Posted by Paul Curbo, Portfolio Manager and Chris Faems, Associate Portfolio Manager
The September Federal Open Market Committee (FOMC) meeting saw the US Federal Reserve increase rates as expected. Additionally, the 10-year US Treasury yield has risen about 42 basis points (bps) off its lows in late August and is up almost 96 bps from a year ago.1 Historically, upward moves in the federal funds rate or US Treasury yields have typically led to diminished sentiment toward real estate investment trusts (REITs) and/or price pressure relative to general equities. But at Invesco Real Estate, we believe investors should remember that REITs are not bond proxies - these assets do not automatically fall in price as interest rates rise. Rising rates often reflect a growing economy, and REIT cash flows (and share prices) may participate in this growth.
Is history repeating itself?
The pattern we have observed with REIT share prices begins with an initial negative reaction to higher rates. This is likely because we believe investors often view REITs as bond proxies and reduce exposure to them in favor of general equity. However, higher rates are often an indication of economic growth - which may help increase real estate demand, drive occupancies (and contractual rent increases) higher and improve REIT cash flows. Looking back to 1994 (which we view as the beginning of the modern REIT era), REIT earnings have grown at nearly the exact pace as the S&P 500 Index, averaging 6.6% per year, while demonstrating less earnings volatility (see Chart one below).
Chart one: REIT earnings growth has kept pace with equities
Source: Invesco Real Estate, Bloomberg L.P. and FTSE NAREIT All Equity REIT Index as of June 20, 2018. REIT funds from operations (FFO) growth estimates are derived from consensus estimates of recurring funds from operations which may be adjusted in order to eliminate the effects of one-time items or extraordinary gains or losses. Equity growth is derived from the S&P 500 Index. Trailing 12-month earnings per share (EPS) represent figures from prior years. Past performance is no guarantee of future results. An investment cannot be made directly into an index.
Over time, investors have rewarded this increasing (and compelling) level of earnings growth, with US REITs outperforming both general equities and the bond market over the same time period (see Chart two below).
Chart two: REIT returns have outpaced equities and bonds
Source: Bloomberg L.P. US REITs represented by the FTSE NAREIT All Equity REITs Total Return Index, US equities represented by the S&P 500 Total Return Index and US bonds represented by the Bloomberg Barclays US Aggregate Index. Past performance is no guarantee of future results. An investment cannot be made directly into an index.
Although REITs have produced better historical returns, it bears mentioning that in the short term, these assets do tend to lag their general equity peers during periods of acute long-term interest rate increases. However, as rates stabilize, REITs tend to resume outperformance. Chart three below summarizes total returns versus general equity during and after periods of rising rates going back to 1990. This pattern is clearly illustrated in the left and right columns.
Chart 3: REITs have bounced back after past rate increases
Source: Lipper, Bloomberg L.P. as of June 30, 2018. Acute periods defined as full-month periods between Jan. 1990 and Jan. 2018 where the cumulative rise in 10-year Treasury yields for each period was above 50 basis points. The acute rising periods are Jan. - March 1990, Aug. 1990, Jan. 1992, Oct. - Nov. 1992, Feb. - June 1994, Aug. - Nov. 1994, Jan. - May 1996, Dec. - March 1997, Jan. - Feb. 1999, April - Aug. 1999, Oct. 1999 - Jan. 2000, March - June 2001, Nov. - Dec. 2001, March 2002, Oct. - Nov. 2002, June - Aug. 2003, April - May 2004, Sep. - Oct. 2005, Jan. - June 2006, April - May 2008, Jan. - Feb. 2009, April - June 2009, Dec. 2009, Sep. 2010 - March 2011, May to Aug. 2013, Aug. 2016 - Jan. 2017. US REITs represented by the FTSE NAREIT All Equity REIT Index and US equities represented by the S&P 500 Index. Past performance is no guarantee of future results. An investment cannot be made directly into an index.
What's more, with US monetary policy on a path to normalization, REIT management has taken steps to position for higher rates by extending debt maturities (Chart four) and reducing leverage (Chart five).
Charts four and five: US REITs have extended their maturities and lowered their leverage
Source: FTSE NAREIT All Equity REIT Index as of June 30, 2018. US REITs are comprised of the companies within this index. Past performance is no guarantee of future results. An investment cannot be made directly into an index.
It is difficult to forecast whether the future for REITs will mirror the past 25 years, but it is worth noting that fundamentally, we believe REITs are positioned to continue benefiting from a strong economy. Tenant demand is healthy, new office supply is relatively controlled, occupancy rates are high and most property types are experiencing positive rent growth, even 10 years into the economic expansion. And as we have noted before, newer REIT property types such as infrastructure, data centers and timber offer structural growth characteristics on a different cycle than traditional commercial real estate. This may help boost overall REIT growth rates as the current expansion matures.
A short-term drop in investor sentiment toward a capital-intensive business like real estate is understandable in a time of rising rates. However, we believe this misses the larger point - REITs are not bond proxies, and are typically positioned to participate in a growing economy. From a valuation standpoint, US REITs are now trading at about a 5% discount to the value of the underlying real estate as of Oct. 5, 2018.2 Although short-term price volatility is possible due to shifts in monetary policy expectations, trade policy developments and market risk appetites, our analysis suggests that patient investors may be rewarded over the long term by using interest rate-induced sentiment erosion as an opportunity to dollar-cost average into their REIT exposure.
About Invesco Real Estate
Invesco Real Estate has nearly 490 employees in 21 different markets worldwide with assets under management exceeding $65 billion as of June 30, 2018. Our focus areas include US real estate, global real estate, global real estate income, infrastructure and master limited partnerships.
1 Source: Bloomberg L.P. as of Oct. 8, 2018.
2 Source: Green Street Advisors as of Oct. 8, 2018.
Blog header image: Sharkshock/Shutterstock.com
A basis point is one hundredth of a percentage point.
A bond proxy is an investment that behaves like a bond - its value can be expected to fall in price as interest rates rise, but increase in value as interest rates rise.
A real estate investment trust (REIT) is a closed-end investment company that owns income-producing real estate.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
The FTSE NAREIT All Equity REIT Index is an unmanaged index considered representative of US REITs.
The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.
Correlation is the degree to which two investments have historically moved in relation to each other.
Dollar-cost averaging is an investment technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. The investor purchases more shares when prices are low and fewer shares when prices are high. Investment in infrastructure-related companies may be subject to high interest costs in connection with capital construction programs, costs associated with environmental and other regulations, the effects of economic slowdown and surplus capacity, the effects of energy conservation policies, governmental regulation and other factors.
Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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REITs: Bond proxy or barometer of economic growth? by Invesco US