Yields Plunge, REITs Crater
- Tired of hearing "rates up, REITs down?" Same here. There are more factors to consider.
- Treasury yields are falling as more investors recognize the death of inflation and call for rates to be cut by the end of the year.
- Chairman Jerome Powell is mostly alone in calling for higher rates. It's time to build his legacy on being late to the pivot.
- I won't complain too much. I'm getting more shares at discount prices. Not too fond of all the extra interest expense we will see on the sovereign wealth fund though.
- The REIT Forum members get exclusive access to our real-world portfolio. See all our investments here »
Get ready for charts, images, and tables because they are better than words. You'll need to hunt for some of them. The ratings and outlooks we highlight here come after Scott Kennedy’s weekly updates in the REIT Forum. Your continued feedback is greatly appreciated, so please leave a comment with suggestions.
Did the Federal Reserve blink? The fixed-income markets seem to think so.
While the 2-year Treasury rates are falling, the rates on longer-term securities are falling a bit less:
Generally, that should be a positive sign as the curve becomes a bit less inverted. However, Chairman Powell’s commentary mentioned twice (including just before walking off stage) that there are no rate cuts this year in his base case scenario. It’s a line he may need to repeat, even if the base scenario is flawed.
Admitting rate cuts may be appropriate later in the year would basically lock them into the forward curve. That could ease credit conditions. As Chairman Powell stated, tightening credit conditions can take the place of rate hikes. They still slow the economy, and the goal is still to push the economy into recession. That’s the goal. It's not a side effect. The goal of “lower inflation” requires a plan. The steps the Federal Reserve is planning on involve creating that recession. If they're lucky, it's a very mild recession.
My plan would’ve been to let the free market handle it. That’s just my silly view that the free market is more effective than a government-appointed official though.
As of 03/23/2023 the inversion is dropping even further:
Look at that! It’s the 2-year rate plunging even further.
The cumulative impact of these drops is that the 2-year Treasury rate is back to levels seen in late September:
That happened despite significant hikes in the Federal Reserve's target rate.
Can investors still buy stocks if the Federal Reserve is targeting a recession? I’ve been willing to do it, though my portfolio has suffered some for that choice. When the whole market is getting a beat down, it's no surprise to see a decline. However, we are doing vastly better than the average of the index ETFs for our sector.
We get into a strange scenario where higher interest rates already have put significant pressure on share prices. Consequently, a recession with falling interest rates may be better than avoiding a recession with higher rates. Normally, the Federal Reserve cuts in a recession. If they do not cut, we get into a really bad situation. Deficits surge (as they do in every recession) and we end up with an even bigger national debt all financed at a higher rate. As a reminder to all my fellow Americans, our sovereign wealth fund (a fun name for our national debt) currently has a balance of negative $31.46 trillion.
Bargains and Base Case
I see bargains all over. However, I should state that my base case is not the same as Powell’s base case. I think there's a decent chance for a reduction in rates late this year. That puts my view between Chairman Powell (no cuts) and the bond market (cuts start in the summer 2023 and continue regularly). If we don’t see cuts by late this year, I think we will need even more severe cuts in 2024.
The Narrative and the TV Watcher
What's so special about Summer 2023 anyway? It comes down to the narrative and the TV watcher. Inflation is usually reported on a year-over-year basis. The vast majority of the inflation included in the current year-over-year metrics is going to burn off over the next few months. Consequently, the year-over-year number should plunge. Further, the thing that was propping up inflation numbers was shelter. Have you seen apartment leasing spreads. Not so great.
AvalonBay (AVB) is trading about 39% below their 52-week high. Camden Property Trust (CPT) is 42.5% below their 52-week high. Essex Property Trust (ESS) was slaughtered as well, but some people will blame that on the California focus. Apartments have been absolutely hammered. Lease inflation died, but the official inflation metrics are still recording shelter inflation from a year ago. Consequently, the official inflation numbers are still reporting big month-over-month increases in shelter costs despite a lack of increasing rental rates.
Sorry, I wrote that yesterday. They fell further today. I guess they have that in common with Treasury yields. Going down. I'm not saying it's forever. I own shares in both of those REITs. Despite all the challenges, they still produce a significant amount of cash flow (with excellent dividend coverage) and I believe most renters are committed to the idea of having shelter.
Inflation Past Dead
The following chart demonstrates three metrics for CPI. We have CPI, CPI: Shelter, and CPI: ex-shelter:
You may notice that the highest bar by a large margin over the last several months is CPI: Shelter. The value for CPI: Shelter is propping up CPI. What if CPI: Shelter was not lagged? It would’ve shown a much larger surge in inflation during 2021 to early 2022. During that period, the lag in CPI: Shelter caused “inflation” to be materially lower than the aggregate change in market prices. Today, the lag in CPI: Shelter is causing “inflation” to be materially higher than the aggregate change in market prices. CPI: ex-shelter is roughly flat since June 2022.
We can demonstrate that by normalizing the chart to set all values equal to 100 as January 1st, 2021. This is the change from then:
That lag is still occurring. However, you can easily see that actual market prices are roughly flat. Not for every single item. No, there are a few things that still increased dramatically. Eggs? Coffee? Vegetable oil? Yes. What do those things have in common? They had huge disruptions in the supply chain.
Moving on to Investments
If you believe the housing market will recover and most people won’t default on their loans, you’ll probably be interested in Chimera Investment Corporation (CIM) or Ellington Financial (EFC). Using our estimates for book value as of the end of last week, EFC currently trades at a 23% discount and CIM trades at a 28% discount. However, I will warn investors that over the last year we’ve seen a material decline in book value per share for EFC and a massive decline in book value per share for CIM. That’s something worth discussing in another article, but I already spent this one going over macro issues.
If you’re interested in shares with a lower dividend yield, we did some great research for subscribers (that means a paywall) on Alexandria Real Estate (ARE). I’ll probably publish a significantly shorter piece on the public side soon. Spoiler alert: ARE is a great REIT trading way below their normal range. I see the macro risks weighing on the sector, but I think they are a great long-term pick. Their decision to focus on long-term fixed-rate debts gave them a very favorable cost of debt.
Finding Our Charts
I posted all the charts as part of another full article (covering some mortgage REIT preferred shares) on my website.
Our goal is to maximize total returns. We achieve those most effectively by including “trading” strategies. We regularly trade positions in the mortgage REIT common shares and BDCs because:
- Prices are inefficient.
- Long term, share prices generally revolve around book value.
- Short term, price-to-book ratios can deviate materially.
- Book value isn’t the only step in analysis, but it's the cornerstone.
We also allocate to preferred shares and equity REITs. We encourage buy-and-hold investors to consider using more preferred shares and equity REITs.
We compare our performance against four ETFs that investors might use for exposure to our sectors:
The four ETFs we use for comparison are:
One of the largest mortgage REIT ETFs
One of the largest preferred share ETFs
Largest equity REIT ETF
The high-yield equity REIT ETF. Yes, it has been dreadful.
When investors think it isn’t possible to earn solid returns in preferred shares or mortgage REITs, we politely disagree. The sector has plenty of opportunities, but investors still need to be wary of the risks. We can’t simply reach for yield and hope for the best. When it comes to common shares, we need to be even more vigilant to protect our principal by regularly watching prices and updating estimates for book value and price targets.
Ratings: Bullish on common shares EFC, CIM, ARE
You should try our service. Unlike most services, our service is backed by a real portfolio. Not a "model" portfolio. Not hypothetical positions. Not 7 different portfolios we made up in Google Sheets so we can brag about the good one. None of that crap.
You get real-time alerts on every trade. See current and past positions. I'm sick of analysts who have to retroactively pick a "portfolio" or get creative about defining "returns". Beat the index or get out.
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Analyst’s Disclosure: I/we have a beneficial long position in the shares of AVB, CPT, ESS, ARE, AGNCO, RITM-D, AGNCP, ARR-C, FBRT-E, GPMT-A, RC-E, DX-C, RITM, SLRC, AAIC, MFA, GPMT, RC, DX, CSWC either through stock ownership, options, or other derivatives. 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.
Colorado Wealth Management Fund and Scott Kennedy are supporting contributors for The REIT Forum. Our ratings and outlooks will often overlap. Any recommendation posted in this article is not indefinite. We closely monitor all of our positions. We issue Buy and Sell alerts on our recommendations, which are exclusive to our members. I have an indirect conflict of interest with ABR and STWD. Neither I, nor any contributor for The REIT Forum, will provide investment advice, reply to questions, or engage in discussions regarding these two mREIT stocks.
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