The Fed Disconnect

Summary

• U.S. equity markets posted gains while benchmark interest rates dipped to the lowest levels of the year as lingering financial stability concerns cast doubt on the Fed's economic and interest-rate projections.
• Posting a second-straight week of gains following its worst weekly decline in six months, the S&P 500 advanced 1.5% while the tech-heavy Nasdaq 100 gained another 1.8%.
• Real estate equities were laggards this week as investors weighed potential tailwinds from lower interest rates against increased credit concerns across several property sectors.
• Homebuilders were a bright spot on data showing a rebound in home sales and a retreat in mortgage rates, suggesting the housing market is beginning to stabilize after a tumultuous year.
• Office REITs remained under pressure this week after Blackstone stopped making debt payments on its $325M loan on the Hughes Center office campus in Las Vegas. CMBS spreads increased this week to the highest levels since July 2020.
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Real Estate Weekly Outlook

This is an abridged version of the full report and rankings published on Hoya Capital Income Builder Marketplace on March 24th.

U.S. equity markets posted gains while benchmark interest rates dipped to the lowest levels of the year as lingering financial stability concerns cast doubt on the Federal Reserve's economic and interest rate projections. Defiant in the wake of two-of-the-three largest bank failures in U.S. history and subsequent emergency policy actions to contain the fallout, the Federal Reserve hiked the Fed Funds rate by another 25 basis points, continuing the most aggressive twelve-month increase in benchmark borrowing costs since 1980.

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Posting a second-straight week of gains following its worst weekly decline in six months, the S&P 500 advanced 1.5% while the tech-heavy Nasdaq 100 gained another 1.8%. The large-cap benchmarks continue to hold up significantly better than their smaller peers amid the recent volatility, with both benchmarks on pace to end March with modest gains, compared to the roughly 8% declines on the Mid-Cap 400 and Small-Cap 600 for the month. Real estate equities were laggards this week as investors weighed potential tailwinds from lower interest rates against increased credit concerns across several property sectors. The Equity REIT Index posted declines of 2.2% on the week, with 4-of-18 property sectors in positive territory, but the Mortgage REIT Index rebounded by 1.6%. Homebuilders were a bright spot on data showing a rebound in home sales and a retreat in mortgage rates, suggesting the housing market is beginning to stabilize after a tumultuous year.

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Unsettled questions over the fate of several flagship European banks and regional banks in the U.S. kept downward pressure on benchmark interest rates across the curve this week. The policy-sensitive 2-Year Treasury Yield dipped to 3.77% while the 10-Year Treasury Yield closed at 3.38% - each closing at their lowest-levels since last September. The week began with the engineer rescue of Credit Suisse (CS) by rival UBS Group (UBS), which appeared to stabilize contagion concerns for several days until Deutsche Bank (DB) plunged late in the week in a sudden bout of turbulence that lacked a discernible catalyst. Stateside, First Republic Bank (FRC) deepened its declines to 90% this month after Treasury Secretary Yellen commented to lawmakers that the federal government is not considering providing “blanket” deposit insurance to stabilize the banking system following reports that Treasury Department was reviewing such actions.

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Real Estate Economic Data

Below, we recap the most important macroeconomic data points over this past week affecting the residential and commercial real estate marketplace.

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Amid the recent financial market turmoil, the sluggish U.S. housing sector has again emerged as a bright spot, consistent with the countercyclical performance trends it exhibited early in the pandemic. Data this week showed that Existing Home Sales rose 14.5% in February compared with January to an annualized rate of 4.58 million units, which was the first monthly gain in 12 months and the largest increase since July 2020. Meanwhile, New Home Sales data showed a third straight monthly increase to an annualized rate of 640k units - up 1.1% from January - above the median estimate of 633K. Freddie Mac reported this week that the 30-year fixed-rate mortgage averaged 6.42% this past week, down 18 basis points from the previous week and 66 basis points below the highs last November of 6.42%.

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Owing to years of tight mortgage lending conditions and a generally slow post-recession recovery in homeownership, the residential real estate market has undergone a period of significant deleveraging over the last decade. At the end of 2022, the mortgage debt service payment ratio as a percent of disposable income remained near the lowest level on record at 3.99%. By comparison, this level was at 7.13% in Q4 2007 before the GFC recession. Importantly, subprime loans and adjustable-rate mortgages - the dynamite that led to a cascading financial market collapse in 2008 - have been essentially non-existent throughout this cycle. Adjustable-rate mortgages - which would be most "at-risk" from the surge in rates have accounted for less than 5% of mortgages originated since 2009, down from nearly 30% at the peak in 2005.

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Equity REIT Week In Review

Best & Worst Performance This Week Across the REIT Sector

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Office: The seemingly relentless selling pressure on office REITs continued this week after Blackstone (BX) stopped making debt payments on its $325M loan on the Hughes Center office campus in Las Vegas with public filing citing an inability to fund future monthly payments, which follows mega-sized defaults over the past two months from Pimco, Brookfield, and RXR. Despite having significantly stronger balance sheets than their private-market peers, office REITs are reportedly being used as proxies by hedge funds and others to bet on mounting distress in the sector encumbered by pandemic-era Work-From-Home headwinds. Regional banks' exposure to office-backed loans has become a focus in recent weeks as the option-adjusted spread ("OAS") on CMBS has increased considerably - a surge that has not been seen on the RMBS side, which actually saw narrowing spreads this week after a bounce earlier this month. At 1.40%, the Bloomberg Aggregate CMBS spread pushed past its previous 2022 high this week to the highest levels since July 2020.

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Of note, several closely-watched office REITs held their dividends steady over the past week, including Boston Properties (BXP), SL Green (SLG), and Cousins (CUZ). In our State of the REIT Nation report, we noted that REIT dividend payout ratios remain near historic lows at less than 70% of Funds From Operations ("FFO"), and even with the expected FFO declines in the office sector this year, the majority of office REITs can still comfortably cover their dividends. A pair of REITs hiked their dividends this week, including CareTrust REIT (CTRE), which hiked its quarterly dividend by 2% to $0.28/share, and micro-cap Presidio Property (SQFT), which boosted its quarterly dividend by 5% to $0.022/share. We've now seen 42 REITs hike their dividends this year, while nine REITs have lowered their payouts.

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Storage: The 'Storage Wars' saga continued this week as well. Life Storage (LSI) - which we own in the Focused Income Portfolio - rallied more than 3% this week after Bloomberg reported that competitor Extra Space (EXR) is evaluating a rival bid for the company after it rejected an $11B bid last month from Public Storage (PSA). In the prior week, Life Storage filed an 8-K last week to increase severance payments to executives in a change of control, fueling speculation that the company may be warming-up to a deal. Last month in our Earnings Recap, we noted that Self-Storage REITs were the top-performing sector of earnings season with results that quieted critics forecasting a dismal year of declining rents and oversupply headwinds. The largest storage REITs easily topped their prior FFO and NOI guidance and provided an initial 2023 outlook calling for mid-single-digit earnings growth, buoyed by "sticky" rent growth on existing tenants.

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Hotel: Pebblebrook (PEB) declined about 2% after providing a mixed operating results, noting that its comparable Revenue Per Available Room ("RevPAR") was about 6% below 2019-levels in February, an improvement from January which saw comparable RevPAR levels that were 13% below 2019-levels. Previously, PEB reported that its RevPAR in Q4 was 7.8% below pre-pandemic levels. PEB commented, "overall demand trends for Q1 continue to be in line with expectations. Leisure demand remains healthy heading into the spring break season. We have not yet seen any impact on demand from fears of an economic slowdown or recession.” This week, STR reported that the U.S. hotel industry posted strong operating performance in February with RevPAR levels that were 14.3% above the comparable period in 2019. Trends through the first three weeks of March have been similarly strong with RevPAR averaging 12.1% above 2019-levels in the three weeks this month.

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Farmland: Gladstone Land (LAND) was among the laggards this week after providing a business update white noted that one of its farms in California suffered flood damage to certain of its structures and that the company is still in the process of assessing the damage, which it expects will not exceed $1M. None of the Company's other farms in California have been materially impacted by the floods. After being an upside standout last year, farmland REITs have been among the laggards this year amid a "triple-whammy" of headwinds: lower crop yield due to drought conditions, low crop price due to normalization effects after a sharp spike early in the Ukraine-Russia war (with particularly sharp price declines on specialty crops), and higher interest rate expense. Last month, Farmland Partners (FPI) reported that it expects its FFO to decline 32% in 2023 following two years of double-digit growth.

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Net Lease: This week, we published Net Lease REITs: Avoiding The Winner's Curse. One of the most "rate-sensitive" property sectors, Net Lease REITs have surprisingly been the best-performing major property sector since early 2021 despite the significant rise in interest rates. Private market values have remained far "stickier" than comparable public market assets. Increases in these REITs' cost of capital have far-outpaced cap rate increases, resulting in record-low investment spreads. Despite the tighter investment spreads, the pace of acquisition activity for some REITs slowed only modestly in late 2022, a strategy that could prove costly if rates remain persistently elevated. Strong balance sheets and lack of variable rate debt exposure have positioned these REITs to be aggressors as over-levered private players seek an exit, but these REITs must wait until the price is right lest they risk falling prey to the "winner's curse." We see the best value in REITs focusing on “middle-market” tenants and the middle-tier of cap rates where inflation-hedging lease structures and initial yields grant more breathing room for higher rates.

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Mortgage REIT Week In Review

Mortgage REITs rebounded following punishing declines in the prior week, with the iShares Mortgage Real Estate Capped ETF (REM) advancing 1.6%, but the performance gap between residential and commercial mREITs widened further, tracking the divergence in the performance of the underlying Residential MBS (MBB) and Commercial CMBS (CMBS) markets discussed above. Small-cap Western Asset (WMC) rallied nearly 5% despite reducing its dividend by about 13% to $0.35/share - the fourth mREIT to reduce its dividend this year. WMC was one of the REITs we flagged as at-risk for a dividend cut in our updated Mortgage REITs report published last week. Positively, WMC reported that its estimated Book Value Per Share ("BVPS") had gained about 8% thus far this quarter to $16.95 as of the end of February. Besides WMC, the remaining six mREITs that declared dividends this week held their payouts steady including: Rithm Capital (RITM), Franklin BSP (FBRT), KKR Real Estate (KREF), Two Harbors (TWO), and Ellington Financial (EFC).

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Elsewhere, Arbor Realty (ABR) - the latest REIT to be targeted by short-sellers - stabilized after authorizing a new $50M share repurchase program. Lument Finance (LFT) gained 3% on the week after reporting decent results, noting that its Book Value Per Share was roughly flat in Q4 at $3.50. In our Mortgage REITs report published last week, we discussed that sharp changes in rates in either direction can wreak havoc on mREITs that are caught over-levered or improperly hedged - a risk that is particularly acute for agency-focused mREITs that typically employ more extensive hedging programs. On that note, agency-focused Two Harbors reported this week that its Book Value has dipped 8% quarter-to-date, citing "heightened interest rate volatility and widening mortgage spreads... [and] elevated hedging and convexity costs, given the magnitude of interest rate moves."

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2023 Performance Recap & 2022 Review

Through the first twelve weeks of 2023, the Equity REIT Index is now lower by 4.5% on a price return basis for the year, while the Mortgage REIT Index is lower by 8.9%. This compares with the 3.5% gain on the S&P 500 and the 1.0% decline for the S&P Mid-Cap 400. Within the real estate sector, 2-of-18 property sectors are in positive territory on the year led by Self-Storage and Industrial REITs. At 3.38%, the 10-Year Treasury Yield has declined 50 basis points since the start of the year - closing this week at its lows of the year - and nearly a full percentage point below its 2022 highs of 4.30%. The US bond market has stabilized following its worst year in history as the Bloomberg US Aggregate Bond Index has gained 3.5% this year.

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Economic Calendar In The Week Ahead

We'll see another fairly busy week of economic data in the week ahead. The state of the U.S. housing market will be a focus early in the week. On Tuesday, we'll see home price data via the Case Shiller Home Price Index, which is expected to show a seventh consecutive month of declining home prices in January with the 20-City composite expected to show that prices are now more than 5% below recent peaks. We'll see some more forward-looking data on Wednesday with Pending Home Sales data, which is expected to show a second straight monthly increase in February following a stretch of thirteen straight monthly declines. The most important report of the week comes on Friday with the PCE Price Index - the Fed's preferred gauge of inflation - which is expected to show a continued moderation in price pressures. In the same report, we'll also be looking at Personal Income and Personal Spending data for February, a key read on the state of the U.S. consumer.

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For an in-depth analysis of all real estate sectors, check out all of our quarterly reports: Apartments, Homebuilders, Manufactured Housing, Student Housing, Single-Family Rentals, Cell Towers, Casinos, Industrial, Data Center, Malls, Healthcare, Net Lease, Shopping Centers, Hotels, Billboards, Office, Farmland, Storage, Timber, Mortgage, and Cannabis.

Disclosure: Hoya Capital Real Estate advises two Exchange-Traded Funds listed on the NYSE. In addition to any long positions listed below, Hoya Capital is long all components in the Hoya Capital Housing 100 Index and in the Hoya Capital High Dividend Yield Index. Index definitions and a complete list of holdings are available on our website.

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Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of RIET, HOMZ, ABR, APLE, BNL, CTRE, CUZ, EQIX, EPR, RFC, LSI, HPP, PSA, EXR, RITM, SLG, SRC, TWO, VNO, CCI 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.

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