REITs In May: Rising From The Ashes

Summary

• In the first part of May, REITs underperformed all asset classes, but since May 15, REITs have been delivering alpha returns ending the month with 5% gains.
• It might seem that the overall performance of REITs in May was solid registering just as appealing return as the S&P 500.
• Yet, if adjusted for the risk, the quality of REIT performance was much worse than for the S&P 500. The REIT return distribution has fatter tails with a left-tail skew.
• Similarly, the Sharpe ratio for REITs was barely positive landing at 0.14x, while for the S&P 500 it was 0.31x.
• In May, the REITs broke through the 16-year average standard deviation for the first time since the GFC as a hallmark to the imminent secular demand changes for offices, retail and hotels.

The phrase "rising from the ashes" encapsulates perfectly the REIT performance in May. The overall publicly traded REIT market began the month with a slight underperformance relative to almost all other asset classes, and already in May 11 took a considerable nosedive while the market remained more or less flat. However, a couple of days later, REITs registered a tremendous rebound and continued the rally till the end of the month.

Source: Verizon Media (compiled by the author)

In the chart above, I have compared the returns in May generated by all of the most popular asset classes (i.e. gold, bonds, junk bonds, commodities, equities and real estate). As a proxy for the real estate/REITs, I have chosen the Vanguard Real Estate ETF (VNQ), which is the largest REIT ETF out there. It is a market cap weighted index with just over 100 holdings of which about two-thirds represent U.S. REITs.

Indeed, the chart depicts what a remarkable recovery REITs have delivered. In May, REITs managed to outperform gold, bonds and ended the month with very similar gains as those of the S&P 500 and the all commodity index (i.e. 5.3% gain for REITs).

Source: Verizon Media (compiled by the author)

However, if we take one notch deeper here, we will quickly notice that the magnitude of return distribution for REITs has been quite drastic. Put differently, the fat tails of VNQ indicate some huge daily moves (both positive and negative) that ultimately implies severe swings that the REIT investments had experienced in May. Even relative to the S&P 500, which has had more normal distribution, the REITs have been rather risky.

Source: Verizon Media (compiled by the author)

The best way to judge the performance is to look at the risk-adjusted returns. The Sharpe ratio does this job quite well. So, in the chart above, I have calculated three different measures of the Sharpe ratio for the more quantitatively-driven readers (i.e. Sharpe based on the expected shortfall, value at risk and classic standard deviation).

The Sharpe ratio that is based on the standard deviation of VNQ's daily returns in May is barely positive - 0.14x. While the May returns for the S&P 500 and REITs have been rather similar, if adjusted for the risk, the picture is completely the opposite. The underlying volatility and riskiness of REITs have contributed to a sub-par performance in May.

Source: Verizon Media (compiled by the author)

Lastly, if we look at VNQ's rolling 12-month standard deviation and contrast it to the ca. 16-year average (all the way since the inception of the VNQ), the whole picture gets a bit clearer.

The REITs have experienced a volatility spike that is much greater than anything that has happened since the GFC. In fact, the level of volatility has broken through the 16-year average - again, for the first time since the GFC. This is a true testament of the shock and massive headwinds imposed by the deadly outbreak of the COVID-19, where many REITs (e.g., office, retail and lodging) are in front of huge secular demand shifts.

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.

Comments

[hardcorepatrickpl]

I searched ones that survived 2009 and thrived after

[UndiversifyBC]

Might be the definition of "dead cat bounce". It's really tough for me to find reit sectors that I feel comfortable with.

Retail? Simply no. As I mentioned in a recent CBL article. Apartment? Probably safest of the sectors but was premium priced prior to downturn and not exactly cheap now. Hospitality? Ebitda pressures even before COVID were worrying. Current environment probably doesn't help. Industrial? The golden child in the growing economy. Signs of possible over building then. Over optimistic likely now. Office? Secular pressures and dependence on growing economy. With COVID secular pressure just went up while economy turns down. mReits? Non agency too risky. Agency, maybe.

Not to say there aren't specific good deals out there. But just can't feel that confident with real estate in general, so hard to get excited with something bundled like a VNQ.

[Roberts Berzins, CFA]

@UndiversifyBC Well, I agree that VNQ is not the best option out there. I think that this is the time to pull your "bottom-up" investor hat out and start digging REIT by REIT. IMHO there are some names which have gone too far down in both lodging and retail. Also in the office space...
But yes, indexation entails quite high probability of delivering subpar results in this instance.
It could be so that data centers (the safest among them all) outperforms all other REIT sector if the 2nd wave comes.
Manufactured housing has some decent prospects...