Banking & Finance

Dividend-Paying REITs to Become Their Own Sector: Managers May Be Forced to Buy

Wall Street money managers are all about weightings in their portfolios, and currently most are underweight the real estate investment trust (REIT) arena, on average by about 3.3%. That could all change on August 31 as REITs will become their own S&P Global Industry Classification or GIC. Managers who mirror the index weightings may be forced to add shares to their portfolios, and that could mean some serious buying.

A recent Jefferies research report doubts that managers actually would equal weight the sector, but that each additional 1% they do add could represent almost $47 billion in buying pressure. That could mean as much as $150 billion in total buying if they come close to an equal weight.

Jefferies acknowledges that REIT valuations are high due to the buying by income investors who have used them as a bond proxy, and the report points to eight stocks that could be targeted. Here we stick with the three large cap companies they list as top picks. All are rated Buy.

Essex Property Trust

This is a top apartment REIT, and the stock recently was upgraded to buy at Jefferies. The analysts think the already very strong West Coast business is getting even stronger for the company. Essex Property Trust Inc. (NYSE: ESS) acquires, develops, redevelops and manages multifamily residential properties in selected West Coast markets. Essex currently has ownership interests in 239 apartment communities with an additional 12 properties in various stages of active development or in the initial leasing phase.

While the stock does trade at a premium valuation to peers, Jefferies has noted in the past that there is a very compelling reason why. Four of Essex’s top market locations, which make up close to 53% of revenues, are in the Top 10 national apartment markets based on annual effective rent growth. An incredible 80% of the company’s total revenues are in the top 20 markets.

Essex investors receive a 2.86% distribution. The Jefferies price target for the stock is $265. The Thomson/First Call consensus target is $245.96. Shares closed Tuesday at $223.52.

Simon Property Group

This is one of the largest REITs and boasts an outstanding market position. Simon Property Group Inc. (NYSE: SPG) invests in the real estate markets across the globe. It engages in investment, ownership, management and development of properties, primarily regional malls, premium outlets, mills and community/lifestyle centers. Through its subsidiary partnerships, it owns or has an interest in about 230 properties in the United States and Asia. The company also has a 28.9% interest in Klepierre, a European REIT with over 260 shopping centers in 13 countries.

The company posted very solid first-quarter numbers and raised its outlook going forward. Growth in operating income and new developments and expansions aided the results. Total revenue in the quarter increased 9.9% year over year, trouncing the consensus forecast.

Simon Property investors receive a 3.1% distribution. Jefferies has a $250 price target, and the consensus target is $229.78. The shares closed Tuesday at $204.96

SL Green Realty

This is a leading large cap office REIT that the Jefferies team prefers now. SL Green Realty Corp. (NYSE: SLG) is New York City’s largest office landlord, and is focused primarily on acquiring, managing and maximizing value of Manhattan commercial properties. As of December 31, 2015, it held interests in 121 Manhattan buildings totaling 48.3 million square feet. This included ownership interests in 30.5 million square feet of commercial buildings and debt and preferred equity investments secured by 17.8 million square feet of buildings.

In addition to its Manhattan investments, SL Green held ownership interests in 33 suburban buildings totaling 5.1 million square feet in Brooklyn, Long Island, Westchester County, Connecticut and New Jersey.

Like Simon Properties, the company posted outstanding first-quarter results and raised its guidance. SL Green Adjusted funds from operations exceeded the consensus number. A rise in combined same-store net operating income aided the better-than-expected results in the quarter. Net rental revenue for the first quarter rose nearly 14% year over year and beat the consensus estimate.

SL Green shareholders are paid a 2.74% distribution. The $118 Jefferies price objective is less than the consensus target of $120.22. The shares closed most recently at $105.14.

While the buying could be sizable, and managers likely will focus on these larger and more stable companies, it is important to remember the REIT distributions can contain return of capital.