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Update For Equity REIT Basket Strategy As Of 4/22/16

Apr. 22, 2016 9:15 PM ETBDN7 Comments
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This topic was last updated here: Update For Equity REIT Basket Strategy As Of 4/12/16 - South Gent | Seeking Alpha

I discussed reasons for maintaining an allocation to REITs here: Update For Equity REIT Basket Strategy As Of 7/24/15 - South Gent | Seeking Alpha (scroll to "Why Own Equity REITs")

I discussed interest rate cycles and REITs here: Update For REIT Basket Strategy As Of 8/11/15/Interest Rate Cycles And REIT Stock Prices - South Gent | Seeking Alpha (scroll to "Interest Rate Movements and REIT Stocks")

I am tracking realized gains and losses, along with annual dividend payments, here:Gateway Post: Equity REIT Common and Preferred Stock Basket Strategy

Total Net Realized Gain Since September 2013 Inception: +$7,271.93 (of which $1,356.09 has been in equity preferred stocks)

During the life of this basket, I believe that dividend income will swamp realized gains and will generate over 70% of my total return.

All of the Canadian REITs make monthly distributions as does BRG, IRT and STAG. The rest pay quarterly.

I do include REIT cumulative preferred stocks in this basket: Advantages and Disadvantages of REIT Cumulative Equity Preferred Stocks (9/25/2009 Post).

Over the past several weeks, I have reduced my allocation to REITs and increased my allocation to regional banks based on my opinion that increases in inflation will trigger a greater than currently anticipated rise in interest rates.

As I become more concerned about a rise in rates, I will shift money out of REITs into my regional bank basket and vice versa when I believe rates will remain stable at abnormally low levels or decline. I consequently manage these two baskets in tandem as natural, though imperfect, hedges for one another. REIT and Regional Bank Baskets (3/20/2014 Post). I am concerned about directional changes in interest rates up or down and the potential decree of directional changes.

REITS performed poorly when the ten year treasury spiked from 1.66% to 3.04% during 2013. The regional bank ETF KRE had a 47.5% total return that year. When interest rates came back down in 2014, KRE had a total return of 1.85% (generated by the dividend payments), whereas the REIT ETF VNQ had a 30.36% total return.

Interest Rates:

A potentially deadly combination for equity REITs is a spike in intermediate interest rates occurring when valuations are already high. That is what happened starting in May 2013.

While equity REITs will generally benefit by rising inflation in terms of increases in rents, that benefit occurs at a price when inflation pushes up financing and other operating costs.

The weighted average maturity of REIT debt is usually in the 4 to 6 year range. Commerical mortgages are typically for 5 years. Other operating costs could also be rising at a faster rate than rent adjustments reflecting an increase in CPI.

Over the next few years, it is certainly possible, even likely IMO, that intermediate interest rates will rise by a faster percentage than inflation, which will not be a favorable operating environment for equity REITs.

This occurs when rates have been kept artificially low by central bankers. Simply returning to normal market based spreads to inflation-with no increase in the anticipated inflation rate, would cause serious percentage losses in bonds and bond like investments.

Treasuries maturing in 5 to 10 years are now near historical lows and will likely provide negative real rates of return before taxes.

A normal historical spread for a 10 year treasury is 2% over the anticipated inflation rate.

Back in the 2013 rate spike, there was no increase in inflation expectations and CPI declined slightly.

Yet, the ten year treasury went from 1.66% on 5/2 to 3.04% on 12/31/13. (2013 Daily Treasury Yield Curve Rates) While many call that the "taper tantrum", I viewed then and now as the market's first effort to return to market based yield pricing rather than a manipulated central bank price, and that effort eventually failed. The 2013 annual inflation rate was 1.47% and has averaged 1.68% for the six year period ending with last year's .12% rate heavily influenced by the commodity price collapse.

This is what annual CPI rates looked like moving back from 2009:

Consumer Price Index, 1913- | Federal Reserve Bank of Minneapolis

So I am not going to view the current break-even spreads for intermediate and long term TIPs as rational given what we know now about the past and the present. The low inflation rates are directly tied to a Near Depression that caused widespread economic anomalies that continue to dissipate. It takes about 6 or 7 years to recover from a "systemic banking crisis": Recovery from Financial Crises: Evidence from 100 Episodes by Reinhart and Rogoff. In other words, it would be a historical mistake to assume the next 7, 14, or 21 years will have the same or similar inflation numbers as the last 7.

10-Year Breakeven Inflation Rate-St. Louis Fed

20-year Breakeven Inflation Rate-St. Louis Fed

30-year Breakeven Inflation Rate-St. Louis Fed

As I have said more than a few times, the Bond Ghouls have lost their marbles in predicting an average annual inflation rate of 1.55% to 1.65% over the next 10, 20 and 30 years.

The market based price, where investors demand and receive a premium to the actual and anticipated inflation rate, is what I mean by a normal rate determined in a free market unfettered by massive and extremely abnormal central bank monetary policies.

The move toward rate normalization would result in substantially higher rates than prevailing now even with inflation expectations remain as abnormally low as they are now. The rate normalization process is likely to occur when central banks cease their massive and extremely abnormal monetary policies including QE programs, negative interest rates, ZIRP and near ZIRP level short term rates when there is inflation.

The FED is the first major central bank to start a gradual policy toward rate normalization, accomplished so far through the end of its asset purchase program (other than reinvestment of proceeds as securities mature) and their move off ZIRP, though only a .25% increase so far.

The important question now is how fast will the FF increases come. The pacing will in large part depend on whether inflation continues to pick up steam, both in the core and sticky prices as well as the headline number. Core prices have increased at a 2.6% clip over the past three months and 2.2% Y-O-Y through March. ftportfolios.com

Investors see at most one .25% late in the year with a 52% probability in November and a 66% probability in December. Countdown to FOMC - CME Group (two rate increases this year would be more than merely surprising now)

The two strong deflationary forces, the decline in energy prices and the rise of USD, have bought the FED some time, but that time is now running out.

Energy commodities were down 21.2% Y-O-Y in March with gasoline declining 20.9%. Consumer Price Index Summary

Prices for energy commodities are now turning back up.

WTI's spot crossed over $40 this week which is about where it was in the week ending 8/21/15. Cushing, OK WTI Spot Price FOB (Dollars per Barrel) On 4/24/15, the WTI spot price was at $55.98 and started a steady decline after 5/29/15 that brought the price into the 30s by year end. So by early August 2016, possibly a little sooner, we may even see energy commodities contribute to annual U.S. inflation rather than substantially detracting from it.

Retail Prices for Gasoline, All Grades

Weekly U.S. All Grades All Formulations Retail Gasoline Prices (Dollars per Gallon)

U.S. Gulf Coast Conventional Gasoline Regular Spot Price FOB (Dollars per Gallon)

New York Harbor Conventional Gasoline Regular Spot Price FOB (Dollars per Gallon)

The Stock Jocks are forecasting a robust upturn in the economy starting in the second half and carrying through 2017. Wage increases are bubbling up from the bottom.

It remains to be seen whether or not the Stock Jocks are seeing things again that are not there, mass delusional episodes are known to happen from time to time, but they are generally better in longer term forecasts than the Bond Bookies who have difficulty seeing beyond the tips of their noses.

And, the warm to hot inflation numbers in several important categories can be dismissed as temporary only for so long before Janet and her cohort of extreme Doves just look ridiculous.

Basket as of 4/22/16:

I am more inclined to keep my Canadian REITs due to their higher dividend yields, lower P/AFFO ratios, monthly payouts and what appears to be a bottoming process underway in the Canadian economy. The largest Canadian REIT position is Northwest Healthcare Properties Real Estate Investment Trust (NWH.UN:TOR) which owns medical office buildings and some other healthcare properites. Properties & Leasing - NorthWest Healthcare Properties

For U.S. REITs, the allocation is tilted in the healthcare sector and to smaller and higher yielding REITs. The largest position remains Omega Healthcare (OHI) at over $10.3K. The next largest is Medical Properties Trust at $8.4+K.

The Lazard U.S.Real Estate Indicators Report for March is available on the internet. As of that month's end, the aggregate P/FFO was high at 17.9. VNQ has moved down in price since 3/31.

So, I am cautious on REITs for two reasons: valuations are in many

cases at or near historical highs and interest rate risk is becoming

more of a threat. My allocation is still high, but coming down.

+++++++++

1. Sold 100 BDN at $14.25+:

Snapshot of Profit: +$55.5

I also received $45 in dividends.

Brandywine Realty Trust (BDN) was my lowest yielding REIT and has not performed well since my last purchase. As part of my ongoing REIT allocation reduction, I decided to shed this small position.

A two year chart suggests that a better entry point would be below $12, but I would not be chomping at the bit to own an office building REIT seven years or more into an economic recovery either.

BDN Interactive Stock Chart

The current quarterly dividend is $.15 per share which has been in effect since the 2010 first quarter when it was raised from $.1. The dividend rate was $.44 in the 2008 4th quarter. BDN Dividend History

The current dividend yield is 4.21% about at $14.25.

Disclaimer: I am not a financial advisor but simply an individual investor who has been managing my own money since I was a teenager. In this post, I am acting solely as a financial journalist focusing on my own investments. The information contained in this post is not intended to be a complete description or summary of all available data relevant to making an investment decision. Instead, I am merely expressing some of the reasons underlying the purchase or sell of securities. Nothing in this post is intended to constitute investment or legal advice or a recommendation to buy or to sell. All investors need to perform their own due diligence before making any financial decision which requires at a minimum reading original source material available at the SEC and elsewhere. A failure to perform due diligence only increases what I call "error creep". Stocks, Bonds & Politics:ERROR CREEP and the INVESTING PROCESS. Each investor needs to assess a potential investment taking into account their personal risk tolerances, goals and situational risks. I can only make that kind of assessment for myself and family members.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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