Point of View with Mark Howard-Johnson and Sherry Rexroad

With the real estate market recovering since 2010, many investors have been asking: will the recovery continue, and what is the best way to gain exposure in a portfolio? BlackRock's real estate securities experts, Mark Howard-Johnson and Sherry Rexroad, discuss how real estate investment trusts (REITs) offer a blend of some of the benefits of stocks and bonds with the potential for strong returns and dividend income, as well as a dose of diversification.

  • REITs offer the potential for competitive income and strong returns, as well as low correlation to stocks and a degree of inflation protection.
  • Many REITs have improved their financial health since the financial crisis, and should perform well in a growth economy.
  • REITs can contribute to every portfolio. Rely on a manager with deep resources to deliver a portfolio of high quality, core real estate stocks.

The real estate market seems to be improving, and I'd like exposure. What do you suggest?

We would suggest investors look for an investment that is scalable and that offers diversification, income and can be readily bought and sold. You've heard the old adage that real estate is all about location, location, location? Well, that is as true today as it has ever been, and means if you want exposure, be sure you know exactly what region and industry—down to the building—you are investing in. For example, in the chart below you can see that while the country is experiencing a relatively broad recovery, there are geographies and property types that are in different points of the economic cycle: some are correcting (suburban Washington D.C. multi-family market) while others are in expansionary mode (Houston office market).

"The unique characteristics of REITs make them compelling for most portfolios."

These examples point out another critical aspect of the real estate market—in addition to geography, there are a range of sectors that offer differing investment opportunities: residential, industrial, office and retail. Further, an expansion is underway into newer specialty property types that may offer better growth, such as data centers and wireless cellular towers.

Importantly, we are not talking about buying a single family house and trying to flip it for a profit or to rent. Such an approach is not diversified and can add substantial risk to one's portfolio, much like owning a single stock. It is also most often highly leveraged, like buying a stock on margin. Finally, it's a depreciating asset and requires great scale to be successful.

Chart: Real Estate Markets Differ in Recovery

What makes a good real estate investment?

Basically, cash flow is the central component to long-term real estate investment returns. Ideally, an investor would seek to combine long-lived, stable and diversified sources of those cash flows to give you the return you seek. Gathering all these elements into an investment requires an investor to look at a professionally-managed portfolio that may be accessed through REIT securities—be they individual stocks, ETFs or mutual funds. Each offers different opportunities to gain exposure to the commercial real estate market and will offer different degrees of diversity, risk and opportunity.

What are the advantages of a REIT?

We believe there are many. REITs are publicly-traded real estate securities that bring the benefits of diversification and potentially the ability to keep pace with inflation. REITs offer strong balance sheets, access to the debt and equity markets, and since REITs are publicly traded, there is transparency and liquidity. They also offer growing cash flow with high current income and the potential for capital appreciation. As you can see in the chart below, REITs have shown strong appreciation relative to stocks and bonds. So while diversification strategies do not ensure a profit and may not protect against losses in a down market, we believe the lower correlation to the stock market and ability to keep pace with inflation make REITs an attractive component of a broad portfolio.

But importantly, because it is actively managed by a professional, capable management team, a REIT can selectively choose its geography, demographics and/or sector—residential, industrial, office, retail or specialty. This flexibility and selectivity contributes to the potential for better risk-adjusted returns.

Chart: REITs: Strong Income and Returns

Furthermore, BlackRock has done research on real estate stocks with its BlackRock Economic Scenario Tester™ and the sector performed well in different market scenarios relative to other investments. This research showed that real estate stocks can do well in either a period of higher inflation or a positive stock market.

How does a REIT work?

It's actually very straightforward. A REIT is a corporation that owns and manages a portfolio of commercial real estate properties and/or mortgages. In our portfolio, we buy and sell publically traded equity REITs and not mortgage REITs. The first REIT was developed in 1960, after Congress decided that smaller investors should be able to invest in larger-scale, income producing real estate, through a traditional method: the stock market. It is what is called a pass-through security because one of the important differences about these stocks is that at least 90% of their taxable income must be distributed to its shareholders in the form of dividends. So a mutual fund that invests in REITs would own a number of varying REITs to seek its goals for investors.

Are there different kinds of equity REITs?

Indeed! That is the exciting part of this sector. There is a tremendous breadth in the types of REITs available. The diversity among different REIT sectors means they may have different drivers or may be more sensitive to various macro factors. For example, owners of retail real estate are in a category of REIT that is more dependent on consumer spending and comes in the form of regional malls and strip centers. Since consumer goods are shipped and housed at various logistics centers known as industrial REITS, there is a correlation between those two sectors. Looking more closely at industrial properties we believe industrial properties in the "smile states"—the West Coast, the Southeast, and areas by Virginia—should benefit the most from improving global growth and trade.

Other categories are more defined by employment, and include office, multi-family apartment and self-storage REITs. Because employment growth has been spotty and clustered around specific industries more Americans are moving to meet that demand. Self-storage REITs are a beneficiary as people store their belongings for short or long terms as they relocate. In addition, we favor self-storage REITs that offer the benefits of scale and are able to increase pricing. Finally, there are demographic-driven opportunities—opportunities that rely on population trends—mainly related to the healthcare business. While not very sensitive to the broader economy, this category must be closely monitored because federal regulations can make a significant impact.

REITs are growing not only in terms of the percentage of the overall commercial real estate market that they own, but also new types of REITs are forming. Single family home rental REITs are an interesting new sub class of residential REITs. New REITs comprised of cellphone towers are being formed and other types are being explored. The REIT structure is expanding globally as well. These are fascinating and exciting opportunities that we believe can offer potential for higher growth and diversification within the REIT space.

Can you provide an example of a sector you favor?

Sure. Let's look at REITs in the industrial sector. As the global economy continues to recover, global trade should increase, with more goods moving through global ports. This improves the demand for buildings owned by industrial REITs, especially those around the coastal cities where activity is the greatest. This increased activity at a time when rental space is already scarce means that REITs that own fully-occupied properties in land-constrained areas should be able to raise rents. The chart below shows how rent growth should improve as demand for properties continues to outstrip supply. This increased rent should lead to strong cash flow which is then passed on to investors.

Is now a good time to invest in a REIT?

We believe so. First, we believe better fundamentals are leading to increased cash flows. Second, many REITs have dramatically improved their balance sheets. Going into the credit crisis, many companies, just like many individuals, were too highly levered. The subsequent downturn prompted management teams to make significant and positive changes to their balance sheets. While the loan-to-value hit a peak of 64% in early 2009, more recently the ratio has hit 35%, and we would say that anything below 45% is a strong story. Finally, we believe the asset class is fairly valued today and should offer the opportunity for attractive risk-adjusted returns over the long term.

What does the recent rise in interest rates do to your outlook?

It depends on the underlying cause of the rate increase. If the rise in rates is based on growth in the underlying economy, investors will see an increase in rents which, in turn, is growth in the income to you, the investor. Conversely, if interest rates rise without economic growth (i.e. stagflation) we would be concerned about any real asset class, though most economists don't believe that is the outlook. Realistically, we don't know the short-term path of interest rates but we're optimistic the economy will continue to grow and support REIT fundamentals.

Chart: REITs Have Improved Their Balance Sheets

How do you manage a portfolio of REITs?

Our approach is one in which we seek to build an institutional-quality, core real estate securities portfolio. We are looking to invest in the best management teams with strong balance sheets and quality assets at attractive prices. We do our research property by property so we know exactly what is in the portfolio. Additionally, we spend significant time with senior management to understand what to expect in the future. Finally, with the help of a proprietary analytics tool that we call the Relative Value Matrix, we are able to understand relative valuations on a daily basis. This helps us make decisions in constructing an optimized portfolio based on our medium- to long-term outlook.

How much real estate is the right amount?

The unique characteristics of REITs make them compelling for most portfolios. While all investors are different, a 5% to 10% allocation seems prudent. Adding BlackRock Real Estate Securities Fund offers:

For investors with no commercial real estate exposure:

  • Instant exposure to high-quality real estate
  • An asset class that historically delivered strong returns and attractive income

For investors looking for inflation protection:

  • Real estate has historically kept pace with inflation
  • Produces reliable cash flows

For investors with a high allocation to equities and/or fixed income:

  • Real estate tends to not be highly correlated to stocks
  • Yield competitive with fixed income with strong cash flow

What is unique about your capabilities?

We augment our deep and experienced team with the broader BlackRock resources. We leverage the BlackRock direct real estate investments' 175-professional, $13 billion global platform. We not only have access to vast amounts of data and tools, but the experience of their on-the-ground research. In addition, we utilize the firm's 250 equity investors, fixed income research and municipal research, as well as the world class risk team. Ultimately, we believe the information flow we have through this unique combination of input and analysis from teams across the firm supports the work we do to analyze each investment to understand its risks and evaluate its potential for returns.

Investing involves risk, including possible loss of principal.

Small-capitalization companies may be less stable and more susceptible to adverse developments, and their securities may be more volatile and less liquid than larger capitalization companies.

Funds that concentrate investments in a single sector will be more susceptible to factors affecting that sector and more volatile than funds that invest in many different sectors.

Convertible securities are subject to the risk that the issuer will not pay interest or dividends and their market value may change based on their credit rating or the perception of their creditworthiness. A convertible security also is subject to the same risks as common stock.

The main risk of real estate securities is that their value may go down depending on economies, vacancy rates, interest rates, tenant bankruptcies, amount of new construction in an area, laws and regulations and real estate maintenance and improvement. The fund may use derivatives to hedge its investments or to seek to enhance returns. Derivatives entail risks relating to liquidity, leverage and credit that may reduce returns and increase volatility. Many real estate related securities issuers are highly leveraged, increasing the risk of such securities.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are those of the portfolio manager profiled as of September 27, 2013, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that may, in certain respects, not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

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