The Misunderstood Outperformer
The sentiment of investors is highly volatile. One day, they may be very enthusiastic about a given asset class to a few weeks later think very differently. In this sense, we are today seeing euphoria in the cryptocurrency markets with Bitcoin (COIN) making large gains in 2017, and on the other hand, more traditional and perhaps “boring” investments such as REITs selling off significantly…
Seth Klarman once noted that:
The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions.
We believe that this quote is particularly relevant when it comes to the REIT market. Despite having existed for many decades, REITs still as of right now, remain deeply misunderstood by the investment community with many large misconceptions causing irrational market behavior.
Many people who traditionally invested in real estate often do not trust – or bother to understand the stock market, while most people who invest in stocks are uncomfortable with commercial real estate. Put differently, REITs tend to be perceived as stocks by real estate investors, and as real estate by stock investors. We think that being a hybrid of both, made it difficult for investors to categorize REITs into one category and led to substantial biases as well as a general lack of interest from the investment community.
One large, and perhaps the largest misconception is that REITs are bond-proxies. This perception comes from the higher than average dividend payments, the stability of rental income, and the belief that REITs cannot grow. Consequently, many investors may irrationally consider that REITs are exposed to outsized interest rate risk and sell-off when anticipating interest rates to rise.
This is exactly what we are seeing today with the major REIT index (VNQ) down about 10% in just a few months:
Investors know that the fed is likely to raise rates once again and are running for the exit. The sudden large supply of shares is putting the market in imbalance and causing the share prices to drop in order to meet the demand.
Now at the newly low price, is this an opportunity to pick up shares of REITs at a discounted valuation?
We think that the best way to answer this question is to look into the past and see how investors behaved in similar situations. While past performance is no guarantee of future performance, we believe that the best predicator of future behavior is past behavior, especially in cases of potential market overreaction. If past market behavior is in fact indicative of the future behavior, then we expect REITs to quickly rebound and outperform most other sectors.
We have observed this at many times in the past years: REITs sell off leading to rate hikes and quickly rebound after. The Fed has raised rates many times before, and REITs seem to always sell off and then quickly recover. This is nothing new; we have profited from this short-term cycle at many times and expect this time to be no different.
Consider the following recent examples:
Less than one year ago, following a favorable job report which beat expectations, the 10-year Treasury rose up to approximately 2.6% and resulted in a REIT market sell-off. In anticipation of even more rate increases, this is how the market reacted:
Was this an overreaction of the market? To answer this question, have a look at the same chart only one month later:
All the losses had been practically recovered. It took only one month for the market sentiment to reverse and those who followed me on this trade back then earned a quick and nice return. This was an easy call for me, and I was confident that a recovery was around the corner simply because that is what history has thought me.
Looking a little further into the past, we can see this repeat over and over again. Another recent example was the rate hike of December 2016:
Can you recognize a similar pattern? A sell-off leading to the rate hike, followed by a quick recovery… This has happened tens of times in the past in a surprisingly consistent and repeatable manner. Periodically, investors get scared off, sell off, but quickly jump back on the train to keep earning their dividends. This makes no sense, but it is clearly what is happening.
Now fast forward to today, and we are back to square one. REITs have sold off leading to more rate hikes, and we expect another rebound just like we have seen so many times in the past. It is third time that we make the same recommendation following a sell-off, and so in this sense, this is “Round 3” for us. Thus far, our track record is very favorable with each time the market recovering its losses.
Yet this should not come as a surprise because REITs are NOT bonds, and their fundamentals are NOT greatly affected by interest rate increases.
Strong Fundamentals Despite Interest Rates Increases
Interest rate increases may greatly affect REIT share prices, but they are not really affecting fundamentals much at all. This is because unlike bonds, REITs are able to grow their cash flow, and this is especially true in times of economic growth as we are experiencing today.
Interest rates are rising today because the general economy is doing well. This leads to higher occupancy rates, higher rents, and more demand for real estate space. All very positive to REITs thus far.
On the other hand, the NAV of REITs may decline due to cap rate expansion, but this is not negatively affecting cash flows. Opposite of that, higher cap rates may allow REITs to achieve more external growth through more profitable new acquisitions.
Lastly, bears point out that rising rates would lead to higher interest expense for REITs; and while this may be true, it ignores that REITs mostly use fixed rate debt and have an average debt ratio of only 30%. As such, the impact is fairly small, and in many cases, not even noticeable for many years until the debt is rolled over. Given that we are talking about 25 basis point rate hikes, we see no reason to panic here.
To recap, the consequences of the rate hikes for REITs are the following:
- Higher rents, higher occupancies result in more NOI and internal FFO growth.
- Higher cap rates result in more profitable new investments and more external FFO growth.
- NAV may decline over the short run, but this is not affecting the real results, which are cash flow and dividends.
- Interest expenses may increase, but this is not causing any immediate impact in most cases as debt is fixed rate and has many years remaining on its term.
So, overall, there is negative and positive, but it is far from being as negative as the general market perception pictures it. I never understood how a strong economy is supposed to be a negative for property owners, yet this is what the market believes.
Think of it this way: If you owned an office building and a very favorable job report came out suggesting that the economy is improving, would you think of this news as rather positive or negative? I would say that it is good news. If the economy improves, it will lead to more demand for office space, higher rents, and lower vacancy. This is simple logic for real estate investors, but not for REIT investors who see this positive news, and turn it into a negative because it may cause interest rates to increase and therefore sell REITs because of the improved economy. It does not make much sense to me, but it is exactly what is happening.
Research shows that it is the wrong thing to do and yet it happens over and over again. The share prices of listed equity REITs have more often increased than decreased during periods of rising interest rates. In the 16 periods since 1995, when interest rates rose significantly, equity REITs generated positive returns in 12 of them. Knowing that REIT benefits from an improving economy, this result should not come as a surprise.
Still not convinced? Consider one last example:
From July 2004 until June 2006, the Federal Reserve hiked interest rates from 1.25% to 5.25%. Anyone would agree that this was a very material increase that we are unlikely to see today. According to the consensus belief, this should have been a horrible time for REIT investors, yet REITs significantly outperformed the broad equity market:
This is proof that REITs can not only "survive" interest rate increases but even prosper and outperform in these periods. While investors were "panicking," REITs returned more than 48% over that time period while the S&P 500 (SPY) only generated 18%. This is because REITs are NOT bonds. REITs are real estate, and as such, they are able to generate cash flow growth that may more than compensate for the increased interest expense.
High Yield Opportunities
There are today many quality REITs that trade between 8-15 times their FFO including W.P. Carey (WPC), Gramercy Property Trust (GPT), Medical Properties (MPW), Omega Healthcare Investors (OHI), Chatham Lodging (CLDT), Simon Property Group (SPG), Tanger Factory Outlet Centers (SKT), STAG Industrial (STAG), Ventas (VTR), and STORE Capital (STOR) to name just a few. If you own one of these REITs and earn a mid-to-high single-digit dividend yield, you really do not need much growth to get to double-digit returns. Even if interest rate hikes cause the FFO multiple to contract a bit, your long-term returns would still look very compelling.
The perceived risk is higher than it really is in my view. Investors are famous for being overconfidence and for overreacting to macro events. Despite being very stable investments, REITs often become the victim of these irrational behaviors; causing abnormal volatility in the market.
I always load up on REITs when this cycle occurs, and this time is no different.
The lessons to be learnt here are:
Be greedy when others are fearful. Focus on fundamental performance, rather than share price performance. Don’t trade in and out of your real estate investments (REITs). Enjoy the stable and growing dividends, and ignore the market noise.
I look forward for more REIT market selloffs. I will keep buying and expect to earn above average dividend yields along with very respectable long-term growth.
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Disclosure: I am/we are long WPC, GPT, MPW, OHI. 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: I am part of the "High Dividend Opportunities" (HDO) research team.