The REIT Paradox: Cheap REITs Stay Cheap

Summary

• The Real Estate Investment Trust industry has evolved considerably since the dawn of the 'Modern REIT' era in the early 1990s. REITs have evolved into dynamic growth-oriented operating companies.
• Even as REITs have permeated into the mainstream, many of the traditional "style factors" and stock-picking techniques that work in other equity sectors haven't worked in the REIT space.
• Counterintuitively, the evidence suggests that "high dividend yield" and "low valuations" as factors led to persistent underperformance in the REIT space while "growth" has been persistently undervalued.
• In a business where "cost of capital" is the true competitive advantage and the driver of more than half of the sector's FFO growth, cheap REITs tend to stay cheap due to limited external growth potential.
• Other factors that have exhibited persistent outperformance include balance sheet quality and property sector selection. We also identified a "sweet spot" of market capitalization that is associated with outperformance.
• This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Get started today »

The REIT Paradox: A Factor Analysis

In this report, we take a deep dive to analyze the underlying factors that drove performance within the REIT sector over the past decade and extract the major lessons that can be learned. Even as REITs have permeated into the investing mainstream, many of the traditional "style factors" and stock-picking techniques that work in other equity sectors haven't worked in the REIT space, a conundrum that has puzzled analysts and investors.

(Hoya Capital, Co-Produced with Brad Thomas through iREIT on Alpha)

Last week, we analyzed the overall performance of the real estate sector during the 2010s in Recover And Rebuild: A Decade In Review. If the 1990s were the "Genesis" and the 2000s were the "Terrible Teens," the 2010s was the "coming of age" decade. REITs moved out of their parent's basement and into their own place in 2018 as GICS carved out an 11^th equity sector for the equity REIT sector. As of last August, real estate represented roughly 3% of the S&P 500 and roughly 10% of the mid-cap S&P 400 index.

Despite entering the 2010s scarred and wounded from the devastation of the financial crisis, REITs and Homebuilders delivered generally strong and steady performance throughout the last decade following an intensely volatile 2000s. Despite being viewed as a more defensive and yield-oriented sector during a decade that saw the longest US economic expansion in history, REITs (VNQ) produced an impressive compound annual total return of roughly 12.6%, slightly shy of the 13.5% annual total return on the S&P 500 (SPY).

Despite the mild underperformance over the last decade, REITs have actually outperformed the S&P 500 by more than 100 basis points per year over the last 25 years according to NAREIT, with average annual returns of 11.18% compared to 10.15% on the S&P 500 and put up similarly impressive numbers compared the small-cap Russell 2000 (IWM) and the tech-heavy Nasdaq (QQQ).

The strong performance raises an important question: How are REITs - which are required by law to pay out 90% of their taxable income every year - able to keep pace or even outperform these other more growth-oriented equity indexes? In short, REITs are far more growth-oriented than they get credit for, a misperception which we believe is the core driver of the unique "style factors" that have perplexed generalist investors.

Among other advantages of the REIT structure (liquidity, scalability, reliable dividends, ability to diversify, and good corporate governance), access to the public equity markets to fuel accretive acquisitions has been the defining competitive advantage for REITs, explaining much of the consistent outperformance over the last 25 years.

Counterintuitively, REITs are fundamentally at their best when their equity valuations are slightly elevated, thus enabling these REITs to utilize the equity capital markets to fuel accretive external growth. For illustrative purposes, we diagram the theoretically expected sources of total returns under two valuations scenarios. While yield-focused investors tend to view more "expensive" (and lower-yielding) REITs less favorably, the total return potential of these REITs has been persistently higher over the last ten and twenty-five years.

What Is Factor Investing?

The popularity of "factor investing" has exploded over the last several years, driven by the rise of "Smart Beta" passive strategies that choose securities based on attributes that have historically been associated with higher returns, not too different from the strategies utilized by active "stock pickers." ETF.com lists no fewer than 290 "multifactor" ETFs with an aggregate AUM of more than $100 billion. Ideally, these factors are the result of a persistent market anomaly, behavioral bias, or risk premium, and can thus persist over a period of time, even after the factors are widely known and understood by market participants.

(Image Source: MSCI)

While there is a limitless quantity of potential factors, the most commonly studied and employed include those initially outlined in the academic research of Fama and French and include value, momentum, and size. Here's the kicker: not only has the evidence indicated that these factors do not work when applied to the REIT sector over the past two decades, the evidence suggests that they have actually worked in the opposite direction and this stubbornness has shown remarkable persistence.

The REIT Factors That Work

We studied REIT performance trends over the last decade and our analysis uncovered five "factors" which have exhibited the most notable outperformance. Headlined by the finding that lower dividend yielding REITs have consistently delivered stronger total return performance, we also uncovered a market cap "sweet spot" for outperformance and found that elevated share price valuations are actually associated with further outperformance, a finding that clashes with the traditional "value" factor.

These findings are consistent with our view that "growth" has been persistently undervalued within the REIT space and that the importance of "cost of capital" (reflected in higher relative FFO and NAV valuations) has been underappreciated by REIT investors over the past decade. Our findings are also broadly consistent with research from other REIT research firms, suggesting that even though these trends are generally understood by market participants, they still persist over time and thus qualify as true "factors." We outline these findings in the chart above and discuss each of these factors in further detail below.

1. Sector Selection First, Stock Selection Second

There's a reason that we dedicate so much time and resources to analyzing (and sharing) our property-level and macro-level sector fundamental analysis: property sector selection is the single most important determinant of performance in real estate investing. Over the last decade, the average year saw a 40% average spread between the best and worst-performing real estate sectors. Importantly, the evidence suggests that higher-growth sectors have been persistently undervalued within the REIT sector while lower-growth sectors have been overvalued, as measured by the trailing 3-Year FFO growth. To give oneself a shot at outperformance, we believe that security selection within the REIT sector must begin with property sector selection.

2. Don't Fall For the High Yield Trap

Like the sirens from Homer's Odyssey, the allure of high dividend yields has led many REIT investors astray over the past decade. For older investors that absolutely need the immediate income, the appeal of higher-yielding REITs is understandable, but other investors should "trust the process" and view REIT dividends as one part of total returns, which include internal growth (same-store NOI), and external growth (acquisitions and development). Splitting the REIT universe into thirds, our analysis indicates that the highest-yielding REITs have persistently underperformed while the lowest-yielding REITs have delivered outperformance by roughly 3.6% per year over the REIT average. 2019 took these trends to an extreme with the lowest-yielding REITs delivering total returns of nearly 39% compared to returns on the highest-yielding REITs of under 20%.

3) Cheap REITs Stay Cheap

In a business where "cost of capital" is the true competitive advantage and the driver of underlying dividend growth, cheap REITs tend to stay cheap while expensive REITs tend to stay expensive. We stress in all of our sector reports the importance of Net Asset Value and how cheap equity capital (as measured by NAV premiums or FFO per share premiums) can help to drive external growth which has historically explained more than half of REIT total returns. Again splitting the REIT universe into thirds, our analysis indicates that the "cheapest" REITs, as measured by FFO per share multiples, have persistently underperformed while the more expensive third of REITs have delivered outperformance by roughly 2.8% per year over the past decade. Similar to the dividend yield factor, 2019 took these trends to an extreme with the more expensive REITs delivering 38% total returns while the cheaper REITs lagged with 19.2% total returns.

4. There Are No Shortcuts: Slow And Steady Wins

In a decade that saw some of the most favorable macroeconomic conditions for companies sensitive to economic growth and an "easy" interest rate environment, one would expect that utilizing higher amounts of leverage would have been a winning strategy. That wasn't the case in the REIT sector in the 2010s, as REITs that used higher leverage - as measured by NAREIT's Debt Ratio - lagged over the past decade as balance sheet quality continues to be one of the more reliable outperforming factors. In 2019, REITs that fell into the lowest third in the debt ratio metric produced total returns of nearly 33% compared to the sub-20% total returns of the more highly-levered REITs. We found that over the past decade, investing REITs with better balance sheets produced outperformance of roughly 2.6% per year.

5) Find The Market Cap "Sweet Spot"

One of the more interesting factors was the discovery of a "sweet spot" of market capitalization that resulted in persistent outperformance. Similar to the valuation effects noted above, small REITs tended to stay small, but REITs that fell into the middle 50% of market capitalization saw the best performance over the past decade. This finding is consistent with the "access to capital" growth theory: REITs that are too small have more difficulty raising growth equity, but once they reach a certain threshold, the differences in access to capital between mega-cap REITs and larger mid-cap REITs is minimal. This 'Goldilocks' effect implies that investors in traditional market capitalization-weighted indexes like the broad-based Vanguard Real Estate ETF are underweight REITs in this "sweet spot" and are failing to capture the positive effects of this size factor.

Recap: Applying These Factors To Portfolio Strategy

While the allure of high yield REITs can be tempting, we stress that while there are no shortcuts in REIT investing, that one can indeed "tilt the playing field" in their favor by having the discipline to focus on high-quality names and long-term dividend growth rather than double-digit dividend yields that can be cut to zero at any moment. Looking at you, CBL & Associates (CBL).

Counterintuitively, in an industry generally associated with lofty dividends, the evidence suggests that "high dividend yield" and "low valuations" as factors led to persistent underperformance within the REIT space while "growth" has been persistently undervalued. Other factors that have exhibited persistent outperformance include balance sheet quality and property sector selection.

We also identified a "sweet spot" of market capitalization that is associated with outperformance, suggesting that exclusively utilizing market capitalization-weighted indexes like the Vanguard Real Estate ETF may systematically underperform due to the natural overweight on the largest capitalization names. While factor analysis is inherently backward-looking and clearly impacted by the macroeconomic regime over the past decade, we believe that several important lessons can be gleaned from these results.

Most importantly, we think that our readers and subscribers should consider the possibility that the REIT sector requires a unique analytical approach due to the critical importance of "cost of capital" on the underlying business operations. "Expensive" doesn't mean quite the same thing to REITs as it does to other equity sectors that are less reliant on equity capital raising, so understanding and forecasting property sector fundamentals become more critical and is the most important determinant to outperformance.

Further, we again stress that focusing primarily on ultra-high dividend yields rather than total return is likely negatively impacting investment performance to a significant degree. While higher-yielding "diamonds in the rough" certainly do exist in the REIT sector, the evidence suggests that systematically overweighting these high-yielding names while systematically avoiding higher-valued, growth-oriented REITs is a losing strategy over the long term.

If you enjoyed this report, be sure to "Follow" our page to stay up to date on the latest developments in the housing and commercial real estate sectors. For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Apartments, Homebuilders, Student Housing, Single-Family Rentals, Manufactured Housing, Cell Towers, Healthcare, Industrial, Data Center, Malls, Net Lease, Shopping Centers, Hotels, Office, Storage, Timber, and Real Estate Crowdfunding.

Analyst’s 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.

Hoya Capital Real Estate advises an ETF. In addition to the long positions listed below, Hoya Capital is long all components in the Hoya Capital Housing 100 Index. Real Estate and Housing Index definitions and holdings are available at HoyaCapital.com. It is not possible to invest directly in an index. Index performance cited in this commentary does not reflect the performance of any fund or other account managed or serviced by Hoya Capital Real Estate. All commentary published by Hoya Capital Real Estate is available free of charge and is for informational purposes only and is not intended as investment advice. Data quoted represents past performance, which is no guarantee of future results. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy.

Comments

[Buy_and_hold_hobbyist]

Nice article. While I don't disagree With the premise, don’t you think it is sort of picking and choosing your numbers to utilize some charts that show the results of a single year? To say that one category out performs and then bring a single year as proof is far too small of a sample size to prove any “rule”. I’ve also been running into the problem recently that your article seems to share; with the market expansion going on for over ten years it is becoming difficult to figure out how recessions effect stock performance. Your assertions of return don’t take a single recession or serious market contraction into account. Even with your ten year charts you are arguing using data from a single market expansion in which growth stocks and generally riskier stocks have not been brought to account by a retraction.

I believe that many of your points are good and valid, but feel that to assert “facts” of market trends based on your chosen time frames creates data that could be self serving and is steeped in a recency bias.

[Hoya Capital]

Thanks, @Buy_and_hold_hobbyist. You certainly raise some good points regarding time period issues that we considered.

We try to make clear the parameters and limitations of the analysis. We also cited other sources that undertook a similar analysis with similar conclusions using data going back to the mid 1990s.

[tradeduck]

Wow, amazing article. This is a must read. So much wisdom, back with data. But I think the great lessons of this article is to make you think about some preconceived ideas. For example, higher yield doesn’t mean better total return. Also, margin of safety: not because you buy cheap that you have protection in the next pullbak/correction/bear. From the sense I got from the article, the better the underlying business is doing, the better you’ll do for total performance.

[Hoya Capital]

Thank you, @tradeduck!

[Berto7]

💎

[Mr.Sceptic]

Awsome article, great commentary, and a must read for investors interested in eREITS. I tend to look at total return rather than just focus on yields. Once the yield gets to 6 or 7% I get gun shy to initiate a position. That’s just me. I’ve been happy with DLR, AMT, PLD, O, STOR, NNN, WPC, VTR, and HASI for several years in IRA’s. Yes, I’ve enjoyed the dividends but love the capital gains also, particularly AMT! I’ve had to trim a few times in several of my holdings, but often layered back in to full positions. I love investing in eREITS. Easier to understand in many respects. They make up about 12% of my total portfolios. I think this year is unlikely to be as good as last year. But I’ve always been a long term holder of most of my investments. Lastly, I do pay attention to debt levels, payout ratios( lower for faster growers like AMT), and great management. Again, a very informative article and commentary. Thank you!

[Hoya Capital]

I appreciate the comments, @Mr.Sceptic. I like that portfolio quite a bit.

[jtonson]

Helpful article, thanks. Agree that high yield and low valued REITs often don't perform or recover compared to higher valued REITs, but how does it happen? Your comment here, that individual REITs require qualitative assessment, seems key, because some of your empirical findings appear to conflate cause with effect. I.e. Higher valuations and lower yields seem more the result of success (e.g. from good management and portfolio selection, consistent operating income, quality investor/analyst relations, etc.), than causes of success. The resulting improvements to cost of capital, lower debt/equity, are then helpful, but not always predictive of future success. Much still depends on just why a REIT appears undervalued or overvalued, and if its management and business model are still sound, and poised to perform well going forward.

[Hoya Capital]

Yes, all very good points. We tried to adjust for those effects by taking the data at the start of each year and comparing it to returns at the end of the year. Certainly, many of the factors overlap as well... especially FFO multiples, dividend yields, and debt ratios.

[Yodaorange]

Excellent analysis! Since this data covers a decade, maybe 10% to 15% of the REITS that existed at the start were bought out or merged by the end. How did you handle the data for these? Or does your analysis only include REITS that traded over the whole time period, leaving out those that fell by the wayside? Thanks, YO

[Hoya Capital]

@Yodaorange There were 10 separate data series, 1 for each year beginning in 2010. At the start of the decade, there were closer to 100 REITs in the series. By the end, there were around 150.

[Yodaorange]

Let me be more specific. For example, these eight equity REITS were trading on 1/1/18, but were all bought out/merged by 12/31/18.

GGP
Quality Care Properties
DCT Industrial Trust
Gramercy Property
Forest City Realty Trust
LaSalle Hotel Properties
Select Income REIT
InfraREIT

How did you account for these in your calculations?
Thanks

[EliasMouawad]

@Yodaorange In deed. GGP had an impressive return. I even recall once reading that it was the best stock ever...

[Okra1]

This was a very informative article. Thank you for publishing it.

[Hoya Capital]

Thanks, @Okra1 .

[surfgeezer]

Excellent article. Yield + DGR matters is how I look at things also, "Total Return" not so much.

I completely get why other people do, I just find it far to fickle to base my investment decisions on. Maybe it is my distrust of crowd thinking. Probably also because I am both a retiree and leveraged myself.

We do agree yield spread is the basic biz of REIT's- and mine. What I don't do in either stocks or my RE is EVER depend on a sale for actual payments- why I distrust "TR". Simply way to volatile IMO, but yep in good times it will always outperform the slow yield spread biz- until it does not.

If your leveraged and depending on TR its a recipe for disaster IMO. So I stick with yield spread and depend on the compounding Amortization inside the leverage for TR- eventually. The compounding of the Interest down and the excessive spread buying shares is my retirement yield spread biz. TR, again, not so much unless I releverage and I can pick those times, which is when TR matters.

We agree CoCapital is a big deal, why I have held O since it was yielding far higher for that agreed nice DGR- when it had a nice yield spread :).

[Hoya Capital]

Thanks and good insights, @surfgeezer.

[myiowahome]

The author is spot on with the major claims here though. Financial integrity coupled with grow in a lucrative sector is the best insurer of rising dividend payout. I've bitten on my share of rotten high yielding apples and have gotten stuck for years with painful dividend cuts adding insult to injury. A great example here is MAA which I came to own through CLP, it sells at rich valuations but has a strong multi year trend line. The yield is below 4% but it recently raised the dividend and gas returned appx 36% in the past year. If you're in retirement assets you should be able to harvest gains easily. TR is really all that matters if you can manage the tax end of it. And taking dividends involves taxation as well. Look at ARCP, PSEC, WPG, CBL and even NLY. Part of the benefit of many REITs as an investment will always be growth potential. If an investor wants the highest yields I think cefs, bdcs and select ETFs provide a better vehicle.

[Robert Hutten]

Thanks so much for the article. The data you provide is always appreciated. I have been looking at your "Real Estate Total Return Performance" chart every time you include it. The discernible patterns I see in it are
--Manufactured homes have beat the index almost every year since 2008, reflecting a limited supply, their affordability, stickiness of the customer, and an aging population with limited resources.
--Net Lease provides a fairly stable return generally above the index--probably a result of low risk and low interest rates coupled with a generous supply of risk averse investors needing income
--Hotel returns are extremely volatile depending on where one is in the economic cycle. Homebuilders also have high volatility--generally reflecting up and down sentiment about the economy and interest rates
--Cell towers and data centers are relatively new categories--cell towers in 2012 and data centers in 2015--and yes they have done very well based on the promise of 5G and cloud computing-- but it is hard to judge what will happen to them in a down cycle.
--Malls and shopping centers have tanked starting in 2016--fear of retail apocalypse. The big question is have they hit bottom--I am betting they have--but that is a speculative bet in the extreme
There are probability a lot of other things that can be said--but point is if one can figure out where the macro issues stand, there is a much better chance of an above average return. I do not believe I would rely on a couple financial statistics, though they are helpful.

[M Plaut]

A wonderful article that IMO should be published and republished once a year.

[Hoya Capital]

Thanks, @M Plaut. Good idea, we'll plan on updating this next year.

[65wildcat]

anyone have any thoughts on APTS - at 52 week low... 8% div....

is this a loser reit lol

[Sam Sawyer]

Great article. Thanks for the great analysis.

[Hoya Capital]

Glad you enjoyed, @Sam Sawyer.

[V1adimir]

Great analysis! Thanks

[Hoya Capital]

Thank you, @V1adimir.

[Ruven77]

Wondering if all your total returns included reinvestment of dividends?
Given the range of yields between high and low payers, this could have made a significant difference in the results.
As Einstein is reputed to have said "The most powerful force in the universe is compound interest."

[Hoya Capital]

Yes, good point. These total return figures would indeed assume reinvestment of dividends.

[team Gabe]

That means the high dividend/low growers would be great candidates for calls selling. ( less risk of assignment)

[Brad Kenagy]

Great article!

From this article, one can infer that mall stocks and a stock like Tanger (SKT) will continue to underperform.

[Hoya Capital]

Ha! I didn't think you'd miss that opportunity to tackle Tanger. ;)

But in all seriousness, as I noted, there are indeed exceptions to the rule. There are a handful of low-yield REITs that chronically underperform (office REITs are a great example) and a handful of high-yield REITs that continue to crush it. (net lease REITs are good examples)

[Allen Greathouse]

this should be mandatory reading

[Hoya Capital]

Thank you, @agtiger1.

[DonPaul Olshove]

nice analysis - so to summarize:
for the last couple decades, the most profitable REITs to own were the "growth" REITs - those that were best at buying RE on the cheap and flipping to the retail market by selling stock.

While the "growth" REITs do include the business of ownership and management of RE, it's clear that the extra profits are coming from the flipping, a somewhat different business than owning and operating RE investments.

Of course this has been a period of decreasing interest rates and excess capital availability. I wonder how the "growth" REITs will do in a capital constrained environment.

[team4325]

Not trying to pick at your comments, but adding some perspective. I don’t believe that flipping is an accurate description of the driving component of growth at any of these companies. REITS have been net buyers throughout the last two decades - really since inception in 1960. For example, the equity market cap of reits in 2000 was roughly 150billion and its 1 trillion+ today. They are constantly managing the portfolios (buying, selling) to optimize earnings growth. Selling assets is usually dilutive to earnings unless you replace that stream simultaneously and these companies don’t get much lasting credit for special dividends.

The fact that these companies pay out a good portion of the cash flow forces constant attention to capital allocation that earnings retaining corporations can sometimes ignore or be more lax with. To grow a reit you really need access to equity capital - often. To raise equity frequently you have to demonstrate the ability to grow per share cash flow. If you can grow cash flow, you can grow the dividend. Investors pay for growth. If you can’t do these things, another reit or a private investor will consume the portfolio and you will go away. It’s pretty Darwinian in an investor positive way. That said, as pointed out in the excellent article here, segment matters. So a “b” mall portfolio doesn’t have a lot of huge interest....though even cbl does have an activist in the mix currently.

It is also not a factual statement that retail investors are getting stuffed or “flipped to” by reits. Most of the reits north of 1bln in equity cap are 90%+ owned by institutions. Most closer to 100%. And Mgmt is aligned because this is their sole activity or at least that is the most common situation.

Nice work Hoya.

[DonPaul Olshove]

REITs are supposedly investment in real estate. "Real" RE investment is done on a long term capitalization rate. The "growth" REITs are selling at prices that suggest capitalization rates of about 4% when the open market is around 7%. Buy at 7, sell at 4 wash, rinse, repeat, and grow bigger. Yes, it works. Nevertheless, it looks to me like the growth REITs are currently overpriced by about 40%, and that's assuming that the current interest rates hold.

[Eric Peterson]

This article is a convincing and well-done proof that lower yields and higher FFO multiples outperformed substantially in 2019. I think what has been shown is that during a very good year for REITs, it was best to be invested in the most aggressive REITs.

But what about longer periods? For example, what about buying the lowest-yielding and "most expensive" REITs at the beginning of each year from 2010 through 2019? What would have been the results? And maybe go back to the beginning of 2007, so we include a couple horrible years for REITs.

[Hoya Capital]

I should have been more clear- the "Winning Factors" chart is the data from 2010-2019.

We focused-in on 2019 because these trends were consistent with the longer-term trends and the data was a little "cleaner." (ie: the yield and FFO thresholds could be defined and actionable)

[Eric Peterson]

Thanks. Yes, I somehow missed the 2010-2019 chart and focused on the 2019 charts. It would still be interesting to see this from the stock market peak in mid-2007 to the low in early 2009, to see if the low-yield and high price/FFO REITs got crushed more than others, or held up better than others.

[hawkeyec]

So my question is are there any REIT funds that invest in a pool of REITs that are based on some or all of these factors?

[Hoya Capital]

The only multi-factor REIT ETF that I'm aware of is Hartford's RORE. However, the factors that they use are not entirely consistent with these findings.

There are a handful of higher-growth (lower-yielding) real estate ETFs as well that would probably be the most appropriate to play these factor tilts.

[T-42]

Yes, SRET is a REIT ETF that I happily own.

[T-42]

Not to mention that SRET gives you a global coverage which may somewhat mitigate the bubble that is potentially brewing in the U.S. real estate.