One reason investors like investing in real estate is the stability of the asset class. They believe that asset prices are fairly stable (despite the great recession), and want ways to invest in stable cash flows. One of the large funds offered to some investors is the TIAA Real Estate Account (QREARX). We want to caution investors about the risks underlying real estate and the impact of the lag between appraisal values and market conditions.
This isn't an attack on the fund. We are highlighting a very timely issue relating to a major disparity between the pricing on REITs and the pricing on QREARX.
Note: You won't even find the ticker "QREARX" listed on Seeking Alpha, but it reported $26 billion net assets.
Brief Summary
Given the importance of investors understanding key points, we’re going to sum it up very quickly. This is a breakdown of the property type in the TIAA Real Estate Account:
Office and Retail combine to be more than 56% of the total portfolio. If you’ve missed the last few months, it has been brutal on Office and Retail. There are major threats to both sectors. We’ve encouraged investors to avoid office properties all together for a long time and we’ve encouraged investors to underweight retail. Small positions are OK, but they should only be in the best operators and they should remain small.
The share prices for major REITs which own “Office” or “Retail” have plunged. Almost every REIT in those sectors has taken a beating and the beating has been absolutely massive. When REITs across a sector trade at huge discounts to NAV (net asset value), the market is predicting that NAVs will decline. When it comes to equity REITs, the market is usually right about declining asset values. The market won’t be able to effectively predict precisely how far the values will decline, but it's a strong indicator of the direction (property values going up or down). Consequently, we believe it is extremely likely that property values will decline materially for “Office” properties and “Retail” properties.
We believe investors who have invested in the TIAA Real Estate Account or any other funds which are extremely similar should look to reallocate their capital.
We believe the value on the TIAA Real Estate Account will underperform significantly over the next few years.
We believe the current price is a function of outdated appraisals of the real estate.
The TIAA Real Estate Account is not like a typical REIT fund. It owns properties directly, rather than shares of stock. Further, it includes a guarantee of liquidity. Consequently, investors should be able to sell at an artificially high (in our opinion) price.
What is TIAA Real Estate Account
According to the Wall Street Journal (paywall):
“TIAA offers the Real Estate Account only in retirement savings plans for teachers and other not-for-profit employees. The Real Estate Securities fund is available to the general public.”
The fund invests directly in real estate but offers investors some significant advantages. Beyond not having to manage the properties themselves, the fund offers investors liquidity at a share price that doesn’t fluctuate at the same time as the stock market:
Source: TIAA’s page on the TIAA Real Estate Account
We want to highlight the “Access to Cash” feature. This is a very material benefit to the investors. If you were simply investing in a typical non-traded REIT, you wouldn’t expect to have easy access to your investment.
When you see the returns on the TIAA Real Estate Account, you’re going to be amazed by the stability. As we will are trying to hammer home, please don't be fooled by the stability seen in the past periods.
Incredible Stability
Many investors who simply look at the performance of a few funds would believe the account is a perfect way to make money. These kinds of funds do have a place. They can be absolutely incredible to buy during an economic expansion. Why buy them then? Because their “stable” price can give investors an opportunity to bail out before the market corrects.
We’re going to compare TIAA Real Estate Account to three other investments:
- Fidelity Real Estate Index Fund (FSRNX)
- Vanguard Real Estate ETF (VNQ)
- Invesco KBW Premium Yield Equity REIT ETF (KBWY)
FSRNX is a mutual fund. It has low expenses. We’ve used it for a small part of some retirement accounts where we are not allowed to pick individual shares. Did we pick it because we thought it was great? No, our choices were severely restricted and we determined it was better than the other mutual funds available to the account. We wanted a fund focused more on apartment REITs, industrial REITs, data centers, and cell towers. We would’ve been happy to include some triple-net lease REITs as well. We wanted to be light on healthcare REITS, office REITs, and mall REITs.
VNQ is the largest REIT ETF. VNQ has changed their allocations over time. Their top six individual stock allocations are:
- American Tower Corp (AMT)
- Crown Castle International Corp (CCI)
- Prologis (PLD)
- Equinix (EQIX)
- Digital Realty Trust (DLR)
- SBA Communications Corp (SBAC)
We have two points to make about that list:
The top two allocations are to cell tower REITs (not traditional “real estate”)
The fourth through sixth allocations are to data-center REITs (also not traditional “real estate”).
Consequently, VNQ isn’t going to be a good comparison to a fund that doesn’t invest significantly in those property types.
KBWY is evidence of something we’ve been warning investors about. Buying high-yield equity REITs is the road to ruin. This is an index designed to emphasize yield and it has been utterly destroyed by other index funds. KBW deliberately allocates to high-yield equity REITs, which tend to be:
- Smaller (bigger overhead burdens)
- Less efficient (weaker margins)
- Overleveraged (crap balance sheets)
Consequently, we would expect KBWY over the long term to underperform compared to a batch of higher-quality REITs.
Time Period for Charts
The charts shown below will end in late May 2020. That isn't an accident. The layout is designed to set the stage for the conclusion. This is a big topic to explore and this method is designed to help readers process it.
Returns Comparison
This is where your eyes should start to bug out a little bit. You’ll notice the blue line is simply WAY too stable:
Source: Marketwatch
Using Marketwatch is unusual for our charting needs. However, the QREARX ticker for the TIAA Real Estate Account isn’t tracked effectively in some tools. Getting a chart on QREARX where we could add other symbols for comparison proved surprisingly difficult.
Prior to March 2020, you could simply attribute the higher volatility in the other funds to “market volatility.” However, we saw an enormous plunge in March. While those shares are bouncing back up, the gap remains huge.
Office and Retail
We need to emphasize that office and retail are dramatically underperforming other types of REITs. To illustrate that point, we’re comparing VNQ with three of the largest office REITs for returns through 5/27/2020:
Source: Yahoo
For investors who want to know more about the office REIT challenges, we have a piece focused on office REIT challenges.
Boston Properties (BXP) has an A- credit rating from S&P. They wouldn’t get that credit rating by running high on leverage. Cousins Properties (CUZ) and Douglas Emmett (DEI) are both relatively strong REITs as well.
We ran that same chart using the three largest retail REITs:
Source: Yahoo
Beyond picking the largest REITs for the exposure, our selection is emphasizing REITs with strong credit ratings:
- Simon Property Group (SPG), rated A (though I expect a downgrade)
- Federal Realty Trust (FRT), rated A-
- Regency Centers (REG), rated BBB+
These REITs were not overleveraged. They had significantly less leverage than average. Consequently, declining share prices don’t reflect dumb decisions about debt. Several of the REITs in these sectors declined far worse than the three we picked for each category.
If Real Estate Stays Strong
We’ve highlighted that when equity REITs trade at massive discounts to net asset values, it indicates a decline in net asset values is probable. What if the decline never happens?
Either the equity REIT prices roar back or the equity REITs begin the process of arbitrage. The REITs sell off properties, pay down debt, then repurchase their own stock. The rate at which they can do this may be limited by taxable gains on the properties, but it still creates accelerated returns for shareholders.
If investors feel overwhelmingly bullish about office and retail property types, they can invest in those REITs at dramatic discounts to their “Net Asset Values.” If those property types perform well, those REITs would be positioned to beat the TIAA Real Estate Account since investors would get them at a huge discount to NAV.
If Real Estate Weakens
The REITs already trade at large discounts, which gives investors some margin for absorbing declines in NAV. If you’re only paying 80% of NAV and the NAV declines by 10%, the same price would still give investors a discount of about 10%.
The appeal for TIAA Real Estate Account is that stable share price, but how will that price react if investors want access to their capital?
When an investor sells a share of a REIT, the REIT isn’t required to purchase it. However, TIAA’s product comes with a liquidity guarantee:
Source: Prospectus for TIAA Real Estate Account
We are not interested in where the liquidity comes from, but we are interested in the idea that liquidity is guaranteed. That gives investors a nice opportunity to escape before the appraisals catch up with the market. The signal that prices for retail and office assets are set to decline would look exactly like that we’ve seen over the last few months. The equity markets have sent a clear sign for investors in funds like the TIAA Real Estate Account to pull out their capital and reallocate.
First Section Recap
Real estate property is inherently illiquid. Appraisals lag real-time transactions. During major changes in the market, the combination can lead to appraised values being far less than market values for publicly-traded REITs with similar assets.
Since TIAA Real Estate Account has a liquidity guarantee, investors in the fund should be looking to close out positions and reallocate.
If the investor still wants to include office and retail in their portfolio, REITs in those sectors trade at large discounts to median NAV estimates. If the investor wants housing REITs, many of the best apartment REITs still trade at substantial discounts (though smaller than office and retail). Within industrial REITs, many trade roughly around their median NAV estimates.
Part Two
In the second part of this article, we're going to provide more comparisons on REIT indexes vs. QREARX.
New Investments
We want to highlight that QREARX may limit new (and returning) investors to a maximum of $150,000. We heard about this from investors in the fund and confirmed it on page 19 and 102 of the QREARX prospectus. Consequently, some investors may face a hard choice. We are talking about investors who meet both (not either, but both) of these criteria:
- Want the fund for a very long-term allocation
- Have significantly more than $150,000 invested
Those investors may decide that the challenges (or inability) to reestablish such a large position warrants taking on the expected decline here.
Core Concept
The core concept that we want to establish for readers is that a huge swing in the value of publicly-traded equity REITs is a strong indicator of future returns for QREARX. A small swing for publicly-traded equity REITs isn’t important, but a huge swing is important.
Further, we want to highlight that as VNQ includes more cell towers and data centers, the correlation will generally weaken. However, we can still evaluate the rough impact of the cell towers and data centers on VNQ.
Data Centers and Cell Towers
Since the COVID-19 panic, data centers and cell towers dramatically outperformed almost every other REIT. Therefore, they are pulling the total performance of VNQ higher. If we could strip out the impact of cell towers and data centers, VNQ’s performance would be materially weaker. We could find exact values, but we don’t need them. It’s like trying to figure out if the score on a test is 54% or 53%. The difference doesn’t really matter, you know the grade.
Charts
This first chart breaks down the concept pretty well:
Source: The REIT Forum, underlying data on VNQ from Yahoo, data on QREARX from subscribers.
So what is the optimal signal for selling? If we ignore the impact of the data centers and cell towers (which are boosting VNQ), the premise is actually pretty simple. If REITs investing in the same property types as QREARX are trading at large discounts to net asset value, then investors want to sell QREARX at net asset value. If they still want to own that property type, they can do it by purchasing shares of the REITs at a major discount.
To drive the message home, we want to modify the chart a little. We’re going to add a golden line to calculate the difference in the performance between the returns on QREARX and on the Vanguard Real Estate ETF (VNQ):
Source: The REIT Forum
That’s everything you need to understand about predicting QREARX, all wrapped up in a nice little package. When the golden line surges, it's a bad signal for QREARX. When data centers and cell towers are performing better than other property types, any increase in the golden line is even more concerning.
What scenarios should lead to the golden line spiking higher? It shouldn’t be a spike in the value for QREARX. The value for QREARX has exceptionally low volatility. Instead, it would be a plunge in the price of VNQ. That plunge is telling us that we should expect at least one of two things to happen:
- Equity REITs roar back to from trading at huge discounts to NAV to deliver incredible gains
- Property values in those sectors proceed to plummet, following share prices.
How about some examples of each scenario?
- Since 2016, mall prices plunged lower following share prices.
- Since early 2018, apartment REITs roared higher from trading at huge discounts to NAV.
Prices for apartment REITs fell again in March 2020, but the rally lasted for two years. It's far too soon to make any declarations about how the discounts reached in March 2020 play out. Yet, we can say that either:
- Apartment REITs should rally OR
- Apartment buildings should decrease in value.
Second Section Recap
The most attractive feature of QREARX isn’t that it offers investors a simple way to invest in real estate on a broad scale. The attractive feature is the guaranteed liquidity, which gives investors a way to get out when other REITs trade at huge discounts to NAV. When those large discounts to NAV are gone (due to rising prices or declining NAVs), QREARX becomes attractive again.
Part Three
With the framework laid, we want to look at what has happened since late May. The following chart shows the last six months and we've highlighted the period in late May where the rest of our charts ended:
Source: Marketwatch
Since late May, we've seen a moderate rally for VNQ and FSRNX, while KBWY is roughly flat. While the rally for VNQ and FSRNX isn't surprising, the lack of a decline in QREARX is a little interesting. Remember that Office, Apartment, and Retail combined to represent more than 80% of the total portfolio.
Analysts covering the equity REITs believe that the value of real estate in those sectors declined over the last few months. We're charting the mean (that's the average) estimate for NAV and the median estimate for NAV. We can start with BXP:
Since late May, we are quite confident that the lines moved lower. Hmm, so analyst estimates believe office building values are declining. What if we try another office REIT like DEI?
The value still goes down. Hmmm.
How about a retail REIT? We can start with SPG:
Well, the estimates went down there also. Maybe it is only because SPG owns malls? How about a strip center REIT? We will try REG:
The values declined less, but they are still down around 2% to 5%.
If retail and office aren't doing so hot, what keeps them up? Perhaps it's multifamily? They had a large allocation there. The NAV estimates for AvalonBay (AVB) are only slightly lower:
However, some of the other great apartment REITs saw NAV estimates decline further. For Equity Residential (EQR), the estimates are down nearly 10%:
Well, those three sectors covered over 80% of the portfolio. Could valuations on industrial real estate really offset declines across the other three sectors?
We can use Duke Realty (DRE) as one of the larger industrial REITs:
The estimates are up, but less than 10%. If you have 15% allocated to industrial and property values go up by 10%, that's only a 1.5% increase.
What To Expect?
It seems like the upside on QREARX is going to be limited. On the other hand, the downside risk will be more significant until we see these trends reversing. While QREARX has been remarkably steady in the appraised value, the major REITs in Office, Retail, and Multifamily have seen consensus estimates for NAV declining.
Consequently, it appears that investors who want to allocate to those sectors are still much better off buying individual REITs. The portfolio value will be more volatile, but the REITs trade at substantial discounts to consensus NAV estimates. Further, the consensus NAV estimates already include significant decreases in estimated property values. That means the publicly-traded REITs have been discounted twice. They've seen NAV estimates decline and they've seen price-to-NAV ratios decline. That's why The REIT Forum emphasizes investing in high-quality individual REITs with strong balance sheets and favorable pricing. The discounted share prices create additional upside and higher yields.
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