Real estate investment trusts (REIT) have become a hot topic among income-oriented investors. REITs offer attractive income in a low-yield environment, and that has enticed yield-hungry investors to pile into the sector with almost reckless abandon. We recently spoke with Damon Andres, vice president at Delaware Investments and senior portfolio manager of Delaware REIT Fund (DPREX, 800-523-1918), to find out his perspective on the REIT market and learn where the best opportunities can still be found. He also offered several examples of some counterintuitive plays in the asset class.

REITs have had a lot of new money flowing into the sector lately.

The capital flows have just been unbelievable over the last several quarters; whether it’s IPOs or secondary offerings, there’s just a lot of money absorbing the liquidity in this sector. REITs have refinanced, strengthened their balance sheets, and even secured equity financing. Since the market’s bottom in early 2009, REITs are up by more than 175 percent.

What is your process for evaluating REITs? 

We ultimately see real estate as a spread investment, as opposed to a growth business or even an asset value business. A lot of people focus on net asset value (NAV) and we do as well to some extent. But spreads are what ultimately drive real estate returns. While many REIT metrics make the space appear somewhat expensive at current levels, REITs still look relatively healthy on a spread basis when compared to Treasuries or corporate bonds.

There are two components to this analysis. There’s the actual yield of the investment, which indicates credit quality and involves real estate analysis. But the primary component is the cost of capital. Although the market doesn’t always focus on the cost of capital for real estate, after what we’ve seen this cycle, more investors are taking that into consideration with their analysis.

To sum up our process, we want to deliver real estate-type returns to our investors over full market cycles while minimizing volatility.

We use what we call a dual bottom-up approach to real estate investing. Many firms in this space would typically describe themselves as an NAV shop, which means focusing on the underlying asset value of the real estate. But you don’t need to take an NAV approach. Instead, it’s important to understand the quality of the real estate, its competitiveness, and what it’s worth in its particular market. By competitiveness, I mean that it’s not necessarily the newest or prettiest shopping center that’s going to attract a tenant, but one that has the location and rooftops and other co-tenancy clients there that will drive better real estate returns.

The other side of the dual bottom-up approach is the company and its financials. Right now, we’re still in the first 15 years or so of the modern REIT era. It’s taken the investment industry a lot of time to understand that REITs are public companies that require some of the same analysis they might apply to other equities. That includes learning about a REIT’s management team and its strategy, understanding its company culture, and analyzing its financial statements.

By contrast, the old school real estate model in the 1970s and 1980s involved closed-end funds that invested in a pool of hard assets and held them for seven to 10 years. The people managing that real estate would starve their portfolio of real estate by not reinvesting their capital. They would just sit locked-up on match-funded debt. Some funds used the cheapest form of debt and therefore had a lot of refinancing risk. But now REITs have shifted their business model toward managing real estate as an ongoing concern.

Investors have been really starved for income over the past few years. Do you think that’s led to yield chasing in REITs? 

There’s clearly been a quest for yield that’s reaching across all sectors, and some investors are getting reckless by not performing the due diligence on what they’re buying.

But I don’t think REITs are trading far beyond their fundamentals. Admittedly, I do occasionally get frustrated that REITs are a little ahead of themselves in terms of valuation. But the average REIT yield is a little over 3.5 percent, while 10-year Treasuries yield 2.25 percent. Additionally, the implied cap rate–the inherent yield that a REIT’s properties generate–is just over 6 percent. So when you take those figures into account, REITs are still trading close to their long-term historical averages on a spread basis.

Year to date, REITs that have the highest dividend yields and implied cap rates have performed best. On the surface, it seems reasonable that yield-starved investors would pursue such fare. But these companies typically have high leverage and lower-quality assets. That suggests that investors are getting a little too aggressive in their quest for yield. 

In prior cycles, investors have gotten into trouble whenever they stretched for yield. These same dynamics were at play in the recent credit spread collapse in the high-yield bond market. Still, we think REITs on the whole are a solid investment at present values, but there are areas where we’re concerned about underwriting standards.

Regional mall REITs are your top sector allocation. How wise is that considering the recent bankruptcy of General Growth Properties?  

Our favorite sector right now is regional malls and we do own General Growth Properties (NYSE: GGP), which just emerged from bankruptcy. General Growth was the third-largest owner of regional malls globally when it went bankrupt, but there wasn’t anything broken with regional malls or the retail mall format. General Growth was a highly leveraged company that had a very aggressive balance sheet. It went into the financial crisis with ridiculous amounts of debt. When that market dried up, it couldn’t refinance its assets and spiraled out of control, ultimately ending up in bankruptcy. 

The irony of that whole saga was General Growth’s asset quality was actually pretty solid. It owned well-situated malls and had a skillful operating team. And the cash flow from those malls actually held up well too. Since its bankruptcy, General Growth strengthened its balance sheet and recently spun off some of its underperforming, lower-quality assets. Those weaker properties are now trading as a separate company, while the asset quality of the real estate that General Growth retained is in the top tier. Its overall asset quality isn’t quite as high as Simon Property Group (NYSE: SPG) or Taubman Centers (NYSE: TCO), but it’s probably the third- or fourth-highest quality regional mall REIT at present. 

In the regional mall space, Simon Property Group is the flagship company because of its absolute size. When you review its fundamentals, it barely even had a hiccup during the financial crisis, as the malls it owned still performed quite well.

Simon Property Group provides the most visible cash flow generation in its sector and its malls have occupancy rates in the mid-90 percent range, which is pretty close to historical highs. And it still has room for meaningful rental rate increases. Consumer and retail demand are driving its growth, as a significant number of retailers are in store expansion mode.

We’re taking a barbell approach to the sector as we watch it recover. Some of the hardest-hit malls were the lower-quality malls, so it tends to be a bit of a higher-risk sector. But we think there’s opportunity there. CBL & Associates Properties (NYSE: CBL) has lower-quality malls and definitely felt the impact of the financial crisis and the pinch that put on the midmarket consumer. Over the past three quarters, CBL has really turned its occupancy rates and leasing velocity around, and that speaks to the recovery that’s underway.

Apartment REITs are your next largest allocation, but I noticed your holdings are higher-quality names such as AvalonBay Communities. Why focus on the higher end rather than on midmarket names like Home Properties?

The long-term trend has been toward higher demand in gateway markets, and AvalonBay Communities (NYSE: AVB) is an example of a well-positioned REIT. Some of the West Coast companies such as Essex Property Trust (NYSE: ESS) are also good. And in a market like the Sun Belt, which is less constrained by supply, there are companies like Camden Property Trust (NYSE: CPT) that operate in high-density markets. 

We don’t own Home Properties (NYSE: HME) because it has significant exposure to the Washington, DC market, which had been very hot but is now one of the softer markets.

The industry as a whole has limited supply, which solidifies our belief that real estate is still a safe investment. Over the last several cycles, the real estate market got into trouble whenever development and supply exceeded demand. That scenario is not in evidence in any of our favored markets at the moment. The one caveat, however, is that in Washington, DC, for example, development is starting to ramp up and it will eventually happen elsewhere too.

When that occurs, it will be in the secondary- and tertiary-type markets, and higher asset quality plays will get hit hardest by additional housing supply. AvalonBay is reasonably well insulated and—this will sound counterintuitive—it has one of the biggest development pipelines in terms of value-add going forward than any of the other apartment companies. So it controls its own destiny with development. AvalonBay has a high-quality management team and a long track record of successfully executing its development strategy.

A big argument in favor of residential REITs is that the downturn created a whole new generation of renters. But how have these REITs been impacted by low levels of income growth?

These REITs’ ability to push through rent increases is probably what worries me the most about the residential REIT space. There were a couple of markets last year where some REITs noted resistance to their rate increases. That underscores our argument that such REITs should focus on high-density markets because that is where the higher income brackets are. 

We’ve examined income-to-rent metrics and the percentage of the average tenant’s income being used to pay their rent is not yet at peak levels. Rents could rise a further 10 percent or 15 percent before hitting that peak. But as the economy recovers, there should eventually be more job growth and income growth to support this sector.

Are there any corners of the REIT market that should be avoided?  

We’re concerned about the health care sector. Government reimbursements are a significant source of income for tenants of health care REITs. As the government reins in its spending, it’s unclear how that will affect the health care sector. Additionally, health care REITs are not particularly cheap on a valuation basis, so we’re underweight in that area.

With regard to industrial REITs, the market has gotten too aggressive in its belief that there’s a global shortage in supply and logistics capacity. The industrial sector has always been somewhat volatile, so we’re underweight there as we await more compelling values.

The lodging sector had a great run last year as investors started buying into the economic recovery story. Although there may be a few good years of upside left in terms of EBITDA (earnings before interest, taxation, depreciation and amortization) generation, valuations have gotten ahead of themselves and aren’t pricing in the economic risk that’s still out there. So while we believe we’re well into a recovery phase, it’s somewhat tenuous given all the global macroeconomic headwinds.

Although the lodging space has low supply, it’s actually moved beyond its peak demand. And now we’re concerned about lodging companies’ ability to continue pushing rates higher, as well as their susceptibility to any macroeconomic shocks. The lodging sector currently trades at about 12 to 12.5 times EBITDA as compared to its historical average of 10.5 times EBITDA. While we generally like lodging’s fundamentals, we also acknowledge that their fundamentals have low visibility and they seem to be pricing in all the good news.

Given the weak demand for mortgages, a number of mortgage REITs have been performing surprisingly well lately. Is that being driven more by the low cost of capital than anything else? 

Yes. Mortgage REITs are more a financing vehicle than a real estate vehicle, so their improvement has been twofold. Investors have been attracted by the extremely high yields mortgage REITs offer, while not paying much attention to their risk. And on the fundamental side, mortgage REITs are benefiting from the way the Federal Reserve is managing the yield curve and the credit markets. Although these companies are okay at the moment, they are highly leveraged and the credit environment could quickly shift to their detriment.

What’s your best piece of advice for investors?

Don’t get too aggressive when seeking income. Look for asset classes or companies that can provide income growth that is driven by increasing cash flow rather than just a bump in the dividend rate.