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REITs in 2019: A tug-of-war between bulls and bears

Both bears and bulls have made compelling cases about what to expect for real estate investment trusts and commercial real estate generally in 2019, and so it may be wise to take a skeptical view of both sides.

Those who have put forward more bearish cases now have several quarters of underperformance in the public market in their corner to back up their projections for continued weakness. Public REITs' total returns have lagged the broader equity markets' for the last three years.

Industry players point to rising interest rates widely perceived as a drag on bond-like REITs and weak earnings growth as the main culprits. But there seems to be an X factor in play as well, expressed in, for example, the existential fear that has gripped dimensions of the retail and office markets.

In an interview, Ettore Santucci, a partner in Goodwin Procter's business law department, said that guessing at any given REIT's "true" net asset value has become "everybody's favorite sport" in the sector.

"At some point we have to wonder whether certain sectors permanently re-priced or at least re-priced for the foreseeable future as opposed to the usual cyclical swing around the NAV mean," Santucci said, citing the "spectacular" discounts for even the highest-quality office landlords.

"It's not that there is a fundamental disequilibrium in the market," he said of the office market. "Frankly, every client I work with is pretty happy with the operations."

The Morgan Stanley REIT team recently upgraded its outlook on the space to "In-Line" from "Cautious," and outlined a measured optimism for REITs in 2019, as the equity market rotates into a more defensive posture overall. The team qualified its thesis, however, as a "relative, not absolute call."

"We do not think REITs will be immune to broader market weakness, and the REIT sector is not broadly defensive, but we think it can perform in-line in the year ahead relative to the S&P 500," the team said, projecting returns for the year of around 5%.

The REIT team at Chilton Capital Management forecast a potentially favorable market for REITs as the broad flow of funds away from the space in the last few years reverses course in a risk-off environment and as low valuations attract more generalist investors. REIT earnings and dividends are more predictable than those of S&P 500 companies, generally. Moreover, new construction has remained low and there is potential for more substantial REIT M&A activity this year.

"In our opinion, the choppy yet positive economy (without a recession) could produce a near 'goldilocks' environment that could drive REIT prices from a current discount of over 14% to within 3-8% of NAV for the first time since 2016," the team said.

Opinions about 2019 range among analysts, who expect opportunity in certain property subsectors and continued weakness in others. Baird Equity Research's David Rodgers sees opportunity in the office market, where valuations do not reflect the improvement in fundamentals. The best opportunities, however, likely will be in the secondary markets and among REITs with exposure to the Southeast and West Coast, he said.

Stifel's John Guinee likes data centers' long-term demand picture, and industrial fundamentals appear to be on the up-and-up. But secular changes will continue to whip up dust in retail, and, in office, net effective rents are decelerating in "almost all markets." Expect underperformance in seniors housing through the year as the industry works through excess supply, he said.

Guinee noted that interest in the space from generalist investors "appears to come and go," and the active-funds flow among REIT dedicated investors continues to be negative.

Mizuho Securities USA's Haendel St. Juste, for his part, expects "more of the same" for mall and strip center landlords "tepid" earnings growth and more headwinds stemming from more store closures.

Goodwin Procter's Santucci said a measure of irrationality will likely continue to color the real estate market, with varied implications for the different REIT niches. The same market sentiment that has punished office and retail has put wind in the data center and industrial markets' sails. He noted that many of the age-old measures for gauging value in real estate across the public-private divide appear to have lost some of their influence, and that the exponential growth in the valuation of the office-sharing company WeWork, which now rivals those of the most established, high-quality landlords, reflects a certain "weirdness" in the commercial market, broadly.

"In a world where the old concepts make sense, WeWork should have been just a meteor, a flash across the sky very bright, very fast, and then it's gone," he said. "But it's still there, and it's burning pretty bright."

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