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By Jeremy Deems and Garvin Jabusch.
Welcome to our dive into the dynamics of the Real Estate Investment Trust (REIT) market. Here, we hope to bring a fresh perspective to the intricacies of the REIT landscape, revealing opportunities amidst market fluctuations. As the REIT market navigates headwinds of change, including rapidly rising interest rates and a significant shift in the office sector due to the global pandemic, Green Alpha Investments is here to decode the complexity. This article will unveil our analysis, providing you with some insight toward understanding the current state of the REIT market and its future potential, particularly in the realm of sustainable investments.
REITs are a necessary part of the Next Economy
You might be asking why a sustainability-focused investment manager is interested in REITs in the first place. Real Estate Investment Trusts offer a unique opportunity to contribute to the Next EconomyTM; they are entities that own, operate, and/or finance income-producing real estate, and their performance is closely tied to the health of the real estate sector and, by extension, the broader economy. Green Alpha believes in the importance of REITs in the Next Economy for several reasons.
- Real estate plays a significant role in climate change, both as a contributor to greenhouse gas emissions and as a sector that is highly vulnerable to the physical impacts of a changing climate. By investing in sustainable REITs, investors can via sending market signals help drive the transition to more energy-efficient, climate-resilient buildings, contributing to the mitigation of climate change.
- As society moves towards a more sustainable future, there is a growing demand for buildings that align with these requirements. This creates significant opportunities for REITs that prioritize sustainability in their investments.
- Investing in sustainable REITs allows investors to have a real-world impact through their portfolio; their investments help to finance sustainable building practices, contributing to a greener and more sustainable future. Finally, humans fundamentally need spaces. If we collectively hope to reach an economy that can thrive indefinitely without succumbing to one or more of our urgent macroeconomic or planetary risks, it will be necessary that the very spaces we occupy form the sustainable bedrock of that economy.
That’s why Green Alpha sees such potential in this sector; we believe that by including sustainable REITs in our portfolios, we can deliver both strong financial returns and meaningful environmental impact, aligning with our broader mission to invest in the sustainable Next Economy.
REIT Selection Criteria
Sustainable REITs are currently an interesting way to invest in companies having significant impact in terms of climate and resource solutions, while simultaneously taking advantage of current headwinds that have all REITs trading down regardless of specific company fundamentals. These headwinds are many, of course, including fast-rising interest rates and significant turmoil from the global pandemic and the resulting remote work environment. And yet Green Alpha sees a compelling future for sustainable REITs. We believe that as the world transitions towards greener and more resilient economies, companies in the REIT sector focused on sustainability are well-positioned to thrive. This transition also aligns with broader market trends, as sectors from technology to finance are placing increased importance on sustainable practices. Despite the recent downturn in the REIT market, Green Alpha perceives that those able to adapt to the new norms of a post-pandemic world, particularly in terms of remote work dynamics and climate resilience, will emerge as market leaders.
Like most sectors, there is also a lot of related exposure with REITs. This essentially means that REITs, while primarily involved in real estate, are also intricately connected to other sectors such as finance, construction, energy, and technology. These interconnected relationships shape the dynamics of the REIT market. Therefore, one can make interesting long-term business and valuation projections based on the specific type of REIT under analysis. So, not all REITs are created equal. Infrastructure REITs like data center, wireless and fiber network providers all come through REIT exposure. Data center and communications REITs are critical to digitalization, dematerialization and overall economic efficiency gains, all of which are key aspects of sustainability, and also key growth sectors. In short, the building blocks of the Next Economy are important holdings.
Other REITs are not as important in the economic transition to sustainable economics. While sustainable REITs actively contribute to the green transformation of the economy by investing in energy-efficient tech, environmentally friendly building practices, and climate-resilient infrastructure, not all REITs place the same emphasis on sustainability. These conventional REITs may focus more on traditional metrics of property value and rental income, with less consideration for environmental impact or sustainability metrics. This makes them less desirable to potential clients and leaves them exposed to risks such as regulatory changes related to climate change, and the physical impacts of climate change itself. This is why Green Alpha Advisors focuses solely on REITs that play a critical role in the transition towards a sustainable Next Economy.
In the office REIT space, the picture is more nuanced–in both business and sustainability terms–than a conversation like retail vs. data center REITs. Some office REITs in larger markets, with higher demand, higher occupancy, and higher lease pricing power are still thriving. Specialty office REIT Alexandria Real Estate (ARE), for example, is turning away applicants for biotech and related lab space. Hudson Pacific Properties Inc (HPP) leases to high demand industries with spaces like digital media production studios. These sectors, and the REITs that supply their space, are thriving despite the overall gloominess around REIT investing.
So, even though recent market dynamics would suggest that mid-western, C-rated, less-sustainable office space REIT valuations should apply to all office REITs, we can see that this is unambiguously a market inefficiency. As a result, the most desirable office REITs are today trading at significant discounts. For Green Alpha, this represents a powerful opportunity to build positions in a carefully selected group of leading sustainable REITs, two of which are highlighted below.
It’s also important to know that, per U.S. Generally Accepted Accounting Principles (GAAP), REITs hold buildings at cost, not at current market valuation. This means that the value of the properties in a REIT’s portfolio on its balance sheet is based on the original purchase price, plus any improvements made, minus any depreciation. This accounting practice may not accurately reflect the true current market value of these properties, especially in a rapidly changing real estate market. For instance, a property purchased years ago may be worth significantly more today due to factors like changes in the local real estate market, development of surrounding infrastructure, or simply due to inflation. However, this increased value wouldn’t be reflected on the REIT’s balance sheet under GAAP rules. Therefore, astute investors need to dig deeper and consider additional data sources and market factors to gain a more accurate understanding of a REIT’s potential worth. Some high-quality REITs are today trading for significantly less than the combined value of their owned properties, less debt. Searching for these, in combination with the above factors, has been our priority.
Exemplary REITs: Driving the Future of Real Estate Investment
Let’s look at a couple examples. As mentioned above, Alexandria Real Estate Equities (ticker ARE) represents a unique exposure within the high quality, sustainable REIT market. Alexandria Real Estate primarily owns and operates high end labs and offices for the leading life sciences, agtech, and technology companies in the U.S. They focus on AAA spaces in key “innovation cluster locations.” The combination of sustainable and desirable properties and tenant focus is key to their competitive advantage. With over 1,000 tenants in their asset base of 75 million square feet, ARE’s model delivers high occupancy levels, long lease terms, high rental rates resulting in higher returns and long-term asset values than peers. As of YE 2022, Alexandria Real Estate’s occupancy of all operating properties was 94.8% with a 10-year average of 96%. Alexandria employs a conservative debt structure, has significant liquidity available to them, no debt maturities before 2025, and very low exposure to variable rate debt (~ half of one % of total debt is variable). They have a weighted average interest rate of 3.53% on their debt. ARE raised its dividend in December 2022 and is currently trading near book value per share.
Hudson Pacific Properties (ticker HPP) is another unique REIT focused on Class A office and state of the art media properties in high barrier to entry innovation-centric markets with significant growth potential. Hudson Pacific is a sustainability leader in the real estate industry with key achievements in solutions to climate change, resource degradation and waste to value economics. Hudson Pacific’s portfolio as of year-end 2022 totals 52 properties with over 21 million square feet with the in-service office portfolio 88% occupied and 89.7% leased. HPP’s balance sheet is strong with 85.1% fixed or capped debt with weighted average maturity of 4.1 years and 4.6% interest rate. They have ~$1 billion in committed liquidity available. Hudson Pacific’s $0.25 per share dividend (quarterly) represents a 20%+ yield currently given the drastically over-sold share price. HPP currently trades at 0.28 price to book and 0.81 price to sales.
Given these two examples, we hope to have shown that trading all office REITs together as if there are no differences within group constituents has been a mistake as there are drastically different operating conditions and dynamics in different underlying exposures and around the country. A carefully selected basket of high quality, differentiated, industry and sustainability leaders in the REIT space today is a promising way to earn high dividend income and to be set up for longer-term price appreciation. Between currently high dividend yields and undervalued market capitalizations, these REITs appear to be set up to be amazing long-term compounders.
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Green Alpha Advisors, LLC is an investment advisor registered with the U.S. SEC Registration as an investment advisor does not imply any certain level of skill or training. Green Alpha is a registered trademark of Green Alpha Advisors, LLC. Green Alpha Investments is a registered trade name of Green Alpha Advisors, LLC. Green Alpha also owns the trademarks to “Next Economy,” “Investing in the Next Economy,” and “Investing for the Next Economy.” Please see additional important disclosures here: https://greenalphaadvisors.com/about-us/legal-disclaimers/
At the time this article was written and published, some Green Alpha client portfolios held long positions in Alexandria Real Estate Equities (ticker ARE) and Hudson Pacific Properties (ticker HPP). These holdings do not represent all of the securities purchased, sold or recommended for advisory clients. You may request a list of all recommendations made by Green Alpha in the past year by emailing a request to any of us. It should not be assumed that the recommendations made in the past or future were or will be profitable or will equal the performance of the securities cited as examples in this article. Not all Green Alpha separate accounts or our sub-advised mutual fund held the stocks mentioned. To inquire whether a specific Green Alpha portfolio(s) holds stock in any particular company, please call or email us.