lining is that interest rates remain low, which is good for REITs, he says. REITs also tend to be viewed as a safe harbor for people who are seeking shelter in a more volatile economic and geo-political environment. So that could also help the sector, adds St. Juste.