There have always been top down analysts who look at macro and sectors first and individual securities as an afterthought. Historically, this has been balanced out by bottom up investors who are primarily concerned with specific securities and look at macro and sector forces as it relates to those specific securities.
The balance between the 2 sides created a healthy equilibrium. There were enough macro investors to cause proper price discovery at the sector level. Areas of the economy that were doing well fundamentally would cause the related sectors to rise appropriately. There were also enough stock specific investors to cause appropriate price discovery within a sector. The stock specific analysts would see the differences in fundamental outlook between stocks within a sector and cause the better relative value stocks to outperform their peers.
Things have changed.
Passive investment has now surpassed active investment. ETFs now exceed $4 Trillion in assets. 20 years ago this capital had to be deployed through individual securities, forcing even the most dedicated top down analysts to put some thought into specific stocks. The rise of ETFs has provided an outlet for top down analysts and allowed them to entirely forgo individual stock selection. Their macro based ideas can now be implemented directly into the relevant areas of the market as a whole rather than through individual stocks. This has tipped the balance. The equilibrium is broken and it is easily observed in the REIT landscape.
REIT sectors move in unison even when they shouldn’t.
- Self Storage REITs have all moved up together while fundamentals have diverged. Extra Space (EXR) and Cube (CUBE) have been gaining market share and growing rapidly on a per share basis while Public Storage (PSA) has underperformed fundamentally. EXR and CUBE have advanced digital advertising while PSA until very recently still relied on yellow pages. Notice how the prices move in lock step. This is top down dominance at work.
I am certain there has been more fundamental variance between the names than is showing up in pricing.
- Hotel REITs have fallen in unison. Again, notice how they move in lock step. Sector level trading is entirely dominating with little to no attention being paid to fundamental differences.
Pebblebrook (PEB) has recently completed a $4.1B acquisition while RLJ Lodging (RLJ) is rapidly selling its hotels with 44 dispositions in the past 52 weeks. An asset aggregator and an asset seller have divergent fundamentals, but it in no way shows up in the market price.
- Industrial REITs have risen in unison. Again, notice the lock step movement.
Fundamentally, Rexford (REXR) is significantly more exposed to trade headwinds than First Industrial (FR), Terreno (TRNO) and Prologis (PLD) because it has a high concentration in the area surrounding the Port of Los Angeles which is heavily exposed to trade with China.
The others are diversified through the U.S. or in Prologis’ case, diversified across the globe. It would seem the fundamentals have diverged more than the lock step price movement would suggest.
I could go on, showing similar charts for each of the 20 fundamental REIT sectors, but I think you get the point - top down analytics are dominating market trading.
With sectors moving together despite divergent fundamentals, mispricing is growing. There is less mispricing between sectors as many of these top down analysts are quite intelligent and collectively they are correct at picking which sectors are winning, but there is more mispricing within sectors. So how does one take advantage?
Bottom up focused research allows capturing this mispricing. There is an abundance of low hanging fruit within sectors that has gone unpicked because everyone else is trading from a macro level. From a 10,000 foot view, one can see the forest, but not the ripe fruits dangling on the low branches.
To capture the opportunity missed by top down analysts, one must go deeper. Due to time constraints it is not possible to go deeper on the entire market. research depth and research breadth are inherently opposing forces. Just as a 2-dimensional object of a given area will be longer the less wide that it is, the narrower one’s research focus, the more granular then can go.
Defined investment universe
We invest almost exclusively in REITs. Real estate has recently been made the 11 th GICs sector and it is smaller than most of the other GICs sectors. We believe that even this is too broad of an investment universe and have further narrowed our scope to equity REITs. There are about 180 equity REITs (it fluctuates with mergers and IPOs), and this is still a rather large universe with over $1 trillion in investable market cap. Within REITs, we focus our attention on value and high yield. This narrows our universe to about 40 to 60 stocks at any given time.
We believe that is an appropriate amount which allows us to study these stocks at a greater depth. The value of defining one’s investment universe extends to all areas of the market. Those with a narrow but deep focus will be able to know their stocks better and catch on to subtleties that others miss.
Knowing these subtleties has always had value, but due to the skewed environment caused by top down dominance, the value of the subtleties has increased. There are more subtleties being overlooked and each subtlety has a greater amount of mispricing associated with it.
The broad brush of top down analysis
Areas of investment are being painted with a broad brush that is missing subtleties.
Among REITs one of the most misunderstood ideas is the impact of interest rates.
Far too often, however, I see the following abuse of logic.
- Lower Interest rates are good for REITs.
- XYZ is a REIT
- Therefore, lower interest rates are good for XYZ.
That is simply not sound logic, but due to top-down dominance of market trading volumes, REITs will often move up as a pack when interest rates drop.
At a more granular level, interest rate increases do not hurt REITs and decreases do not help REITs. Instead what happens is it increases or decreases cap rates which raises or lowers NAV. This effect is offset by the change in accretion of external growth. While it offsets for REITs in general, the summed impact for individual REITs can vary wildly. Certain REITs benefit materially from lower interest rates (SLG RLJ BRX), while others are harmed by lower interest rates (IIPR, SAFE).
SL Green (SLG) RLJ Lodging (RLJ) and Brixmor (BRX) have had net dispositions during this interest rate downdraft. This means that rather than the lower cap rates of external growth offsetting the benefits of higher NAV, these companies have benefitted on both ends. In addition to the rising NAV, they get increased growth from being able to sell properties at more favorable (lower) cap rates.
On the other side of the spectrum, Innovative Industrial (IIPR) and Safehold (SAFE) suffer increased downside from lower cap rates as they are both in heavy external acquisition mode. This is not offset by increases in NAV as both companies have enterprise values that are drastically higher than NAV. Thus, there is no path to realizing benefits of existing properties growing in value.
Subtleties of this nature are missed when looking at REITs top down. A similar broad brush is incorrectly applied regarding externally managed REITs.
- External management is misaligned and destroys value
- XYZ REIT is externally managed
- Therefore XYZ REIT is a bad investment
Again, this is faulty logic.
Externally managed REITs are often bad, but when you study a small universe so closely, there is no need to rely on blanket statements. A generalist would have no way of knowing the difference between dangerously misaligned external managers like RMR Group (RMR) and Ashford Inc (AINC) versus hidden gems like NexPoint Residential (NXRT) and Gladstone Commercial (GOOD). These subtleties only become apparent after years of focused scrutiny.
REITs are fundamentally sensitive to the strength of management.
Lexington Realty Trust (LXP) looks fantastic on paper. Both triple net REITs and industrial REITs are loved right now and LXP is both. Further it trades at a cheaper multiple than either triple nets or industrials. They are internally managed and their balance sheet looks fine. It is an easy trap for anyone considering an investment from top down view.
However, a close examination reveals subtleties that destroy the value proposition. LXP seems to always make the wrong decisions and continuously destroys shareholder value by chasing whatever is hot. They used to be primarily office but have switched to industrial now that industrial is hot and office is cold. This means selling office at high cap rates and buying industrial at low cap rates. This is causing FFO/share to plummet.
Source: SNL Financial
Mispricing is rampant among REITs in both directions. Those that have been unfairly punished by being lumped in with sector level headwinds that do not apply are quite opportunistic and those like LXP that are being unfairly buoyed by sector level tailwinds are getting overpriced.
The benefits of focusing one’s research narrowly and deeply are significant. There are, however, 2 hurdles one has to be willing to deal with to achieve this focus.
- A wiliness to miss out on winners
- Staying in your lane
Alpha is ubiquitous. Every year, thousands of stocks materially outperform the index. Negative alpha is also ubiquitous. It is just as important to avoid bad stocks as it is to find the good ones. We don’t go fishing in the ocean; we find a small pond that we understand and within that small pond we put all of our effort into discerning the good from the bad. We missed out on Facebook and Amazon, but that is okay, because we also avoided UBER and Snapchat. The winners missed will often be washed by the icebergs one avoids by staying in their lane.
An exercise of humility
I strongly believe the content stocks like Netflix (NFLX) and Disney (DIS) are deeply overvalued. While I am confident in my abilities as an analyst, I am also confident that there are subtleties I am missing. There could be aspects of these companies that make them valuable which I am not seeing from my view as a REIT analyst who is not deeply involved in the content space. Just as highly skilled generalists miss subtleties in REITs, I have to recognize that as a REIT dedicated analyst I am almost certainly missing the subtleties of other areas.
2nd Market Capital and its affiliated accounts are long RLJ SLG, BRX, NXRT and GOOD and short IIPR . I am personally long RLJ, BRX, GOOD and SLG and short PSA. This article is provided for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Information contained in this article is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. The reader must determine whether any investment is suitable and accepts responsibility for their investment decisions. Dane Bowler is an investment advisor representative of 2MCAC, a Wisconsin registered investment advisor. Commentary may contain forward looking statements which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC and its affiliates cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts and findings in this article. Positive comments made by others should not be construed as an endorsement of the writer’s abilities as an investment advisor representative.
Conflicts of Interest. We routinely own and trade the same securities purchased or sold for advisory clients of 2MCAC. This circumstance is communicated to clients on an ongoing basis. As fiduciaries, we prioritize our clients’ interests above those of our corporate and personal accounts to avoid conflict and adverse selection in trading these commonly held interests.
Disclosure: I am/we are long BRX, RLJ, SLG, GOOD. 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.