You Are Right Because Your Data And Reasoning Are Right

Summary

• When the economy is improving and real estate fundamentals are strong, yield-driven corrections have historically been a time to consider adding an allocation to REITs.
• "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." Cohen & Steers.
• In order to take advantage of market declines to buy low, you need a strategy that takes the emotion out of the decision-making process.

When my co-author and I were thinking about a title for my REIT book, I knew right away that I wanted to call it “The Intelligent REIT Investor.” Like many value investors, I was inspired by Benjamin Graham’s book, The Intelligent Investor, that has become the bedrock for my REIT investing strategies. In fact, much of Graham’s reasoning has become part of my DNA, as Graham explained:

“The more the investor depends on his portfolio and the income therefrom, the more necessary it is for him to guard against the unexpected and the disconcerting in this part of his life.”

REITs are wonderful vehicles, especially for those relaying on monthly dividend income. While February was a brutal month for REITs, the Vanguard REIT ETF (VNQ) was down over 8%, it’s important to recognize the reason you own REITs and the opportunities that exist today. Graham said:

“Price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

That is precisely what I am doing.

Over the last few weeks, I have read over dozens of earnings transcripts and I have been able to form an opinion as to the state of the REIT market. One good thing about my broad coverage universe is that I am equipped to analyze a variety of property sectors hoping to dissect “nuggets of wisdom” that could help gain an edge.

Yesterday I published the March edition of the Forbes Real Estate Investor and I explained to my subscribers:

“While the market is still expressing fear that REITs will not be competitive in a rising rate environment, the fundamentals are speaking a different language.

Arguably, REITs are better positioned today than they were in 2013 (beginning of taper tantrum), because most have reduced leverage and disposed of non-core properties. REITs have been preparing for rising rates for quite some time, yet the market has responded as if it’s an apocalypse.”

I began my monthly newsletter service in May 2013 and that period felt a lot like today. REIT shares were getting hammered from the fear of rising rates and the perceived impacts thereof.

Eventually, solid operating fundamentals began to steer the market, instead of impulsive selling, and REITs were able to generate robust returns in 2014 (+30.14%). Then in late 2015, markets began to get jittery again, as the Federal Reserve began to target the first rise in rate (since the Fed pushed the key rate to 5.25% on June 29, 2006). This of course spooked the market and REITs turned in modest results in 2015 of 3.2%.

In 2016, the market heated back for REITs, fundamentals and most property sectors enjoyed a solid return averaging 8.5% (due in large part to the year-end Trump rally). Then 2017 turned into being a solid year as evidenced by our core portfolio (Durable Income Portfolio) that returned over 12% and our Small Cap REIT portfolio returned over 22%.

As we entered 2018, most analysts suspected that the fear of rising rates had already been priced in and nobody (including me) suspected that there would be an extreme February selloff in REIT-land. After all, REITs were exhibiting strong earnings and dividend growth performance and there was really no reason to suspect Mr. Market would spook the crowd once again.

However, Ben Graham provides us with some direction:

“Experience teaches that the time to buy stocks is when their price is unduly depressed by temporary adversity. In other words, they should be bought on a bargain basis or not at all.”

Yesterday we provided Marketplace readers with the following REIT sector returns for the month of February 2017:

As you can see, there are opportunities in most every property sector, and while the fear of rates has certainly spooked the market, we consider the selloff to an excellent time (like May 2013) to initiate new positions and/or dollar cost average shares. As Ben Graham said best:

“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

Source: Pexels

You Are Right Because Your Data And Reasoning Are Right

While rates could continue to remain a factor, we consider the pullback to be an opportunity to build allocations to REITs. As Thomas Bohjalian, CFA, Executive Vice President at Cohen & Steers explains:

“One of the things we find that some investors and the financial press consistently get wrong about REITs is the relationship with interest rates— that if rates are rising, you shouldn’t 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. But 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. That hasn’t been the case recently.

As I referenced above, since the start of 2015, REITs have been among the most out-of-favor segments of the market, delivering flat returns even while growing cash flows at 7–8% per year. Bohjalian at Cohen & Steers believes that today there is a “perfect storm of factors (that) have contributed to the (more recent) negative sentiment:

• Interest-rate sensitivity has been unusually high, with rates coming off historically low levels amid the unprecedented unwinding of quantitative easing (QE).
• Markets are anticipating the need for faster rate hikes in response to tax cuts, tight labor markets and rising inflation.
• REIT fundamentals have slowed as the cycle has matured, while corporate tax cuts will not directly benefit REIT earnings (the benefit is likely to be more gradual as a result of stronger demand, and many investors may benefit from lower taxes on REIT distributions)."

Recognizing these unusual circumstances, it’s true that interest rates could continue to be an outsized factor in the current environment, and volatility could persist. However, Bohjalian at Cohen & Steers points out that “waiting for the ideal environment in any asset class is not practical—and in the meantime, we are seeing credible indications of value on multiple fronts.”

REIT correlations with stocks are at a 16-year low.

REITs have the potential to be strong diversifiers with financial assets, illustrated by their low correlations to stocks and bonds (see below). 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.

REITs are trading at attractive historical values relative to stocks, bonds and private real estate.

Vs. stocks (see below): Over the past five years, REIT earnings multiples have contracted, while those of the S&P 500 have expanded, accounting for most of the broad market’s outperformance compared with dividends and earnings growth. Paradoxically, the market seems less concerned about the risk that higher interest rates and the QE unwind poses to stocks even though their multiples are more inflated by comparison.

Vs. bonds (see below): REITs are often valued in terms of the income they provide in relation to bonds. REITs currently offer a yield premium of 175 basis points over 10-year Treasuries, wider than their historical average of 114 bps, indicating relative value compared with fixed income.

Vs. private real estate (see below): Since 1994, REITs have traded at a 2.7% average premium relative to their property holdings, measured by net asset value (NAV). This premium partly reflects the expected value that REIT managements may add over and above the underlying real estate. As of February 15th, REITs were trading at a 4.3% overall discount based on our estimates - meaning investors gain access to properties for less than what private investors are likely to pay, while getting the management operations for free.

Since the early 1990s, there have been 11 times when REITs ended the month at a NAV discount after spending at least six months at a premium (see below). Most of these discounts occurred in periods of economic expansion and strong fundamentals, just 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. When the economy is improving and real estate fundamentals are strong, yield-driven corrections have historically been a time to consider adding an allocation to REITs.

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 $200 billion in tax cuts for 2018.

Furthermore, we believe property supply in the U.S. 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.

As Bohjalian at Cohen & Steers explains, “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. When the economy is improving and real estate fundamentals are strong, yield-driven corrections have historically been a time to consider adding an allocation to REITs….

Furthermore, we believe property supply in the U.S. 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.”

Demand for private real estate is substantial and growing.

Managers of private equity funds are holding onto a record $250 billion of uninvested capital (“dry powder”) earmarked for real estate (see below). Fundraising efforts have increased for 2018, suggesting that this amount is only likely to grow. With the recent underperformance of REITs, private fund managers are warming up to acquisitions through the listed market, particularly for companies trading at deep and sustained discounts.

Cohen & Steers sums up (in BOLD):

“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.”

DAVOS 2.0

Benjamin Graham reminds us that “if you want to speculate do so with your eyes open, knowing that you will probably lose money in the end; be sure to limit the amount at risk and to separate it completely from your investment program.”

As I said at the outset, I am a hardcore value investor and while Benjamin Graham’s famous book (The Intelligent Investor) does not provide us with the crystal ball as to whether REITs continue to underperform, it does provide us with a set of principles that help form an investment philosophy.

Specifically, value investors have guidelines that can point you in the direction of good stocks, and just as important, steer you away from bad ones. Simply put, buying stocks when they are cheap has always been the best way to grow money and stock of high-quality companies on sale reap the highest returns.

Recently I was speaking at a conference and someone asked, “If you started today and wanted to pick five of the best REITs, which ones would you select?” Immediately, I thought about my ‘DAVOS’ portfolio, and I replied that I would buy four of the five REITs - Digital Realty (DLR), Ventas (VTR), Realty Income (O) and Simon Property Group (SPG) - but I would wait on American Tower (AMT), which yields just 2%. I then said I could still call it ‘DAVOS 2.0’ and swap out AMT for AvalonBay (AVB).

The point is, I highly recommend all four of those DAVOS names, and in fact, I plan to open accounts this week for my kids (tuition funds). I will use the DAVOS 2.0 names, which includes AVB. These REITs are high-quality performers, and I suspect the price of their shares will soon reflect the strong value of the underlying real estate.

In order to take advantage of market declines to buy low, you need a strategy that takes the emotion of the decision-making process. The dependability of dividends is a big reason to invest in REITs and as Ben Graham remarked, “earnings are the principal factor driving stock prices.” He added:

“It is the consistency in the products that creates consistency in a company’s profits. Consistency and durability are attributes for competitive advantage.”

Never forget, “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.” Happy SWAN investing!

Source: Pexels

The Intelligent REIT Investor is available on Amazon (and we are excited that our publisher (Wiley) recently created an all-new Chinese-translated version).

Disclaimer: The mention of specific securities is not a recommendation or solicitation by Cohen & Steers to buy, sell or hold any particular security and should not be relied upon as investment advice. For a complete list of holdings of any Cohen & Steers U.S.-registered open-end fund, please visit their website at cohenandsteers.com.

With over 30 years of REIT investing experience, Cohen & Steers has built the world’s largest investment team dedicated to real estate securities, giving us a unique perspective on the market. Historically, this knowledge advantage has given us an edge when managing REIT portfolios, allowing us to deliver consistently superior results for our investors over multiple time periods.

Note: Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and be assured that he will do his best to correct any errors if they are overlooked.

Finally, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking. If you have not followed him, please take five seconds and click his name above (top of the page).

Analyst’s Disclosure: I am/we are long ACC, AHP, APTS, ARI, BRX, BXMT, CCI, CHCT, CIO, CLDT, CONE, CORR, CUBE, DDR, DEA, DLR, DOC, EPR, EXR, FPI, FRT, GEO, GMRE, GPT, HASI, HTA, INN, IRET, IRM, JCAP, KIM, LADR, LAND, LMRK, LTC, MNR, NXRT, O, OFC, OHI, OUT, PEB, PEI, PK, PSB, QTS, REG, RHP, ROIC, SBRA, SKT, SPG, STAG, STOR, TCO, UBA, UMH, UNIT, VER, VTR, WPC. 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.