REITs Are Undervalued Relative To The S&P
Summary
- The S&P is poised to benefit from a strong economy, and it appears to already to be priced in.
- REITs are poised to benefit from a strong economy, and it appears to NOT be priced in.
- A recent price divergence has created favorable relative valuation for REITs.
The MSCI US REIT price only index (RMZ) has turned negative YTD while the broader market surges higher.
I postulate that this divergence is the product of misunderstanding about how economic forces impact REIT fundamentals. Further, I believe that, given the valuation difference, REITs are opportunistic relative to the S&P.
The divergence between REITs and the S&P began in early 2017, as seen below. Note that this is around the time it became likely that tax reform was going to happen.
We believe this is driven largely by misunderstanding. Each of the tailwinds that are fueling the broader market seems equally beneficial to REITs. Let us examine them 1 at a time to demonstrate this point.
Positive market forces
Arguably the biggest tailwinds behind the S&P are the strong economy and reduced taxes. As more stocks are cyclical than countercyclical, it is fairly obvious why a strong economy would benefit the S&P.
When the economy is strong, Apple (AAPL) sells more iPhones and Nike (NKE) sells more shoes. These drivers are in such plain sight for much of the S&P, so it has been easy for the market to price in the benefits of the strong economy. The benefits to REITs are either less obvious or delayed. In REIT sectors that are obviously cyclical, we have seen strong performance mirroring that of the S&P. Hotel REIT prices are up 25% in the last 2 years.
However, in the majority of other REIT sectors, the benefits of a strong economy are less obvious.
Demand for most property types increases with economic strength, but REITs often have long leases, so they will not see the full benefits until the current contracts expire. Thus, while the broader market gets the benefits immediately, REITs with long contracts have to wait for the rollups to occur as contracts expire over the next 10 years.
Essentially, the strong economy increases the organic growth rate of REITs for an extended duration of time as higher market rates eventually become fulfilled on lease renewal. This is huge for the fundamental value of REITs, but I do not think the market is seeing it.
The street only forecasts FFO through 2019 or 2020 for most REITs, so even if the analysts are understanding the implications of the economy on organic growth rates, only 2-3 years of the organic growth are visible through their reports.
In other words, I believe only 2-3 years of REIT benefits from the strong economy are being priced in, when the fundamental impact is closer to 8-10 years of increased growth (the amount of time it will take for higher market rates to price into rolling leases).
Tax reform has been equally obvious in benefiting the S&P. When companies pay less taxes, more revenues flow through to earnings. REITs are pass-through entities which do not pay taxes in the same fashion, so if one looks at a REIT income statement before and after tax reform, they will see virtually no benefit. For this reason, I think the tax cut tailwind has not been priced in to REITs at all.
However, pass-through entities like REITs still pay taxes, just indirectly through shareholders. REITs pay out at least 90% of their taxable income as dividends, and shareholders are taxed on those dividends. This is where the benefits of tax reform come in.
Starting in tax year 2018, 20% of qualified REIT dividends will be deductible against ordinary income, and this deduction can be taken whether or not the individual itemizes deductions.
This is a huge advantage that is unknown to most of the market, and it significantly increases the fundamental value of REITs to shareholders.
The silver wave
A well-known demographic trend is that the large baby boomer generation is reaching retirement age. This bodes well for healthcare providers as demand for services will likely rise.
Similar to the other tailwinds, the broader market has wasted no time pricing it is as the healthcare sector hit an all-time high this week. Healthcare REITs, however, have gone the opposite way, down significantly on the year.
Source: SNL Financial
Just as with the other REIT sectors, the benefits to REITs are delayed and not obvious to investors. Instead, the sector has become feared due to troubles with specific tenants that are not performing well. While this is a real headwind that is actually hurting the earnings of some healthcare REITs, it is temporary in nature. Tenants can be replaced, and the long-run earnings of these REITs will ultimately be determined by demand for the properties. As the silver wave flows through to increased demand for services, we anticipate demand for healthcare properties increasing proportionally.
Tech boom
Perhaps the biggest contributor to the S&P's runup is the tech sector. Large-cap tech companies are capturing massive market share and revenues. As evinced by the sky-high multiples on some tech names, many believe these revenues can later be translated to earnings through margin expansion. I'll leave that plausibility discussion up to those better versed in tech than myself.
What is often overlooked, however, is that REITs have a massive exposure to tech. The Vanguard Real Estate ETF (VNQ) has 4 tech names in its 9 largest positions.
American Tower (AMT), Crown Castle (CCI), Equinix (EQIX), and Digital Realty (DLR) alone make up 14.11% of the index.
The difference here is that REITs trade on cash flows, making the same sky-high multiples almost impossible. The 4 biggest tech REITs trade in a range of 17.1X 2019 consensus est. FFO for DLR to the high of 23.7X for Equinix. In comparison, many broader market tech companies trade at multiples in the hundreds or even infinite as some large caps still have negative profits.
Even at cash flow grounded multiples I consider some of the tech REITs to be overvalued, but the overvaluation is slight compared to the extreme multiples of broader market tech. There is a huge valuation gap between tech REITs at ~20X FFO and broader market tech, which, in many cases, features multiples in the hundreds. I don't think the difference is clearly justified.
The REITs have exposure to the same drivers.
Tower and fiber REITs have had explosive demand growth with the rollout of 4G and can continue to have explosive growth in the rollout of 5G. This is still in the early innings.
Data center REITs have had impressive demand from the rise of big data and the increasing necessity of colocation and redundancy. The REIT model remains the most efficient form of owning this kind of asset, and there are no signs of the demand growth slowing.
Consumer spending
With the strong economy, consumer products companies have experienced massive price appreciation.
Source: Google Finance
Over the last 2 years, the Consumer Discretionary SPDR ETF (XLY) is up 50%.
Consumer-facing REITs, however, have sunk.
Source: SNL Financial
I would argue that the underlying fundamentals are somewhat similar. Both are driven by consumption spending, which is unequivocally strong, even when inflation adjusted as seen below.
The argument against retail REITs which has cratered their prices is that much of this consumption is going to online. This is certainly true, but I think the magnitude of e-commerce is greatly exaggerated by the media. If fact, Statista estimates e-commerce having a market share of only 10%.
Source: Statista
Note that this is up from 8% in 2016. Well, let us crunch some numbers.
Based on the FRED data charted above, overall consumption is up 5.28% over the last 2 years. This change outweighs the market share grab of e-commerce. (105.28 * 90%) = 94.75 > (100 * 92%) = 92. In other words, consumption, excluding e-commerce, has grown in real terms. This should benefit brick and mortar retail.
Outside of the B and C malls, same-store sales growth has broadly been positive, and NOI has been up materially. The drop in retail REIT prices over the past 2 years corresponds to a time period of generally improving fundamentals.
I would also note that the portion of consumption growth that goes through e-commerce has been a huge boon to the industrial REITs. This means that consumption growth benefits REITs regardless of how it is split between brick and mortar and e-commerce.
Summary of fundamentals
General economic strength in the US is helping a majority of businesses. Based on the reasoning detailed throughout this article, we believe REIT fundamentals have improved just as much as those of the broader market. The major difference has been in the price action of the stocks.
We attribute divergent price action to a timing window, which is masking the fundamental accretion to REITs. Broader market stocks enjoy immediate double-digit earnings growth from the economy and tax reform, while REITs get a similar magnitude of benefit but stretched over 8-10 years. Quite simply, I think the market is only seeing and pricing in the first couple years of growth. As a result, REITs have become opportunistically valued relative to the broader market.
Relative valuation
Over the past 5 years, S&P 500 trading multiples have expanded from the mid-high teens to 25.19X trailing earnings.
Source: Multpl.com
The Shiller PE has grown even more to 33.29X.
Source: Multpl.com
This does not necessarily mean the broader market is overvalued. To the extent that the economic prosperity continues, there could easily be enough earnings growth to justify this somewhat lofty multiple.
However, I think it does mean that REITs are relatively more opportunistic. Over the past 5 years, REITs have had virtually no multiple expansion with the REIT index still trading below 20X trailing FFO.
Source: SNL Financial
The bottom line
- The S&P is poised to benefit from a strong economy, and it appears to already to be priced in.
- REITs are poised to benefit from a strong economy, and it appears to NOT be priced in.
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