Despite a generally healthy real estate market, Reits have been held back amid heightened short-term sensitivity to interest rates.
While rates could remain a factor, we see the recent pullback as an opportunity to build allocations to Reits: they look attractive next to stocks, bonds and private real estate; equity correlations are at a 16-year low; and better fundamentals may be on the horizon.
Rising rates do not happen in a vacuum. One of the things we find some investors and the financial press consistently get wrong about Reits is their relationship with interest rates: if rates are rising, you should not own Reits. This belief – however disconnected from historical evidence – often seems too ingrained to suggest otherwise.
Interest rates are part of the equation, and sudden moves in bond yields can create volatility. However, Reits are not bonds. In an improving economy, landlords can raise rents as tenants fight for more space, potentially increasing cash flows to offset the effects of higher rates. In other words, it should matter why rates are rising, not simply that rates are rising.
Rising Treasury yields have been historically positive for Reits when accompanied by a stronger economy. This has not been the case recently.
What has driven recent underperformance?
Since the start of 2015, Reits have been among the most out-of-favour segments of the market, delivering flat returns even while growing cash flows at 7-8% per year.
Reits have pulled back sharply in early 2018, trailing the broad market by 12% through 15 February, bringing the one-year underperformance to 24%. Reits have also fallen behind private real estate, compared with a 3% annual return premium to the private market over the past three decades.
A perfect storm of factors have contributed to the negative sentiment. Firstly, interest rate sensitivity has been unusually high, with rates coming off historically low levels amid the unprecedented unwinding of quantitative easing (QE). Markets are also anticipating the need for faster rate hikes in response to tax cuts, tight labour markets and rising inflation.
We believe an opportunity is emerging. While there is no way of knowing exactly when a bottom will occur, we believe an opportunity is shaping up for increasing Reit allocations, taking advantage of their attractive valuations and diversification potential.
Attractive valuations and low correlations
Reits have the potential to be strong diversifiers with financial assets, due to the low correlations to stocks and bonds. We believe the need for diversification is especially important at a time when bonds face challenging return prospects in the face of QE unwinding, which could suppress their effectiveness in countering the volatility of stocks.
Earnings multiples for Reits have contracted over the past five years, while those of the S&P 500 have expanded. This accounts for most of the broad market’s outperformance compared with dividends and earnings growth. As for bonds, Reits are often valued in terms of the income they provide in relation to bonds. Reits currently offer a yield premium of 175bp over 10-year Treasuries, wider than the historical average of 114bp.
As we can see for private real estate, Reits have traded at a 2.7% average premium relative to NAV since 1994. This premium partly reflects the expected value Reit managements may add over and above the underlying real estate. As of 15 February, Reits were trading at a 4.3% overall discount, based on our estimates.
Since the early 1990s, there have been 11 times Reits ended the month at an NAV discount after spending at least six months at a premium. Most of these discounts occurred in periods of economic expansion and strong fundamentals, like now. In the 12 months following these occurrences, Reits generated an average total return of 16.1% and, in the majority of cases, returned to trading at a premium to NAV.
In our view, NAV discounts alone should not be viewed as a buy signal, but rather as context for understanding the relationship between Reits and the health of the underlying property market.
We are confident in the prospects for economic growth over the next year, supported by a continued upturn in the business cycle, regulatory relief and continued job growth amid one of the broadest global expansions on record – with added fuel from tax cuts.
Furthermore, we believe property supply in the US appears to be peaking, which could lead to some acceleration in fundamentals later in the year. In this context, we believe a reasonable framework for return expectations is roughly 9%, composed of mid-single-digit cash flow growth plus 4.7% dividend yields, assuming no multiple expansion.
While we cannot say when Reits will reverse their recent underperformance, we see this as an attractive opportunity to begin legging into higher Reit allocations, taking advantage of low relative valuations, strong diversification potential and robust demand in the private market.