Real Estate Weekly: Digital Realty Becomes A Cloud Computing … – Seeking Alpha

Weekly Review

The REIT ETF indexes (VNQ and IYR) finished the week lower by 0.3% as the 10-year yield climbed 7bps following the UK elections. The S&P 500 (NYSEARCA:SPY) gained 0.3%. The homebuilder ETFs (XHB and ITB) were lower by 1.0% on the week. The commercial construction ETF (NYSEARCA:PKB) gained 0.2%.

(Hoya Capital Real Estate, Performance as of 12pm Friday)

Across other areas of the real estate sector, mortgage REITs (NYSEARCA:REM) finished the week higher by 0.5% and the international real estate ETF (NASDAQ:VNQI) declined 0.6%. The 10-Year Treasury yield (NYSEARCA:IEF) gained 7 bps on the week, recovering from YTD low yields earlier this week.

REITs are now higher by 0.8% YTD on a price-basis and higher by roughly 3% on a total-return basis. The sector divergences are quite significant: the Data Center sector has surged 24% while the retail-focused REITs have fallen double-digits. REITs ended 2016 with a total return of roughly 9%, lower than its 20-year average annual return of 12%.

REITWeek Recap

This week was NAREIT's annual REITWeek conference in New York City, the biggest industry conference of the year. We listened to about 25 presentations across all the major REIT sectors.

We came away with a slightly more positive outlook on the REIT sector as a whole. Retail REITs were unquestionably the major focus for many investors. The bifurcation between high-quality and low-quality retail space has intensified. High quality retail space in desirable locations continue to perform very well and, in many cases, the apparel downsizing has actually been a net positive as the vacated space has been put to more productive and higher-traffic uses. We detailed our judgments in "Short Squeeze May Send Mall REITs Surging."

We also published, "Obamacare Uncertainty Remains A Drag On Healthcare REITs," our update on the Healthcare REIT sector. We discussed that healthcare REITs have outperformed over the past quarter, but this outperformance is entirely attributable to plunging interest rates. Healthcare REITs are up 8% as the 10-year yield fell 45bps. Hospitals and skilled nursing REITs, the sub-sectors most exposed to changes in healthcare policy, continue to trade at substantial discounts as Obamacare crumbles and its replacement appears politically infeasible. While much of the media focus is on drug prices, labor costs are the true drivers of healthcare inflation. This is a structural allocation-of-resources issue within the American education system.

Finally, we also published our Net Lease update, "Retail Contagion Continues To Trouble Net Lease REITs" where we discussed that despite the significant decline in interest rates over the past quarter, net lease REITs have badly underperformed the broader REIT indexes, a worrying development for the sector. Net lease REITs are the most yield-sensitive REIT sector, but these REITs have not acted as bond-proxies so far this year. Investors have been rudely reminded of the significant retail exposures of these names. Credit issues with key tenants at Spirit Capital has dragged down the entire Net Lease sector. More than other REIT sectors, net lease REITs depend on their cost of capital advantage for acquisition-fueled growth. Spirit's credit issues may have meaningfully impaired the sector's competitive advantage.

Arguably the most significant piece of REIT news this week actually came after the conference, as Digital Realty (NYSE:DLR) announced a merger with DuPont Fabros (NYSE:DFT) to form a data center giant that appears more fortified to go head-to-head with the public cloud providers, Google (NASDAQ:GOOG) and Amazon (NASDAQ:AMZN). While demand has continued to be robust and outstripping supply, pricing power has been a concern among investors as companies have increasingly utilized public cloud solutions rather than using their own server racks in the data center. In many cases, both the public and private cloud are both located in these REIT data centers, but the rent per megawatt is lower when, for example, Amazon is the tenant rather than an individual mid-sized company. We think consolidation is the right move. We will write a full report on it early next week.

The six best performing REITs on the week were Dupont Fabros , LaSalle Hotels (NYSE:LHO), Diamondrock (NYSE:DRH), Pebblebrook (NYSE:PEB), Sunstone (NYSE:SHO), and CoreSite (NYSE:COR).

The six worst performers on the week were Care Capital (NYSE:CCP), National Retail Properties (NYSE:NNN), Store Capital (NYSE:STOR), Realty Income (NYSE:O), Digital Realty , and CubeSmart (NYSE:CUBE).

Economic Data

Every week, we like to dive deeper into the economic data that directly impacts real estate.

(Hoya Capital Real Estate, HousingWire)

Home Prices Continue To Rise As Mortgage Rates Continue To Fall

Core Logic's Home Price Index showed a 6.9% YoY rise in home prices in April, a slight deceleration from the 7.1% YoY rise in March."Mortgage rates in April dipped back to their lowest level since November of last year, spurring home-buying activity," said Dr. Frank Nothaft, chief economist for CoreLogic. "In some metro areas, there has been a bidding frenzy as multiple contracts are placed on a single home. This has led home-price growth to outpace rent gains. Nationally, home prices were up 6.9 percent over the last year, while rent growth for single-family rental homes recorded a 3 percent rise through April, according to the CoreLogic Single-Family Rental Index."

Zillow's April Case-Shiller forecast sees a 5.6% rise in home prices for April. Home price appreciation has reaccelerated in recent months after showing signs of slowing in early 2017 as mortgage rates shot up nearly 100bps from the summer 2016 lows. All else equal, lower mortgage rates lead to higher home prices.

Bottom Line

REITs fell 0.3% on the week as the 10-year yield climbed 10 bps. Hotels and retail REITs were the best performers. This week was the annual REITWeek conference in NYC. We came away with a more positive outlook on the REIT sector as a whole, especially the higher quality retail space.

Apartments and hotels have been upside surprises this year and have defied the headwinds from higher supply. Demand has been robust in both sectors and has largely offset higher supply. Digital Realty will merge with DuPont Fabros to form the largest data center REIT. Consolidation will allow these REITs to command better pricing power with the public cloud providers.

Please add your comments if you have additional insight or opinions. We encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.

Disclosure: I am/we are long VNQ, SPY, CCP, COR, DLR, CUBE, SHO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: All of our research is for educational purpose only, always provided free of charge exclusively on Seeking Alpha. Recommendations and commentary are purely theoretical and not intended as investment advice. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. For investment advice, consult your financial advisor.

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Real Estate Weekly: Digital Realty Becomes A Cloud Computing ... - Seeking Alpha