Technological advancements have given us the ability to work remotely, but it wasn’t until COVID-19 that society gained a general acceptance of this. We at AACA believe this (and a handful of other structural shifts) may create significant headwinds for office landlords for decades to come. While there may be relative winners and losers in this scenario, we hold that office valuations do not reflect the new reality for the sector – particularly in dense gateway markets like New York City.
The Challenges of REITs, Rising Interest Rates, and Inflation
Investment in real estate securities and real estate investment trusts (REITs) have been seen as a diversifying opportunity to a well-balanced portfolio and one that can generate income. REITs, given that they own or operate real estate assets and typically generate income, can offer benefits of both income and capital appreciation in a portfolio. However, despite the benefits, REITs can also be correlated to equity and fixed income markets, due to their exposure (and dependence) on both.
In particular, REITs can be highly sensitive to interest rate changes. It can be observed that, over the short-term, prices of REITs may be inversely correlated to interest rate yields [FIGURE 1].
Diversification does not ensure profit or protect against loss in a positive or declining market.
P/NAV is an industry standard metric that shows valuation levels in real estate. Correlation is a statistical measure of how two securities move in relation to each other.
Why is this? A few fundamental reasons:
- Leverage. Many REITs are levered, and thus depend on debt to boost returns. As the cost of servicing the debt rises, the income generating potential is diminished.
- Rising rates. More importantly, even REITs that have low leverage can still be affected by rising rates or inflation. This is because not only are bonds impacted by rising interest rates, but, in fact, all bond-like instruments are impacted. That is, any instrument with an up-front capital cost and fixed dividends with no adjustment for growth or inflation will see a drop in value in a rising rate environment. Real estate fits this category very well, as the cost of properties is typically paid up front, and although lease amounts can be adjusted, the landlord’s ability to adjust the rent is proportional to lease length, which may be several years long.
- Higher yield requirement for risk. When interest rates rise, REIT investors also require a higher rate of return. Because there are additional risks in investing in REITs versus corporate bonds rated BBB- (which are the lowest investment grade tier, and typically used as a reference point for REITs), then REIT dividend yields must be higher to accommodate for this risk premium. Since the REIT yield cannot be adjusted upwards, the REIT price thus adjusts downwards to create a higher dividend yield.1
Because of a combination of these reasons, REITs can be hit in a rising interest rate or inflationary environment.
Can any REIT lessen the impact?
So how does one find opportunities in the REIT space that mitigate the effects of interest rates or inflation? We believe that AACA’s real estate strategy seeks such investment opportunity. Broadly speaking, AACA’s investment philosophy is centered on seeking investments where the landlord has leverage over tenants. This leverage manifests itself via more favorable lease terms for the landlord, and such investments by their nature have fewer of the characteristics previously mentioned.
Real estate companies that AACA seeks to buy have adjustments for inflation and should be less impacted by rising rates. For example, the largest cell phone tower company, which leases its network to mobile phone companies, has clauses in their contracts that adjust the lease amount by either 3% or an inflation index. As inflation in the U.S. has consistently been at or below 3% for the last 10 years, this company has benefitted from the higher 3% rent escalation. If inflation exceeds 3%, we believe that they will be protected, nonetheless.2
There are real estate companies that either reinvest a portion of their income, are growing faster than the economy and their cost of debt, or both. For example, the sole public property company that leases laboratory space to pharmaceutical companies has experienced same store net operating income growth of 5% per year for the past 10 years.3
Past performance is not indicative of future results. There is no guarantee that any investment will achieve its objectives, generate profits or avoid losses.
1 Dividend yield is only one component of REIT returns, along with the dividend growth rate and capital appreciation. In this example, we use them interchangeably as the yield is a large component of returns. 2 Source: Public company filings. 3 Source: SNL Financial.
AACA’s real estate investment strategy
Thus, AACA’s investment strategy is to be both better insulated from the impact of rising rates, and to demonstrate other characteristics beneficial to generating investor returns. More specifically, AACA seeks real estate investments with several unique, growth-oriented characteristics:
Monopolistic characteristics. For example, there are only three companies that have cellular tower networks. Competition is light in this subsector, especially when compared to the residential leasing subsector, which has hundreds of residential apartment providers.
Barriers to participant entry. A cell tower start-up would need to have the infrastructure, capital, and technological know-how to build 60,000 new cellular towers. By contrast, most anyone with a pick-up truck and an easily obtainable construction license can build apartments in Texas.
Barriers to tenant exit. The largest wireless phone provider has a strong marketing campaign based on the strength and reliability of their network. We believe that they are unlikely to switch tower providers for marginal lease savings, especially if it puts their reliability (and reputation) at risk.
Secular tailwinds/demand drivers. Consumers are voraciously data-hungry; Cisco recently did an analysis and estimated that data consumption in the US will increase 20% year-over-year for the next five years.4 Increasingly, consumers are using their mobile devices to consume this data, which subsequently increases demand for data centers. In contrast, residential apartments typically grow in the long term at about the US economic growth rate of 2%-3%.
In addition to those mentioned, there are multiple sub-sectors within real estate that meet most or all of these characteristics, such as infrastructure, gaming, and ski resort companies, that can help to lessen the effect of interest rate rises.
Past performance is not indicative of future results. There is no guarantee that any investment will achieve its objectives, generate profits or avoid losses.
4 Source: Cisco.
Overall, current prices in the real estate sector present an opportunity that has historically favored investors. A key metric, price/net asset value (or P/NAV), has historically shown marked cyclicality.
When P/NAV of the SNL Equity REIT Index has been low, subsequent returns have historically been positive [FIGURE 2].
More specifically, the forward six-month returns of the REIT Index were positive 90% of the time during these discounted periods [FIGURE 3]. Alternatively, when P/NAV has been high, subsequent returns have been mixed—some have been positive (57% of the time), while others were negative (43% of the time).
Although this is no guarantee of future performance, all else being equal, we believe it to be prudent to invest in REITs when they are trading at a discount P/NAV.
Opportunistic Real Estate
The unique, growth-oriented and inflation-protected characteristics of real estate investments exhibiting the qualities discussed above may prove to be useful in a rising rate environment. Furthermore, the current discount within the real estate sector has proven beneficial in the past to investors who have purchased at these lower P/NAV valuations.
SNL Equity REIT Index. A market capitalization-weighted index that included all U.S. domiciled publicly traded (NYSE, NYSE MKT, NASDAQ, OTC) Equity REITs in SNL’s coverage universe.
KEY RISKS: Stock market risk—stock prices may decline; Industry risk—adverse real estate conditions may cause declines; Interest rate risk—prices may decline if rates rise.
Many people don’t have an investment allocation to real estate investment trusts (“REITs”) because they believe they already have “enough” exposure to “real estate” through ownership of their home. REITs and your home are very different asset classes with very different characteristics. REITs invest primarily in commercial real estate, which is any non-residential property used for commercial profit-making purposes. Your home is an investment in residential real estate, which is a type of property, containing either a single-family or multifamily structure, which is available for occupation and non-business purposes.
Over the past 20 years publicly-traded REITs have returned an annualized 11.23% total return and homes have returned 3.47%, or just a little more than inflation. Over these 20 years, REITs returned more than 7x (740%) while homes didn’t quite double (98%). Publicly-traded REITs have been one of the top performing asset classes and homes have been one of the worst over the past 20 years.
There are many differences between REITs and your home that contribute to this notable difference in performance. The largest contributor is that commercial real estate can generate positive cash flows but the residential home you live in cannot. By living in your home, you are effectively consuming the market rate rent that your home might have procured. If you forgo rent, as you do by living in your home, the return profile changes to be basically little more than an inflation hedge. Performance of real estate follows the following formula: Total Return = price change + rent collected
With your home, 100% of the asset is in one property type and in one geographic market – this is concentration in its purist form, the opposite of diversification. On the other hand, with publicly-traded REITs, investors can choose from dozens of property types (including, but not limited to, specialized real estate sectors such as data centers, cell phone towers, casinos, medical research labs, infrastructure, prisons, ski areas, etc.) across any market in the U.S. and most major markets in the world. The opportunity for diversification in publicly-traded REITs vastly exceeds that of a single home.
Homes are relatively illiquid compared to public REITs that can be traded every day the stock market is open and settle to cash virtually immediately. This is in stark contrast to the home market, which may be illiquid for months, seasons, or even years, and can take months to settle to cash.
Transacting a home is much more costly than transacting in publicly-traded REITs. When you sell a home, the typical transaction cost is more than 6% of the home’s sale price (for perspective, based on data from the last 20 years as shown in the Total Return chart above, this is equal to about five years’ worth of your home’s price appreciation after inflation). In contrast, it costs little more than pocket change to trade shares of a public REIT ($7.95 per trade at Fidelity and $4.95 per trade at Scottrade).
Home ownership is not flexible. The entry price for a home is typically six-figures and you can’t really buy or sell a percentage of a home – it is binary: either you are in all the way or you are completely out. With publicly-traded REITs you can buy almost any amount you wish in single share increments (typically $20-$50/share) on the stock market. With public REITs you can trim, add or change a position in almost any amount on almost any day.
Supply & Demand
Perhaps the single most impactful factor that undermines home price appreciation is the ability of developers to add new product to the market. In our opinion, homes are the type of real estate most likely to be oversupplied because we believe they are the cheapest, smallest, quickest and least complicated real estate product type to build. AACA also believes that whenever the cost to build new homes is below the current market value of existing homes, builders will build new homes, which could create a price ceiling on the appreciation of your home. Additionally, in recessions, construction costs (materials and labor costs) decrease, which makes building new homes less expensive and creates additional new supply. This combination of factors could dampen your home’s price rebound out of a recession relative to public REITs, as shown in the historical graph below.
Let’s look at volatility of publicly-traded REITs and homes. Below is a graph of the past 10 years, which includes the financial crisis. Since public REITs trade on the stock market, the share price of these REITs are subject to fluctuation in the stock market and as such experience volatility. However, we would argue the underlying physical real estate owned by the REITs can’t be much different in volatility than your physical home. The difference is that your home isn’t bought and sold every day and marked to that market price. That being said, in the graph below we see that homes sold off -32.81% and public REITs sold off -58.89% in the financial crisis. However, looking at a longer period of time, homes captured 56% of the downside and 8% of the upside of public REITs over the past 10 years – homes have been asymmetrical to the downside. And public REITs have since gone on to return 105.17% over the past 10 years while homes have returned 8.56% in that same time period.
We believe you should think of your home first and foremost as the place you and your family live and second as an inflation hedge for your invested principal – nothing more than that. You should not think of your home as an investment in real estate (as history shows there has been almost no meaningful return after inflation). Publicly-traded REITs and your home are very different asset classes with very different characteristics.
But what if I rent my home out?
But what if I buy a home and rent it out? That would be good, right? Sure, you will grab the warranted rent (assuming you can find a good renter), but you may also be the one grabbing a plunger to fix the toilet on Christmas Eve when your renter calls. Also, you still need a place to live so you will presumably either be buying or renting a home to live in. Additionally, it is probably unlikely that you can rent one house as efficiently as a public REIT that has professional leasing, revenue optimization software, economies of scale, expert experience, market knowledge and real-time industry data. Lastly, if you want to buy a home and rent it out, there are several publicly-traded REITs that do that.
This is a summary and does not constitute an offer to sell or a solicitation of any offer to buy or sell any securities or to participate in any investment strategy. This material is for information purposes only and its content should not be relied upon in making any investment decisions. The information provided is not a complete analysis of the market, industry, sector, or securities discussed. While the statements reflect the author’s good faith beliefs, assumptions and expectations, they are not intended as research and are not guarantees of future or actual performance. Furthermore, American Assets Capital Advisers, LLC (“AACA”) disclaims any obligation to publicly update or revise any statement to reflect changes in underlying assumptions or factors, or new information, data or methods, future events or other changes. This document may contain forward-looking statements that are based on current expectations, forecasts and assumptions that involve risks and uncertainties that could cause actual outcomes and results to differ materially.
Flush with record levels of cash, many private capital real estate managers are buying up publicly traded real estate investment trusts (“REITs”) to take advantage of the gap between public REITs and private real estate valuations. Historically, commercial real estate in the private market has usually transacted at, or near, fair value (or else the property doesn’t trade), while shares of REITs often trade at a discount or premium to their underlying net asset value (“NAV”) in the public markets. This is because REIT share prices fluctuate in the public stock market while the underlying real estate NAV remains relatively constant (in the same way private real estate’s NAVs do).
Most of the REITs recently acquired by private capital have been trading at a material discount price to NAV in the public market; however, when these discounted REITs are acquired, it is at a price closer to NAV. These REIT acquisitions have been readily agreed to because they can create value for the private capital (who may get institutional-quality real estate relatively quickly, easily, and less expensively) and for the REIT shareholders (who may get a nice return from the substantial share price increase from the pre-deal share price). This activity of private capital buying beat-up REITs can effectively create a put option for the holders of the publicly traded REITs – if the price drops enough, the REIT may be taken out closer to NAV, and certainly at a premium to the discounted pre-deal share price. In addition to creating a price floor for individual REITs, this buying activity can also create a supporting tailwind bid for the entire REIT asset class.
- The current market cap of domestic public REITs is about $1 trillion; the total value of underlying real estate assets is about $1.5 trillion, assuming 33% leverage, which is typical for public REITs.
- As of 6/30/15, private real estate managers had a record $249 billion in unspent capital commitments (this is equal to about 25% of the total public REIT market cap!). Private capital typically employs meaningfully greater levels of leverage than REITs do, which only further increases its REIT-buying power.
- It is generally faster, easier, and less costly for private capital real estate managers to buy public REITs than private real estate.
- Private capital can buy a large REIT portfolio in one bite. For example, Excel Trust was recently acquired by Blackstone for approximately $2 billion. The Excel Trust portfolio included 38 retail shopping center properties across 18 states. If Blackstone had to buy these properties in one-off transactions, they would have had to travel to every property, conduct their own data gathering and due diligence, review and audit financials and every lease contract, and successfully create and close potentially 38 separate deals with 38 different parties. It is much easier, faster and less expensive for Blackstone to buy an institutional quality portfolio, already equipped with GAAP accounting, lease abstracts, financial audits, and publicly available granular property level data, in one fell swoop. Not only are transactional costs less, but it may be getting it at an arguably cheaper price.
- In the past year, a number of REITs have been purchased by private capital, including but not limited to the following list:
- Investors sometimes pose the question, “Why buy the goods when you can buy the store?” In effect, private capital is answering that question by buying discounted REITs instead of individual properties. We expect this trend to continue as long as REITs trade at material discounts to their NAVs and as long as private capital is looking for ways to deploy nearly $250 billion in unspent capital commitments.
This is a summary and does not constitute an offer to sell or a solicitation of any offer to buy or sell any securities or to participate in any investment strategy. This material is for information purposes only and its content should not be relied upon in making any investment decisions.The information provided is not a complete analysis of the market, industry, sector, or securities discussed. While the statements reflect the author’s good faith beliefs, assumptions and expectations, they are not intended as research and are not guarantees of future or actual performance. Furthermore, American Assets Capital Advisers, LLC (“AACA”) disclaims any obligation to publicly update or revise any statement to reflect changes in underlying assumptions or factors, or new information, data or methods, future events or other changes. This document may contain forward-looking statements that are based on current expectations, forecasts and assumptions that involve risks and uncertainties that could cause actual outcomes and results to differ materially.
As real estate securities analysts, most of the things we do have some basis in being knowable. For example, we analyze business plans, visit assets, build models, talk to tenants and reach conclusions about a company’s portfolio, prospects, management and stock valuation. While none of this is completely knowable, it’s partly knowable.
In the last 10 years, however, under the current administration, there has been a very concerning trend of government agencies reaching into the real estate business, often with politically motivated goals. This has introduced an aspect into the business that is less predictable. Some instances are effectively zoning or permitting processes where, if the applicant (usually a company) has followed the rules, they ultimately get building permits or the equivalent thereof. Other instances are not so simple. There are dozens of examples we could talk about, but one in particular raises such concern that it bears discussion.
Some of the portfolios we manage own shares in a company that is developing the Cadiz Valley Water Conservation, Recovery and Storage Project (project description). For readers not in California, the State has an environmental review and vetting system – The California Environmental Quality Act, or CEQA for short. It is the result of decades of legislative efforts; it is costly, complicated, slow-moving and open to the public. It has its failings, but it is an established legal framework under which all the parties to the process operate.
At 30,000 feet, CEQA requires large real estate infrastructure projects to create an Environmental Impact Report (“EIR”) (CEQA process flow chart). For the Cadiz project and many others, these reviews are multi-year and multi-million dollar undertakings. They also provide fodder for the environmental plaintiffs industry, which sues project participants on many approved EIRs. Imagine putting together a 3,000 page review of anything, and environmental lawyers can probably find a potential nit.
What happens in practice is large projects like Cadiz are sponsored by government agencies, in this case the Santa Margarita Water District and the County of San Bernardino, so the defendants in these environmental lawsuits are generally government agencies.
The process is generally something like the following:
- Hire qualified, independent scientists and consultants to establish the project impacts under applicable local and federal law;
- Design or redesign the project to mitigate these environmental impacts;
- Create a 3,000 page document that covers any real, imagined or perceived environmental impact that your project may create;
- Pull this together into a draft copy and publish it for comment for 90 days; during the comment period, hold open meetings for citizens, project participants and other concerned people to address the lead agency (in this case the water district) face-to-face; and
- Collect all the feedback, consider reasonable commentary, incorporate plan design changes to address these reasonable concerns and put out a final copy of the EIR.
A scheduled vote is then held and a branch of the California government approves or rejects the project. This effort, start to finish, is typically two-to-five years, although in many cases it is much longer. In the case of Cadiz the vote was in 2012 and the project was unanimously approved. In the immediate time period after the approval, the environmental legal industry geared up and sued. No matter that a branch of the California government approved it. There were six challenges, all of which were dismissed in an Orange County court in 2014. (Judge Andler’s dismissals)
As expected, the losing plaintiffs appealed, as there is no material cost to do so and part of the effort may be focused on delay. In the Cadiz case, that appeal was heard on March 23rd and we believe the plaintiffs’ appeals will be dismissed.
At a high level, this should concern any right thinking person, as we start with a two-to-five year EIR process and add at least two-to-three years of litigation. So in California, any project of meaningful scale has a six-year approval process. We would imagine that if we had this conversation with Texas Governor Rick Perry, he would say that’s just great and remind us that Toyota is moving from California to Dallas.
Having said all this, at least the process is final, right? You get a certified EIR and off you go. Technically yes, but in the case of the Cadiz project, no. The Bureau of Land Management (“BLM,” a federal agency) is actively working to interfere with a state-approved project.
There are two particularly troubling aspects to this. For a California project like this, CEQA is law, plain and simple. The reason California has CEQA is to provide a slow-moving, open vetting process; not to engender backroom politics by other, including federal, agencies.
To transport water from the CEQA-approved project, the project sponsors (Cadiz and the various water agencies) are proposing to build a pipeline in an existing railroad right-of-way. Of course, the pipeline is covered in detail in the approved EIR. According to members of Congress and the U.S. Senate, the BLM is attempting to reinterpret 140 years of non-controversial railroad right-of-way law initially put in place by Congress in 1875. (1875 act) In short, this law allows railroads to lease space to other commercial users along their right-of-way (typically 100 feet of surface and subsurface on either side of the rail line). Historically, the railroads had the right to do this as long as it did not interfere with rail operations. More recently, the Solicitor General of the Department of the Interior issued a document called the “M 37025 Opinion,” which provides: “A railroad’s authority to undertake or authorize activities within an 1875 Act ROW is limited to those activities that derive from or further a railroad purpose” (M 37025 Opinion). This is the legal standard and allows railroads to lease space to all sorts of commercial users. The example provided in the M 37025 Opinion is MCI’s fiber line, which was clearly built for commercial purposes, but allows as a railroad benefit some of the fiber capacity for the railroad’s use. Cumulatively there are easily more than twenty thousand miles of railroad rights-of-way in the western United States. It is estimated by Congress that there are 3,500 existing utility uses on railroad rights-of-way over federal lands, which Cadiz believes are similar to its proposed pipeline.
So Cadiz, the Arizona and California Railroad, and the Santa Margarita Water District submitted a proposal that had more than a handful of attributes (e.g., water conveyance pipeline, fire suppression system, access road, power line and supported facilities, and a steam-based excursion train) they felt should qualify as “further[ing] a railroad purpose”. In particular, the railroad along this route features crossings constructed of creosote-soaked wooden trestles, which are flammable. Trestle fires are common. Hence, the pipeline is designed with automated fire suppression equipment to assist the railroad in preventing or containing fires.
In our opinion, it is reasonable to conclude that automated fire suppression is preferable to having railroad employees hop in a truck, race miles to the fire and throw sand on it. Yet the BLM argued in their non-binding letter of response that since the traditional method was the throwing of sand, adding automated fire suppression would not “further in part, railroad use.” (BLM letter) The BLM director that made this statement has since left the California office of the BLM.
Congressional reaction has been swift in condemning this (Congress letter to BLM). Nine Congressmembers, both Democrats and Republicans, have co-authored a letter to the BLM Director saying that the ruling is contrary to the M 37025 Opinion. Congressmen Tom McClintock and Tony Cárdenas in particular have met with the head of the BLM in Washington in person to convey the same opinion. Senator Orrin Hatch is also on record as being “deeply disturbed” by the actions of the BLM.
What is particularly troublesome to members of Congress is that the BLM’s action has clouded the title of all existing uses within railroad rights-of-way. The discretion applied by BLM to reject the opinion of the railroad that the Cadiz project furthers railroad purposes means that BLM, not the railroad, will be the arbiter of the question. This diverges from the M 37025 Opinion where the railroad’s opinion formed the basis of the determination that the fiber optic cable was providing a communication railroad benefit.
Consequently, in addition to the initial backlash from the legislative branch as to the Cadiz project, the issue is being subsumed within a larger cause that has enlisted many members of Congress in an effort to explore every available legislative and administrative means to clarify the scope of railroad rights-of-way.
The problem goes beyond the railroads themselves. Hundreds of millions, if not billions of dollars have changed hands in consideration for the use of these rights-of-way. How would the BLM propose to unwind those transactions if the railroads did not have the authority to lease in the first instance? How will projects be financed in the future? The impact of the BLM’s action effectively is that now every potential use of a railroad right-of-way will have to secure sign-off from the BLM before it may be financed to remove the cloud. But now even if the BLM were to sign-off, its decision would be subject to second guessing by parties in the Courts. The issue seems ripe for action by Congress.
The Cadiz project itself has widespread approval, with at least 30 politicians in favor as well as dozens of community leaders (support for project). As far as we can tell, the only current political opposition is from Senator Feinstein (whose office made no comments and asked no questions of either the Santa Margarita Water District or San Bernardino County, the parties reviewing the Project under CEQA). She has recently indicated her opposition was based on her belief that the project would damage the environment. Since the EIR is approved under California law and indicates the opposite, we fail to see how her opposition has any merit.
Ultimately we believe the project will be approved, hence our investment, but this federal process is adding time and has strained our faith in the operation of the federal government.
This is a summary and does not constitute an offer to sell or a solicitation of any offer to buy or sell any securities. Views are as of April 13, 2016 and are subject to change at any time based on market and other conditions. The author’s assessment and opinions of a particular company, security, and/or other information discussed in this article is not intended as research or advice. While the statements reflect the author’s good faith beliefs, assumptions and expectations, they are not guarantees of future or actual performance or results. The securities and companies discussed are for illustrative purposes only and do not represent all of the securities purchased, sold or recommended for advisory clients. The reader should not assume that any securities discussed were or will be profitable. Furthermore, American Assets Capital Advisers, LLC (“AACA”) disclaims any obligation to publicly update or revise any statement, including forward-looking statements, to reflect changes in underlying assumptions or factors, or new information, data or methods, future events or other changes.
This document may contain forward-looking statements that are based on current expectations, forecasts and assumptions that involve risks and uncertainties that could cause actual outcomes and results to differ materially. The following factors, among others, could cause actual results to differ from those implied by the forward-looking statements in this presentation: changes in general economic conditions; political factors; changes in specific markets; legislative/regulatory/policy changes (including, but not limited to, environmental laws/regulations/policies and laws/regulations/policies relating to railroads, rights-of-way, land management, and real estate); and changes in generally accepted accounting principles. While forward-looking statements reflect AACA’s good faith beliefs, assumptions and expectations, they are not guarantees of future or actual performance.
A tale of two stocks and a tale of two investors that, we believe, demonstrate the sometimes illogical nature of perceptions and how those perceptions can drive valuation.
The stocks are BioMed Realty Trust (BMR) and Alexandria Real Estate Equities (ARE). They are the only two public companies currently focused on ownership of lab/life science space in the US. For the last two decades, they have had a duopoly in this real estate sector. Alexandria effectively gave birth to the industry in 1994, and BioMed’s executives (who were former Alexandria executives) later followed suit. For many institutional investors they were interchangeable, although, as one would expect, both companies would be keen to point out differences and advantages. While lab/life science is a niche, it is a relatively sizable one. BioMed, at the time of its purchase by Blackstone in January 2016, was valued at $8 billion and Alexandria is currently valued at about $10 billion.
The two investors in our tale are: the stock market at large and Blackstone; and the crux of the story essentially revolves around valuation perception of these two.
Blackstone purchased BioMed and the deal closed at the end of January this year (the deal was announced October 8, 2015). They paid $23.75/share, which was 103.6% of the last consensus estimate of net asset value (NAV) published by SNL Financial. The characteristics of the companies are duopolistic with a limited supply of new space, cluster markets (all US inventory of this type of space is in six markets), barriers to tenants moving out, and secular demand drivers. So Blackstone’s calculation that it was worthwhile to pay a slight premium for BioMed to enter the business was very logical, in our opinion.
Blackstone is currently among the largest buyers of real estate in the US, and, based on our experience (they purchased Excel Trust, a public shopping center company with whom I served as an independent director), we believe Blackstone is both sophisticated and thoughtful, thinks for the long-term, and is not prone to overreaction.
Flash forward to February 29, 2016 (the time of this writing) from last October when the BioMed deal was announced. As shown in the chart below, the remaining public company, Alexandria, is now trading at 76% of consensus NAV, which is approximately 1.6 standard deviations cheap. The market price of the shares have tracked closer to NAV more than 95% of the time over the last 10 years (the average valuation over the last 10 years—including the Great Recession—is 97% of NAV). Also, if we remove the Great Recession, the shares have never traded this cheaply. So Blackstone thought Biomed was worth 104% of NAV but the stock market thinks Alexandria was worth 76% of NAV. Between the two companies, in our opinion, Alexandria has the better portfolio as evidenced by the fact that Alexandria’s average same-store net operating income growth has been about 33% greater per year than BioMed’s for the past 10 years of reported data (40 quarters Q4-2005 to Q3-2015; the average annual same-store net operating income growth for ARE was 5.39% and BioMed was 4.06%). This makes no sense to us that Alexandria would trade about 28% cheaper than BioMed.
The public markets seem to have become caught up in a hailstorm of short-term, confusing and frequently false data reads. China, the Fed, interest rates, et cetera, have caused a significant disconnect in public market perception. Given the discrepancies between what Blackstone thinks about value and what the market seems to think, we think Blackstone is more likely correct.
ARE Market Price/Estimated NAV per Share
February 28, 2006 – February 29, 2016
In the last 10 years, 95% of the time, shares have traded above Feb 29th’s price to net asset value.
Data prepared by AACA, compiled from SNL Financial
This material is for information purposes only and its content should not be relied upon in making any investment decisions. The information provided is not a complete analysis of the market, industry, sector, or securities discussed. While the statements reflect the author’s good faith beliefs, assumptions and expectations, they are not guarantees of future or actual performance. Furthermore, American Assets Capital Advisers, LLC (“AACA”) disclaims any obligation to publicly update or revise any statement to reflect changes in underlying assumptions or factors, or new information, data or methods, future events or other changes.
The author’s assessment of a particular security is not intended as research. This commentary and the information contained herein is not, and does not constitute, directly or indirectly, a public or retail offer to buy or sell, or a public or retail solicitation of an offer to buy or sell, any fund, units or shares of any fund, security or other instrument, or to participate in any investment strategy. All data in this document, including that used to compile performance, is obtained from sources believed to be reliable but is unaudited and not guaranteed as to accuracy. The performance data cited represents past performance, which does not guarantee future results. The securities discussed are for illustrative purposes only and do not represent all of the securities purchased, sold or recommended for advisory clients. The reader should not assume that any securities discussed were or will be profitable.
Net asset value (“NAV”) is one of the core valuation metrics for real estate investment trusts (“REITs”). The metric aims to determine the inherent value of a REIT by assigning approximate liquidation values to the underlying real estate. To do so, investors must derive a series of go forward expectations such as net operating income (NOI) and cap rate assumptions to estimate a current market value of the underlying real estate.
As one may expect, general bouts of market volatility allow for share prices of publically traded REITs to deviate from their underlying net asset value. Thus, REIT shares typically trade at either a premium or discount price to net assets value (“P/NAV”). Generally, whenever REITs are trading at an elevated premium P/NAV, we expect lower go forward rates of return; and whenever REITs are trading at a deep discount P/NAV, we expect go forward rates of return to be higher. Fluctuations in P/NAV can create opportunity when REITs are trading at a premium to consider reducing positions or consider incorporating hedges, particularly in those REITs that are poorly positioned in their respective markets. Additionally, as evidenced by the recent pick up in announced REIT M&A activity, P/NAV discounts can grant opportunity to a variety of external buyers. These opportunistic buyers can generate a profit by selling off individual assets in the private market at an amount greater than the price they paid for the company in the public market. Hence, all else being equal, we believe it to be prudent to invest in REITs when they are trading at a discount P/NAV.
The SNL US Equity REIT Index (“REIT Index”) P/NAV has historically been somewhat mean-reverting with share price trading within a band of the underlying NAV. Looking at the “post-financial crisis” time period (trailing five years, 4/30/10 to 3/31/15), the mean P/NAV of the REIT index over this period was a 6.3% premium. As of the most recent month end (9/30/15), The REIT index was trading at an 8.5% discount to NAV (about 14.8% below the REIT index’s mean P/NAV for the trailing 5-year period studied).
In the study time period, when the REIT Index was trading at a discount P/NAV, the forward six-month returns of the REIT Index were positive 100% of the time. When the REIT index was trading at a premium P/NAV, the forward six-month returns of the REIT Index were positive 73% of the time during the study time period. Negative forward six-month returns of the REIT Index during that period only occurred when the REIT Index had been trading at a premium P/NAV.
As of the most recent month end (9/30/15), the REIT Index was trading at an 8.5% discount P/NAV, which we believe may suggest a positive forward six-month return.
This is a summary and does not constitute an offer to sell or a solicitation of any offer to buy or sell any securities. The performance data featured in this document represents past performance, which is no guarantee of future results. Views are as of the dates indicated and are subject to change at any time based on market and other conditions. All data in this document, including that used to compile performance, is obtained from sources believed to be reliable but is not guaranteed. Data is unaudited. This document may contain forward-looking statements that are based on current expectations, forecasts and assumptions that involve risks and uncertainties that could cause actual outcomes and results to differ materially.
The following factors, among others, could cause actual results to differ from those implied by the forward-looking statements in this presentation: changes in general economic conditions; changes in specific real estate markets; legislative/regulatory changes (including changes to laws governing the taxation of real estate); and changes in generally accepted accounting principles, including policies and guidelines applicable to real estate funds. While forward-looking statements reflect American Assets Capital Advisers, LLC’s (“AACA”) good faith beliefs, assumptions and expectations, they are not guarantees of future or actual performance. Furthermore, AACA disclaims any obligation to publicly update or revise any forward-looking statement to reflect changes in underlying assumptions or factors, or new information, data or methods, future events or other changes.
The SNL US Equity REIT Index. The SNL US Equity REIT Index (“REIT Index”) is an index comprised of all the publically traded US equity REITs and is considered to be generally representative of the US real estate market as a whole. Results for the REIT Index include dividends and the reinvestment of all income and are presented gross of fees. At times, the volatility of your investment may be greater than the volatility of the REIT Index. Unlike the REIT Index, your investment may be actively managed.
A look at how REIT exposure may enhance risk adjusted portfolio returns.
Over the years we have had countless conversations with investors regarding their exposure to public real estate, primarily if, and how much to allocate. The purpose of this whitepaper is to frame the question within the rigor of the Markowitz Mean Variance Efficiency Frontier, the basis for Modern Portfolio Theory (“MPT”), for which Harry Markowitz was awarded the Nobel Prize in 1990. Derived from nearly 40 years of historical performance, our findings show that adding publicly-traded real estate to a stock and bond portfolio has historically improved a portfolio’s risk/return profile versus one comprised solely of stocks and bonds.
We like to focus on companies that own assets that we believe are unique to the tenant or user and are difficult if not impossible to replicate. In the retail sector, one metric we focus on is what we call “income density.”
Retailers, especially large national retailers, have very sophisticated demographic data and models that allow them to predict sales per store or sales per square foot, often with a high degree of certainty. This in turn allows them to carefully construct expansion campaigns and manage their store networks in a way that gels with their branding goals and the needs of their specific demographic target market.
Whole Foods, for example, is perhaps the most sophisticated retailer in the country. They have an incredible amount of descriptive data about their shoppers, and based on this they choose locations where they have the highest density of potential Whole Foods customers. Specifically, they seek out education density (college or post graduate population within a given area). They believe post-graduates are more likely to seek out free trade, organic kale than high school dropouts are. As it turns out, education density and income density have a high degree of overlap and are highly correlated.
The primary demographic metric that upscale retailers are looking for is trade area income density: how many people are in the trade area and how much money they earn. This is the numerator in their sales model. The denominator is the number of other places in the trade area where customers can shop. The trade area is driven by the tenant draw for the specific center. For instance, a mall with Saks, Nordstrom, Bloomingdales and an Apple Store will have a trade area as large as 25 miles (even in a dense area with other shopping alternatives) while Sears and JC Penney will have a trade area as small as a few miles. Of course there are other drivers as well, some empirical and some subjective, and each location is unique.
This is the formula we use for our stock selections in retail:
Another popular way to measure income density is “Super Zips”. These are zip codes in which both education and income are in the 95th percentile. According to US Census data from 2010, there are 891 super zips (of 42,000 US zip codes and 32,000 zip code tabulation areas – which are zips in which the US Postal Service has calculated boundaries and which form the basis of census data), housing 9 million adults older than age 25, which compromise the top 5% of the US.
For the purposes of The Gap clothing store, just focusing on super zips is not a large enough population footprint to have thousands of stores. Most super-regional malls have a trade area larger than a zip code and zip codes are not like trade areas. They were established by the US Postal Service for delivering mail, not by economic demographers trying to figure out how to sell you kale. But for the purposes of Tiffany and Louis Vuitton it’s probably just right.
Mall Sales Density
Data prepared by AACA, complied from Green Street Advisers and SNL Financial
As shown above, Taubman (TCO) has 74% more income density than the average of the public companies – i.e., more wealthy people surrounding their malls. When we adjust this for trade area reach the numbers become even more compelling as Taubman’s malls have more exclusive tenants that will pull customers from a larger trade area than competitor’s assets. This shows in sales/square foot, which are almost 2x the mall peer group average. By comparison, CBL has only 26% as much income density surrounding its assets as Taubman – and since malls can’t be moved, in our opinion this becomes a permanent advantage for TCO and a permanent disadvantage for CBL.
In short, this is our basis for investing in the retail sector. We buy the retail assets with the highest concentration of wealthy people surrounding them.
By way of anecdote, I spent several hours stuck in a tour bus with the CFO of BMW USA and over the course of a crazy traffic jam he explained to me the ”psychographic profile” of their owner as compared to Audi and Mercedes. To the casual observer, these companies all compete for the same customer – in reality, not so much. There had to be twenty or thirty owner characteristics they measured and understood and tried to reflect in their cars. BMW’s owner profile is meaningfully different from Mercedes or Audi. They referred to qualities such as “adventure seeking”; this is why they don’t refer to their SUVs as SUVs. They call them SAVs – Sport Activities Vehicles.
BMW is ahead of most retailers in our opinion. For instance, Macy’s and Dillard’s make fewer distinctions between their customers than BMW and Audi, but as retailers get more sophisticated with massive amounts of customer-related “Big Data,” it allows them to further refine their offerings and store portfolios. We invest in retail property companies that pursue high income density locations because we believe they own properties that are and will be the most sought-after by rent-paying retailers even as retailers refine their target customers. We think this strategy will allow our portfolio to remain relevant over time.
Why we think Macau is the best gaming environment.
The gaming industry in Macau offers interesting opportunities to investors. Combining a restricted casino and hotel supply with a huge demand for gaming in China, Macau is now the world’s top casino market, with more than five times the revenues of Las Vegas. In a lot of ways it’s actually a better business environment than Las Vegas for gaming and entertainment companies.
Formerly a Portuguese colony and located just across the Pearl River estuary from Hong Kong, Macau is a tiny peninsula attached to mainland China. It is one of two Special Administrative Regions for the People’s Republic of China, the other being Hong Kong. The Chinese government legalized gaming in Macau in 2002 and has issued a limited number of licenses to operate casinos. Right next door to Macau reside more than 1.35 billion people in China. The resulting mismatch between supply and demand has created the kind of oligopoly we find to be a compelling opportunity.
The average visitor to Macau arrives from Hong Kong or mainland China, and loses approximately $1,100 per day, or roughly 30 times as much as the typical visitor to Las Vegas, who loses $36 per day. In the fourth quarter of 2013, VIP gamblers at the Wynn Macau resort alone wagered $34.4 billion; annualized, this comes to $137 billion. For comparison, the 2013-2014 budget for the state of California was $98.4 billion. In other words, last year, VIP gamblers in one Macau facility the size of a supermarket gambled 1.4 times the annual budget of the 12th largest economy in the world.
The limitation on supply is driven both by physical constraints (Macau is 11.4 square miles) and the limited number of gaming concessions issued by the Chinese government. The return on assets (unlevered) to U.S. companies with casinos in Macau – Wynn Resorts, MGM Resorts and Las Vegas Sands –has historically been in the mid-20 percent range or higher. By comparison, unlevered returns on commercial real estate in the US have typically ranged from 5%-9%, depending on the sector and location. Unlevered returns on new development of casinos in Las Vegas have typically ranged from 9%-13%, so on an apples-to-apples basis, the companies in Macau have developed assets about twice as profitable as in the U.S. This advantage is a function of exceptional demand drivers meeting limited supply.
Over time, we believe it is not likely that this advantage will go away. About 13 percent of the U.S. population is represented in visits to Las Vegas and anyone that wants to go there, can. Macau’s visitation is only about 1.2 percent of the Chinese population and China’s government is allowing more of their population to visit. The Chinese are also pouring money into the area’s infrastructure, including new high speed rail, inter-city rail, border gate expansion and a 31-mile, $10.7 billion bridge linking Hong Kong to Macau. These expenditures will likely make Macau even more tourist-friendly to the world’s most populous country, and subsequently, bode well for its gaming industry.
Of course, any meaningful slowdown in the pace of growth in China’s economy could reduce the rate of growth in gambling and vacation travel. Additionally, internal travel policies such as the individual visitation scheme could change and this may affect travel to Macau.
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