Morningstar Advisor - August/September 2011 - (Page 34)

Sector Rap Martin: It would be both. Location is important, but the ability to execute a strategy certainly cannot be discounted. If you’re defining a moat, it could be a niche. Alexandria Real Estate Equities ARE, for example, leases space to biotech and pharma companies. It’s one of the go-to providers when a GlaxoSmithKline GSK, Johnson & Johnson JNJ, or Novartis NVS wants specialized lab or R&D space. Alexandria benefits from a unique expertise, competitively advantaged locations in key lab space/biotech clusters, and strategic relationships and proximity with universities. Alexandria has a business model that is very difficult to replicate, and there are very few competitors. readily drop a poorly performing property, or maybe you have a better-performing property that’s making up rent on a poorly performing property. There are a lot of protections on these leases that are hard to get out of. Guziec: Where are the opportunities now? Martin: There’s real opportunity, even in a slow-growth environment, for dividend growth and for REITs to maintain dividend yields. FFO dividend payout ratios average 69%—the historical low is about 66%, and they’ve historically averaged 70% to 75%—so REITs are very well positioned from a cash-flowcushion and balance-sheet standpoint to maintain current yields and inflation “plus” dividend growth. That’s important because we may see higher interest rates and inflation, and equity REITs are well positioned to meet these headwinds. Generally, our stance right now is to be a bit more defensive, so we’re focused on equity REIT portfolios and business models less dependent on the economic cycle. We would also gravitate to longer leases, where there is less cash flow volatility—for example, health-care REITs. Lukasik: We think that the sector in general is 15% to 20% overvalued relative to what our underlying fair value estimates are for the REITs we cover. But we are finding pockets of opportunity for investors that need to have exposure to the space. We were talking earlier about Alexandria—that’s one that’s trading at a discount to our fair value estimate right now. But in general it’s difficult to find undervalued REITs. In retail, for example, Realty Income O is the only stock that trades below our fair value estimate, and its discount is slight. Choosing specific REITs will be very important for investors who want to make money in the space over the long term. Guziec: What’s driving the overvaluation today? Is it as simple as yield-chasing? Lukasik: I think it’s a combination of a couple of Other differentiators might be a management team with a full-service real estate skill set, where there is an ability to acquire, develop, redevelop, and manage properties. This ability provides flexibility and growth options throughout an economic, financial, or real estate cycle. We are looking for REIT business models that are not one dimensional and are positioned to better manage risk through the real estate cycle. Certainly, locations can constitute a competitive advantage. I’m thinking of Federal Realty FRT on the retail side; it’s been in the business of owning properties for decades, and it has some of the best urban infill locations for retail shopping centers in the country, characterized by high incomes, consistent population growth, lots of traffic, and very few competing land parcels. Lukasik: When we’re talking about moats, we’re talking about the sustainability and growth of long-term cash flows. The management teams that have decided upon a strategy that focuses on space-constrained markets or areas with very favorable demographics are the ones that have been able to build moats around their property portfolios. Ren: Underwriting can also lead to defensibly growing cash flow to shareholders. In health care, they’re writing these leases that are cross collateralized. If you’re a tenant, and you’re locked into a 10- or 15-year lease, you can’t I would also highlight multifamily. Despite there being some valuation concern about share-price multiples, as all of our apartment REITs under coverage trade at least 30% higher than our estimates of their fair values, the multifamily REIT sector benefits from fundamental tailwinds. Supply is healthy, and demand is increasing; a combination that has resulted in strengthening operating performance and cash flows. Driving multifamily demand is a difficult mortgage financing environment and singlefamily home valuation uncertainty. On top of this, home ownership can be expensive. Home ownership attitudes are being reassessed. Helping to fill the void has been multifamily. Many of the equity REITs own high-quality assets that are professionally managed and offer numerous housing options and amenities. Guziec: What’s mispriced today? What can an investor buy? things. One is yield, as you suggested. As traditional yield-type investments, like U.S. Treasuries or corporate debt, have seen yields go down, many investors are looking for sources of yield, and the dividend yields on REIT stocks have looked attractive. The other factor is just a huge amount of capital that has been allocated to commercial real estate. We’ve seen it both on the transaction side for individual properties and in the public markets as well. There’s been a huge sum of money that’s been raised to invest in commercial real estate. And as that money flows into the market, it drives down the cap rates and drives up the values that people are able to get for the assets that they sell. Ren: There are quite a few motivated buyers out there, but not as many motivated sellers as one would expect given refinancing concerns. The banks have still been playing a bit of “extend and pretend” on commercial real estate credits, so the availability of properties on the market—there haven’t been the grave-dancing opportunities that people prepared for. K Philip Guziec, CFA, is a derivatives strategist for Morningstar. 34 Morningstar Advisor August/September 2011

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2011

Morningstar Advisor - August/September 2011
Contents
Contributors
Letter From the Editor
Simplicity and Design Matter
Do You Use ETFs Strategically or Tactically?
The Institutional Way
How to Analyze an ETF
Eyeing ETFs’ Next Chapter
Small-Cap/Large-Cap Flip-Flop?
Four Picks for the Present
Investment Briefs
Morningstar Investment Conference
Pitfalls of Peer Groups
A REIT Recovery, With a Catch
Turning Fund Distribution on Its Head
Here Come ETF Managed Portfolios
Circle These Picks Amid the Crop of New ETFs
ETF Analyst Favorites
Beware, the Accidental Portfolio Manager
It’s the Destination, Not the Vehicle
New Growth, Rooted in Experience
Better Ways to Look at ETFs
How to Better Manage Your Clients’ Future(s)
More Bargain Than Bubble
Cheap, Local, and On a Roll
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
First-Quarter Assets Hit an All-Time High
You Say You Want a Revolution?

Morningstar Advisor - August/September 2011