- Oil is sucking the life out of the market.
- Banks made the situation worse by providing leverage.
- Lower rates from the Federal Reserve could push banks to get a job.
- Some landlords braced for economic destruction. Some didn't.
- We can still lock in a low-risk yield near 7%.
- This idea was discussed in more depth with members of my private investing community, The REIT Forum. Get started today »
The stock market is having a terrible few weeks since 2/20/2020. The REIT Forum is down 6.13% during those weeks as of 3/9/2020.
The last few weeks have been dreadful for share prices. The decline has finally given us some buying opportunities. We are still in a very defensive position. We still have a substantial cash allocation and preferred shares are still the largest part of our portfolio as of 3/10/2020.
Why did oil and banks plunge?
The most recent damage to the market can be attributed to over leveraged oil companies and banking stocks.
We will start with the oil stocks.
Many companies in the oil and gas sector have too much debt. The excessive amount of debt makes lower oil prices extremely painful. They would be rough without high debt, but excessive debt kills weak companies.
To be clear, strong companies do not take on excessive debt in the first place.
On Monday, the Vanguard Energy ETF (VDE) plunged 19.82% in a single day.
Shares closed at $45.01. To put that in perspective, at the start of the year shares were more than $80 (red box):
Investors in the oil and gas space got slaughtered. Their losses are more than thrice the losses for the S&P 500 (SPY).
Low oil prices don't create a recession
We have consistently argued that low oil prices by themselves do not create recessions. Wall Street has consistently misinterpreted low oil prices. When gas is cheap, people spend their money on other things. Cheap gas does not stop the economy. Extremely low oil prices can be a temporary headwind as increased bankruptcy in the sector can create unemployment. Currently, unemployment remains very low which mitigates some of that risk. We recognize that oil and gas workers can't necessarily transition into different employment fields quickly. So, there's a minor potential headwind but strong demand in other sectors can usually cover the issue.
In today's environment, it could be a little more difficult. We expect employers to pull back on hiring given the uncertainty with COVID-19.
Moving on to the banks
The next factor to consider is the banks.
Banking stocks are doing poorly. There are multiple factors in play.
- One factor is that many banks have loaned too much money to highly-leveraged oil and gas companies. These banks were not careful enough in their underwriting and took on unwise risks. In the event of bankruptcy for the oil and gas companies, the bank could have their assets impaired.
- Banks also have a second potential challenge. Banks earn interest from loaning out money. However, they also earn interest from not loaning money. The second concept is referred to as interest on excess reserves or IOER for short.
I have a comparison for IOER which bank investors hate. IOER is like unemployment for banks. It's quite literally paying the bank for not making loans. It is an interesting policy decision. It was created with the official purpose of giving the Federal Reserve more control over short-term interest rates. In practice, it serves to increase a bank's profits by paying them for not producing loans.
The reason bank investors hate this comparison is that it highlights the lack of work involved for the bank. They will argue that it's Federal Reserve policy that ultimately dictates how much excess reserves are in the system. Since the Federal Reserve policy is determining the amount of excess reserves, they would like the Federal Reserve to be responsible for paying more interest on it.
If that sounds a little bit absurd, that's because it is.
The Federal Reserve is attempting to stimulate the economy by reducing interest rates. The lower rates have three functions.
- The first is that they encourage the banks to loan. If you were going to be paid less money each week for not doing work, you would have a greater incentive to get a job. OK, that part makes sense.
- The second factor is that it lowers the interest rate on adjustable-rate loans that already are in existence. The reduction in interest rates gives the borrower more room to breathe while meeting their interest payments.
- The third factor is that it encourages businesses to borrow money from banks for investment. That's one way to encourage more investment spending within the economy.
The net result of plunging short-term rates combined with the risk of write-offs on bad loans to oil companies allowed the banking sector to get pummeled. The financial select sector SPDR ETF (XLF) declined by 10.72% on Monday.
While the S&P 500 took a nasty hit, it was not as bad as the damage in the banking or oil/gas sectors.
Credit spreads are widening
You may hear that credit spreads are widening. That's a true statement. Investors are becoming more wary of owning risky debt. However, we should put that in context. One of the reasons for wider credit spreads is the probability that some oil and gas companies will go bankrupt. The expanding credit spreads are partially driven by a dramatic decline in the value of bonds issued by those companies. If you own debt issued by Apple (AAPL) or 3M (MMM), your debts are still likely to be paid. There's less need for a dramatic increase in the spread between the rate on those bonds and Treasuries.
If you own debt in a highly-leveraged oil or gas company, your bonds are at greater risk. We do not cover individual oil and gas companies. It's outside the scope of The REIT Forum. However, we can recognize that plunging prices for oil and gas should increase bankruptcies in the sector.
Insights into the REIT sector
We would like to go over several of our views in the REIT space. This will include some bullish and bearish ideas.
The housing REITs are under pressure. Some have declined more than others. American Homes 4 Rent (AMH) has declined less than many of its peers. At this point, we are bearish on AMH based on relative values. We recently closed our AMH position and reallocated the money to Essex Property Trust (ESS).
We've closed our position in American Homes 4 Rent at $28.50 and added to ESS at $294.20:
The net result is a slight increase in our allocation to housing REITs.
Our closed position in AMH delivered 43.18%:
That's a very solid return.
To demonstrate the performance of AMH, we're pulling the $100k chart. Remember that this chart demonstrates how much-needed to be invested to reach $100k as of the latest close:
Source: The REIT Forum
We've added the blue arrow to point to our buying date. Using closing prices from 3/4/2020 (day before trade), our pick was tied for second best in the sector. Most of the sector was down 2% to 3% on 3/5/2020, but AMH was down less than 1%.
Source: Seeking Alpha
Consequently, if this chart were drawn with the intra-day price (rather than 3/4/2020's close), AMH would have sole possession of second place.
However, look toward the right side of the chart. The outperformance for AMH is almost all occurring since the start of 2020. This is a shift in investors favoring the single-family REITs and suddenly recognizing the value in AMH. To further demonstrate, we're adding in a Yahoo Chart:
Again, you can see that the blue line for AMH was often near the bottom. It's the sudden shift in relative valuations that has us making the trade.
We're happy to switch to ESS in this environment. Let's dig a bit more in ESS and AMH.
Essex Property Trust
ESS usually trades around net asset value, as demonstrated below:
During the last six years, ESS has usually traded in the general range of net asset value. Meanwhile, they've been retaining part of their FFO each year to invest for additional growth. The result is a solid REIT which has regularly grown FFO per share:
The main theory for ESS underperforming recently is that investors are concerned about the exposure to rent control measures in California. We don't expect a huge impact to ESS and recent commentary from management suggested they didn't expect much impact either.
On the Q3 2019 earnings call, Mike Schall (president and CEO of ESS) said:
"Lastly, before I turn the call over to John, I'd like to comment on the passage of California's Assembly Bill 1482, 1 of 18 housing-related bills that were signed into law by Governor Newsom earlier this month. Most of these new laws are expected to remove barriers to build more housing, incentivize affordable housing and fund housing production. AB 1482 will generally cap rent increases to CPI plus 5% and is intended as an anti-gouging measure.
At Essex, we've had a longstanding practice of limiting renewal rents to 10% and do not expect this legislation to have a material impact on our results. With rent regulation a recurring theme amongst legislatures across the country, we remain committed to California and will continue to advocate for smart housing policies."
Note: Bolding added, obviously, since transcripts don't have bolding.
American Homes 4 Rent
AMH is trading right around net asset value also. However, for AMH, that's higher than average:
AMH also is driving solid growth in AFFO per share, but they've done it by keeping their payout extremely low:
The payout ratio for AMH isn't just low, it's incredibly low. Reinvesting cash flow has been a very important part of AMH's growth story. We are happy to see management reinvesting that cash flow, but ESS is offering a pretty similar growth profile with a higher yield. We also see ESS carrying slightly less risk (in our view).
ESS and AMH - final thoughts
Based on the sudden shift in relative valuation, we decided to move our small position in AMH to a small position in ESS. The change gives us a slightly lower average risk rating on our positions, but we retain a similar exposure to the housing REIT subsector.
You need more preferred shares
The next share I want to discuss is AGNCO (AGNCO).
Source: The REIT Forum
We are bullish on AGNCO. It offers a very respectable yield, has some dividend accrual, and trades below call value. If the economy recovers, shares of AGNCO could rally to trade above call value again. In the meantime, they provide a solid source of income with lower risk.
More bearish talk
We also are a little bearish on Mid-America Apartment Communities (MAA) for the same reason as AMH. Shares have dipped less than many peers and rallied much harder over the last year.
Notice MAA well above the pack?
While MAA was very attractive at some points in the past, they have several peers who are currently more attractive.
More Apartment REITs
For the sake of being a little more complete, I'm also feeling a little bearish on Clipper Realty (CLPR) and Independence Realty Trust (IRT). These two smaller REITs have dipped a little more than the larger apartment REITs, but they are still much further off of their 52-week lows. These apartment REITs have less strength in their balance sheets compared to the larger apartment REITs.
If we actually enter a recession, which appears to be a very significant possibility, it could be more damaging for CLPR and IRT than it would be for lower-risk apartment REITs like ESS, AvalonBay (AVB), Equity Residential (EQR), or Camden Property Trust (CPT). Those 4 REITs each have risk ratings of 1 or 1.5. Their balance sheets are exceptional. They would be able to withstand a recession dramatically better than the much smaller and weaker peers. That difference in resilience is not fully reflected in the share price yet.
We will continue to monitor the market closely in attempting to find the best deals. When the market is this volatile, skilled investors can find the best opportunities while other investors are sitting on their hands or running for the door. That doesn't guarantee we will be right every time. However, we are continuing to gradually build some lower-risk positions in shares we've had our eye on for years. While we are starting some new positions, we also want to highlight which shares we are clearly not purchasing today.
- bullish on AGNCO and ESS
- bearish on AMH, MAA, CLPR, and IRT
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Colorado Wealth Management is a REIT specialist who began his decades-long investment career in a family-owned realtor office before launching his own company and embracing his drive for deep-dive REIT analysis. He passed all 3 CFA exams. He focuses on Equity REITs, Mortgage REITs, and preferred shares.
Features of the group include: Exclusive REIT focus analysis, proprietary charts and data models, real-time trade alerts posted multiple times a month, multiple subscriber-only portfolios, and access to the service's team of analysts and support staff for dialogue and questions on the REIT space.
Analyst’s Disclosure: I am/we are long ANGCO, AGNCP, EQR, ESS, MAA. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.