What Does PIMCO's Bill Gross Think Of REITs?

 |  Includes: ICF, IYR, RWR, VNQ
by: Aurora Research


Bill Gross is one of the most prominent assets mangers in history, overseeing nearly $2 trillion in mainly fixed income assets.

Under his rule, PIMCO has recently made public its outlook on future interest rate levels in the US, which is very different than what current market prices imply.

If Bill Gross is correct in his outlook, while the markets’ expectations will turn out wrong, all financial assets will be affected, with substantial potential pricing implications over time.

This will also affect REITs, which will potentially outperform, relative to current implied market expectations, since these imply higher rates and financing costs, than implied by Gross’s view.

Bill Gross may be right or maybe wrong in his outlook. Judging by PIMCO’s long term relative success, he has been more often right than wrong.

Bill Gross is considered by many one of the most successful asset managers of all time, and perhaps the most successful when it comes to fixed income assets. Gross has successfully grown PIMCO, which he co-founded in 1971, to a management firm with nearly $2 trillion assets under management (AUM).

Having a track record of more than 4 decades, and showing the AUM growth which PIMCO has shown, says that in most likelihood, it's not just luck. More often than not, PIMCO and Bill Gross are making wise investment decisions on behalf of PIMCO's clients. It's hard to imagine that only luck and marketing are responsible for the long-term growth of PIMCO.

It is therefore probably a good idea to hear what Bill Gross has to say. Sure, even the smartest and most experiences sometimes miss, but it is hard to argue with success. If history shows that someone is often right, it may be a good idea to at least listen -- even if one elects to dismiss the idea.

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Source: PIMCO website.

Bill Gross is a frequent visitor on TV, radio and elsewhere. However, I believe that where one can best "hear" what Gross thinks through his monthly newsletters, which are published on PIMCO's website. Though the newsletter is published on PIMCO's website, they are signed personally by Bill Gross, so I can assume that a person such as him wouldn't sign his name if he doesn't fully back the ideas the newsletter forwards to the readers.

Naturally, most of the letters deal with macro-oriented issues, and less on micro issues. Being one of the biggest if not the biggest long-term holding fixed income asset manager, there's no doubt that macro issues play a vital part in the decision making process of such a business. So it is no surprise that there's substantial thinking at PIMCO on such broad topics (more than 700 investment professionals are working for PIMCO, a certain part of which deal with such research).

Interest rates outlook - PIMCO vs. the market

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Source: SNL Financial.

It's worthwhile to start out from the market implied interest rate assumptions: Currently, and as it's been over recent months, based on the futures market, it is possible to see what the market as a whole believes with regard to the interest rate trajectory over years to come.

In his letter, Bill Gross states that "forward markets now anticipate a 4% nominal policy rate sometime out in 2020." In addition to him, and in order to validate this comment, one can read one of the many very thorough articles of SA contributor Donald Van Deventer who follows and discusses the market implied figures, most recently here. In Van Deventer's latest, it can be seen that the market believes that short term interest rate (1 month T-Bill) is expected to reach nearly 4% (3.7%) out around year-end 2020 (fed funds rate and one-month T-Bill are very close in terms of yield, one-month being nearly the shortest term rate).

In his newsletters of May, June and July 2014, Bill Gross (and PIMCO) thoroughly outlined his outlook on interest rates in the U.S. in coming years, which is substantially different, and somewhat revolutionary, relative to the markets' expectations. As history shows, Bill Gross isn't one to be fearful of market common ideas (as he says: "PIMCO tries to think out of the box," and it does). He goes to say:

"High debt levels don't necessarily change the rules of finance (you gotta pay to play), but the models upon which they are based. Interest rates have to be lower in a levered economy so that debtors can survive, debt can be reduced as a % of GDP, and economies can avoid recessions/depressions!" (bold in original)

Or in other words:

"Commonsensically it seems to me that the more finance-based and highly levered an economy is the lower and lower real yield levels must be in order to prevent a Lehman-like earthquake." (bold in original)

Bill Gross goes on to discuss what that "magical number" (that is the longer term stable federal funds rate, which supports all the above statements) may be, citing various research work done by, surprisingly, Fed participants or associates of and one work by PIMCO internally. All suggesting that the "magical number" is around 2%, and not 4% as the market expects. He goes on to say:

"I suspect these estimates which average less than 2% (that is the estimates of the works cited, as mentioned above -- AR), are much closer to financial reality than the average, 4% 'blue dot' estimates of Fed 'participants.'"

Interest rates' impact on market

It may be obvious by now to those more familiar with economics, etc., but why is that so interesting or important? Well, instead of me explaining, Bill Gross can probably do so better, saying:

"If future cash returns are 2% (our belief) instead of 4%, then other assets such as stocks and real estate must be assumed to be more fairly priced as well. Current fears of asset bubbles would be unfounded." (bold in the original)

And also:

"Savers would much prefer to receive a 4% yield on their savings than a 2% rate. No-brainer there. But the journey to 4% would be much bumpier and "bear market" would be an apt description of the next half-decade. That is what the Fed is trying to avoid, but in the process they "financially repress" markets, offering a "Yellen put" but distributing low asset returns as a result. Potentially 2% instead of 4% for cash; maybe 3% instead of 5% yields for 10-year Treasury bonds; 4% returns instead of 5-7% for stocks."

Some readers may argue that Mr. Gross is speaking from a position, as one of the largest asset managers anywhere in the globe. However, it seems that Mr. Gross is putting some \of his money where his mouth is -- recently it has been made known that Bill Gross has poured $200 million of his own private wealth into investments which will benefit from low interest rates, mostly leveraged closed ended funds.

What does that may mean to REITs:

Despite the title, I don't know what exactly Bill Gross thinks of REITs. Obviously, I've never had a chance to ask. What I will do is try and guesstimate his thoughts on REITs, given his broader outlook on interest rates, and given the type of investments he has done recently as mentioned above. Over the past year, numerous articles have been written everywhere, and on SA specifically, on the future of REITs in an increasing interest rate environment. Most of them where thorough and thought provoking.

There's no doubt that an increasing interest rate environment is a more challenging environment for REITs than a decreasing interest environment. History shoes that REITs can perform well in an increasing rate environment, but I believe that there's no argument on the fact that it's more challenging. And good performance by REITs in such an environment requires other factors to support that performance (growth, etc).

One of the very important issues, which may affect the performance of all assets and REITs specifically in such an environment, is the speed and magnitude of interest rate change. Under current implied market expectations of interest rates, we can know the expected magnitude of that rate change and the speed (note -- that's just the expectations; things may turn out differently).

With the federal funds rate eventually being the benchmark for all costs of credit and pricing of bonds, stocks and other assets, the end point of that federal funds rate (that "magical number" mentioned above) is critical, as Bill Gross says:

"Well, if a bond investor knew whether 4% or 2% was the long term neutral policy rate, he/she would literally have the key to the kingdom." (bold in the original)

I'd just add that this is probably true to investors in other asset types as well. So surely, the future value of the federal funds rate has extreme implications with regards to REIT performance, which ultimately has major influence on current REIT market pricing. I'll mention two factors which change dramatically, given the above original view by Bill Gross on interest rate trajectory, looked at through the prism of the discounted cash flows method (DCF).

Assets' valuations are determined in various ways; the most coherent and explicit being DCF, to derive at the current value of those future streams. Normally, that would be the amount a buyer would be willing to pay for an asset.

Discount factor -- the denominator

Investors in real estate use the DCF method all the time, sometimes without realizing it: the cap rate, which everyone is relatively familiar with is, a basic form of a DCF. That's a perpetuity growth model, in finance lingo, which basically assumes that the current cash flow would go on forever, at a certain implied growth rate and pricing that cash flow, by dividing an assets' NOI by the relevant cap rate. This calculation, of NOI/cap rate, gives the value of the asset.

In order to calculate the value of the equity in an asset (or in a REIT), one would use as the discount factor, not the cap rate, but rather a variant of the weighted average cost of capital (WACC), which takes into account the blended cost of all types of capital used (equity, debt, preferred). The most important determinant in DCF, to which the final result is most sensitive to, is the discount factor, the WACC. The discount factor, as in the pricing of any financial asset, depends on the risk-free rate, which starts out from the federal funds rate. One of the concerns regarding an increasing rate environment is the growth in the discount factor, which over time would lower assets values.

All else being equal -- if current market valuations assume that the risk free rate (federal funds rate) would end up being 4%, and eventually the federal funds rate would end up at 2%. Or, in another way to view it, if 10-year yield instead of ending up at, say, 5%, would stabilize at around 3%, as Bill Gross assumes, then current pricing is excessively low. (Current pricing does currently imply the markets' expectations, under which the risk free rate is expected to rise from current levels up to 4% over the coming years, thereby increasing the cost of funds.)

Cost of debt -- the numerator

Real estate in general is a very capital intensive business. REITs as an asset class use substantial leverage in its ongoing operations, more so than other asset classes. The cost of the debt is instrumental in the ability of REITs to gain profits. A high cost of debt drastically lower the logic of using it, and vice versa. The very low cost of debt over the past 5 years, among other reasons, has been instrumental in the profitable operations of REITs.

The cost of debt is of less importance when valuing an asset, as oppose to equity (as different investors may use different capital structures to finance an acquisition, which shouldn't change the value of the asset), but is of the highest importance, when valuing the equity part of an asset, or in our case, the equity worth of a REIT (the market cap). The cost of future debts, therefore, is important in establishing an estimate for the future equity cash flows of REITs, the FFO estimates. These FFO estimates are the figure in the numerator, the figure which is then being discounted using the WACC, as mentioned above, in order to derive at the current market value of that equity.

Again, all else being equal -- if future interest rates would end up being lower than the markets' expectations, which is what will happen if Bill Gross is correct in his thesis, than future cost of debt would be lower than currently implied by interest forecasts, and would result in higher future FFO estimates, making current valuations over depressed (based on higher future interest rate assumptions). All else being equal, higher future FFO estimates relative to current estimates taking into account current future interest rate expectations, will lead to higher current valuations for REITs.

Summing Up

Bill Gross (and PIMCO) thinks differently than the market, judging by his view relative to market implied figures. All current market pricing is based on the assumption implied by the market, in this case, that of increasing federal funds rate from current levels to nearly 4% within 5-6 years. Bill Gross believes the more financially relevant figure is 2%.

Whatever the federal funds rate will end up being, will largely influence and drive all other credit costs as well as the value of all other financial assets. If Bill Gross's view will occur, then REITs, which seem fairly priced as an asset class (assuming current market expectations on future rates, since the market uses these estimates to value), would turn out to be underpriced today. Therefore they would outperform going forward providing higher returns (with asset values decreasing less and with future financing costs being lower than currently expected). This would hold both to investing through ETFs (VNQ, IYR, RWR, ICF) or through direct holdings.

Listening to every person's opinion is generally good advice. Listening to the opinion of the largest fixed income asset manager out there on issues on interest rates is a must. He may be right, he may turn out wrong -- judging by the relative success of PIMCO which he heads, he was more often right than wrong.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.