Be honest gentle readers, if asked to name the latest hot and exciting investment opportunity, exactly how many of you would’ve picked REITs? Given that they make up less than 3.5% of the broad Russell 1000 Index, or slightly more space than is taken up by just Microsoft (MSFT), we’re going to wager that REITs are probably the last thing that comes to your mind when you think about hot returns. But you might want to expand your horizons because stolid, boring old REITs are quickly shaping up to be one of the strongest returning plays in 2019.
In fact, REITs have been among the better performing sectors for some time now, defying common investment “wisdom” that says their negative correlation with interest rates should hold back their performance even as the later stages of a business cycle see a reluctance by major tenants to invest in long-term leases. Instead, REITs are partying like it’s 2015 (the last time they outperformed the broader market) with our own favorite proxy, The Real Estate Select Sector SPDR Fund (XLRE) up over 14% YTD through 3/11 versus 9.8% for the broader SPDR S&P 500 ETF (SPY) that it pulls its portfolio from. Add in the relatively minor losses XLRE endured in the 4th quarter and it’s up over 18.4% in the last year compared to a 1.8% return for SPY. So investors are no doubt piling into REITs right?
Quite the opposite in fact, with our fund flows report for the last month showing most of the ten largest REIT ETFs with negligible flows and only the sector heavyweight, the Vanguard Real Estate ETF (VNQ) pulling in serious money, slightly more than $900m in the last month. That amount is less than 3% of its total assets and more than half of that figure came in just the past week which, for some investors, might seem to be a case of money chasing hot returns. But for those technical analysts willing to take a serious look at REITs, a bullish set-up could be forming with the promise of more returns to come.
Our chart analysis this week is very straightforward, and we’ll continue to focus in on XLRE which, while far more concentrated than VNQ, draws all of its holdings from the S&P 500, meaning they tend to be among the larger and more financially stable names in the space. Just think of it like the old song “New York, New York”. If a fund like XLRE can make it here, then just about any REIT fund can too.
We’ve already talked about how strongly XLRE has performed this year and if you enjoy studying technical charts, you may see a familiar pattern indicating a lot more price action to the upside. Looking at the chart, we see a very robust move higher from the low in December with price consolidating in what appears to be a downward sloping flag (highlighted by the blue).
These pennant patterns are typically considered to be consolidation patterns after either a strong advance/decline. In this case, XLRE recovered all of its December losses and then some, taking out that December high of around $34 in the process. In the short term, this was a very strong move and you would normally anticipate that $34 would become support going forward. This is shown via the parallel line in green.
We had planned to recommend waiting to see price breakout positively through the highlighted blue parallel lines or even the overhead resistance before considering a long trade but even as we were writing this, XLRE closed above the prior resistance around $35.25 to close at a new high! Compare that with most sector funds that have taken out their December highs but remain below their 52-week peaks. Even SPY is still down more than 5% from its 52-week high! Now the question investors must ask is whether they watch for a retest of support or just dive in?
Those trying to consider the possible end-game should remember the classic technician’s wisdom for a pennant pattern suggests that the likely outcome of move higher can be measured from the bottom of the pole, December 24th to the top on February 22nd, which is roughly 5 points or around $40 per share.
What could be the catalyst that could help push XLRE higher from here? There’s no denying that XLRE has gotten a boost by shifting attitudes towards future rate hikes by the Federal Reserve, heck all stocks should, although we should note that the relationship between REITs and interest rates is anything but cut and dry. Most investors feel that rising rates would hurt income growth but a 2018 update on the NAREIT website (here - REITs and Interest Rates) points out that REITs are relatively lightly levered compared to their historical averages. Combine that with the fact that rates tend to rise in the later stages of a rally when the economy is performing strongly, and you can put that piece of common investment wisdom to rest.
Instead, we think there’s a much simpler answer, although still somewhat dependent on the Fed, to what needs to happen to drive REITs higher from here. Thinking about that old argument about REIT performance and rising rates led us to a different conclusion that focuses on why people own REITs in the first place. They’re a popular tool in investor portfolios largely for their ability to generate income; in fact, their operating structure makes it obligatory to pay out at least 90% of its taxable income as dividends.
The means REITs can be veritable cash machines, albeit non-qualified ones, meaning their dividends are taxed as ordinary income although the trimming of individual tax rates as part of the Trump tax reform helped reduce that pain to some extent, raising the potential value of REIT income. But we think a far more important factor related to the Fed is the opportunity cost of holding an asset. There’s no denying that more than a few conservative investors have been excited by the rise in short-term interest rates with larger institutions offering one-year CD rates just under 2.8% and with little to no credit risk. For investors forced to take on unwanted term or even equity risk during the bad years of zero interest rates to earn any kind of income, that’s like manna from heaven.
Rising rates will eventually have a negative impact on equity performance, largely though the P/E ratio, but with the Fed shifting to a “wait and see policy”, all sorts of risky assets have seen a boost as the opportunity cost, in this case the risk-free income investors could earn, levels off. As investors consider whether rate hikes are on an indefinite hold, their desire to hold cash in anticipation of even more rate hikes drops, making alternative investments, like REIT funds, which had lower valuations and higher yields, far more attractive, especially with those now lower tax rates on those non-qualified dividends.
That’s a lot of speculation on investor psychology but now that XLRE has broken through to new highs, there’s no denying that REITs are the hot play! The question is who is willing to join in?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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