Early into 2019, in an article entitled "Why Now is the Time to Load Up on REITs" - we argued that REITs were cheap and fundamentally strong.
While a victory lap feels nice in the moment, we must not rest on our laurels. Especially today, as we enter more volatile times, we must make more efforts than ever before to identify the few remaining bargains in this otherwise fully-valued market place.
Today, five months later, our opinion of the market has changed quite radically. We now make the opposite argument: today is "not" the time to load up or be greedy! Below we exceptionally share the latest Market Update of High Yield Landlord to the public:
General Economic Outlook
The global economic environment is currently very favorable for business as most major economies are generally strong, with unemployment levels at or near multi-decade lows. Capital is generally freely available at low cost to good borrowers, and bond covenants are not as stringent as they have been in the recent past without being excessively loose as they were in previous bubble periods. That being said, there remains considerable geopolitical and macroeconomic risk around the world and we are not naive to the fact that valuations in virtually every sector (including real estate) are at or near all time highs, thanks to the past decade of record-low interest rates.
Our investment thesis throughout 2018 and 2019 has been that interest rates are peaking for the foreseeable future (though longer term, they will likely eventually go up again at some point), and that global economic growth is slowing down. This conviction is based on projections by the Federal Reserve and numerous other well-respected economists and businessmen that economic growth is projected to slow over the next several years, with some even calling for a recession to hit sometime in the next 6-18 months. While all of the major economic indicators such as the unemployment rate and GDP growth continue to signal a solid economy, there are numerous warning signs that a significant slowdown and/or recession may indeed be just around the corner. These reasons are, in our view, what has caused the Federal Reserve to reverse its strategy of raising interest rates towards a more “wait and see” - if not dovish – approach.
(1) Trading Partner Slowdowns: Data from major economies across the globe - particularly in those with significant trade ties to the United States – are showing signs of slowing, if not shrinking economic activity. Italy is already in a recession while data from other European trade partners (even Germany) is pointing towards a slowing. Japan is also flirting with a recession while China’s economy shows significantly decelerating growth (though recent economic stimulus has been producing some short-term green shoots). Given these countries’ significant ties to the U.S. economy, it is only a matter of time before these trends hit American shores. The only reason it likely hasn’t yet is due to the still-rippling boost from the 2018 tax cuts as well as the significant roll back of regulations from the Obama era.
However, our view is that, regardless of the outcome of the trade war between the United States and China, the tailwind from the tax and regulation cuts will begin to run out of steam over the next year or two as the deteriorating economic growth outlooks in our major trade partners begins to overwhelm it.
(2) Heavily Leveraged Economy and Misallocated Capital: Thanks to over a decade of quantitative easing and artificially low interest rates from the Federal Reserve, household, corporate, and government debt levels have spiked to new record highs. This has created a bubble like economy where growth and profits have been juiced by applying excessive amounts of cheap capital while discouraging savings. As a result of this environment – which has pushed asset valuations ever higher – investors have had to allocate capital to increasingly risky assets in order to maintain their previous levels of profitability. In the process, economic calculation has been disrupted due to market-level capital costs and consumer demand being artificially tampered with by government/central bank planners. The result is a fragile economy and capital market that is highly sensitive to even modest interest rate increases.
This flimsy state of affairs was displayed during the stock market declines in the fourth quarter of 2018 as the Fed’s tightening and interest rate raising approach spooked investors. This shows that the Fed is in a tough spot: interest rates cannot be cut too much at this point without pushing the economy into a further overleveraged state, resulting in possibly too much malinvestment, overheating, and eventual collapse similar to 2008; at the same time, however, interest rates cannot be raised too much without causing a crash due to the vast amount of heavily leveraged capital that has been allocated based on the current low interest rates.
Interest Rate Outlook
Due to these factors, the Federal Reserve will be forced to keep interest rates close to their current levels. However, if/when a global recession hits and/or mal-investment reaches a point that leads to a bursting of the bubble and a meltdown in the United States, the Federal Reserve will likely have to return to quantitative easing and cutting interest rates once again.
REIT Market Outlook
Since investors in general will likely become more worried about future growth and see more value in defensive real asset investments, we expect the current macroeconomic environment to favor REITs and other more defensive high yielding investments. In such an atmosphere, we expect most of the returns to come from income rather than growth, which is why our Core Portfolio is geared to generate a high ~7-8% dividend yield with a conservative 67% average payout ratio; we do not rely on growth to generate attractive total returns. Given our cautious outlook, we agree that the best real estate opportunities in the U.S. are found in non-traditional and more defensive traditional property sectors. In particular, we are bullish on triple net lease REITs and our Real Money Core Portfolio holds an overweight position in Spirit Realty (SRC) and EPR Properties (EPR) accordingly.
(We are currently finalizing an interview with the CEO of STORE Capital (STOR) - a $7.6 billion dollar net lease REIT. He is helping us to prepare a unique "Guide to Net Lease Investing". It will be exclusive to High Yield Landlord members and help us identify future opportunities)
Our Plan of Action
The long-term impacts of these sustained historically low interest rates are uncertain and could very possibly lead to more mal-investment and an eventual enormous economic meltdown. While we do not believe that we are at risk of an imminent recession, we do believe we are getting fairly close to it and, therefore, now is the time to prepare. At the same time, we do not know for certain how the future will play out. Therefore, we are taking the following steps to hedge our portfolio against this uncertainty and cautious outlook while still seeking to generate attractive returns today:
- (1) We are maintaining a strategic cash position to be able to react quickly and opportunistically to market volatility by snatching up positions in high-quality REITs on our wish list that are too pricey right now (i.e., Realty Income (O), STORE Capital (STOR), Ventas (VTR), etc.).
- (2) Diversifying into precious metals. Precious metals are a proven safe-haven asset with zero counterpart risk that are significantly undervalued relative to bonds and stocks on a historical basis. They also generally serve as excellent hedges against inflation, geopolitical unrest, and stock market volatility due to their low correlation to other asset classes.
- (3) Diversifying into short-term real estate-backed loans through the Groundfloor website. The short-term real estate-backed loans are not risk free. However, their LTVs of 70% or less and 1 year or less durations give them significant margins of safety against volatility in the real estate market (similar to preferred shares) and their short durations serve as a hedge against rising interest rates and/or inflation. Furthermore, their low correlation to the stock market and short durations give us liquidity in a fairly short period of time to capitalize on stock market volatility if/when it comes again.
- (4) Diversifying into more fixed-income assets, preferred shares in particular. This is because, as interest rates decline (which will likely happen as the Federal Reserve will be inclined to cut rates once the economy begins to falter), fixed income assets - by their very definition – will see valuations rise. We also see these investment as inherently safer than equities and likely to outperform them in a down market.
- (5) Maintaining our preference for real assets and increasing our Real Money Core Portfolio’s diversification and defensive posture. As a result, we have sold several speculative positions and either (A.) moved up the capital stack into preferred shares or (B.) reinvested proceeds into undervalued blue-chips such as Weyerhaeuser (WY) and Monmouth (MNR). Furthermore, as new capital comes in, we have favored building positions in more defensive sectors such as single family rentals (Front Yard Residential (RESI)). Slowly but steadily, we continue to fortify our portfolio so that we are better prepared to face the next market downturn. We are well on our way; but we not done yet.
- (6) However, we also find opportunity on the riskier end of the spectrum, where we believe that fears over retail REITs are overdone. Given our overall weighting towards defensive investments as well as our strategic cash reserve, we have the flexibility to make some speculative investments in this more cyclical sector. As a result, we currently hold several retail REITs that each trade at significant discounts to NAV, giving them a considerable margin of safety. These REITs are Class A mall landlords Brookfield Property REIT (BPR) and Macerich (MAC), preferred shares in Class B mall landlord CBL Associates (CBL.PE), and Brixmor (BRX) for grocery-store anchored shopping centers. However, even in this sector it is important to note that we have taken careful steps to ensure we are maximizing our risk-to-reward by focusing the vast majority of our capital on the Class A malls and the grocery-store anchored shopping centers, both of which are expected to be more resilient in the event of a recession. Also, our lone high risk position in the sector (CBL.PR.E) is a preferred stock, meaning that its dividend is very well covered by cash flows and therefore should continue to pay out full dividends through a recession unless the company headed towards bankruptcy. Additionally, 85% of our retail real estate capital is deployed into the lower risk positions while only 15% is in the riskier CBL preferred shares. We expect to keep it this way. High risk positions will remain a very small part of our Core Portfolio – and going forward, we have little interest in adding more retail investments. We own enough of them and prefer to focus on other less risky property sectors.
We are well on our way for solid performance in 2019 and beyond as our REIT picks have outperformed the broader stock market (SPY) and REIT (VNQ) indices thus far. However, we suggest that our readers resist the urge to be greedy and set some capital aside into cash, precious metals, short-term bonds, and/or short-term real-estate backed loans as we expect market volatility to remain a regular attender of the public markets at this late stage in the cycle where valuations are so elevated and interest rates remain low relative to historical levels.
As always, we believe that part of our success here on Seeking Alpha is the fact that we have significant “skin in the game” and show exceptional transparency in our portfolio trading. This way, when you win, we win, and when you lose, at least you can take comfort in knowing that we are losing as well.
High Yield Landlord, The #1 Service for Real Estate Investors
We are the largest community of Landlords on Seeking Alpha with over 500 members. We spend 1000s of hours and well over $20,000 per year researching the market for the most profitable investment opportunities and share the results with you at a tiny fraction of the cost.
Join Us Today Before Price Increase! Don't let tenants, toilets and trash ruin your life. Beat the price increase and become a “Passive Landlord” with our 8% yielding diversified Real Estate Portfolio.
Disclosure: I am/we are long BPR; RESI; BRX; SRC; EPR; MNR; WY; MAC; CBL.E. 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.