Insights by Hubert Weyers (Reitway Global REIT Analyst)

Whether it’s your dream destination, moguls on Forbes billionaire list, booms and busts, or your everyday surroundings, real estate is present by association.  For investors, it is not a dam like gold, it is not a tempestuous ocean like stocks, but a river of cash flow into your pocket.

Adding professional management to real estate, as is the case with real estate investment trusts (REITs), keeps the river lush, flowing, and growing. 

But REITs have hit a dry spell since the start of 2022, which suggests they may have come to be misunderstood by the market gods.

Leading up to the subprime mortgage crisis, all was uncertain but death, taxes, and the US housing market. Then that perception got blown up, and half of the financial world with it. Currently, we are seeing the parallels of debt and real estate back in the market, and people’s minds have been jolted back to the dystopia of the subprime days.

The advent of the Silicon Valley bank collapse thread a series of events in America, from deposit flight to small/regional bank loan portfolios put under the microscope to reveal a pathogen: Commercial real estate (CRE), this sending news stations in a frenzy and producing mass investor hysteria.

When the turmoil started, the FTSE Nareit All Equity REITs index (All-Equity REIT Index) dropped for 10 days longer than the Russell 3000, driven by concerns over leverage in CRE. Since then, the All-Equity REIT Index only managed to claw back a little over half of the loss from that catastrophic drop. The Russell 3000 more than fully recovered, trading 2.9% higher than it did before the turmoil.

As of April 30^th, the REIT market sat with a short interest of 3.8% vs. 3.1% for the broader equity market. 2023 offered little reprieve from the 2022 flogging where US REITs experienced net fund outflows of 12% of total assets compared to equities’ 4.7%.

Year to date, the mid-to-large cap segment of the equity market has seen a strong high single digit recovery while REITs have been left behind alongside the Russell 2000, a risky small cap index. Since the start of the rate hiking cycle the earnings yield of the Russell 3000 has increased by ~1.17%, the option-adjusted spread of the ICE BofA US High Yield Index expanded by ~1.69%, and the All-Equity REIT Index earnings yield by ~ 2.40%.

The market has placed REITs as significantly riskier than both high yield (junk) bonds and equities after the events that have transpired. The culprit behind these REIT floggings has been interest rates, a factor REITs are considered hyper-sensitive to, same as bonds.

A simplistic view would be to say: “Well REITs are bond-like in that their cash flows (dividends) are contractual and therefore you can expect them to behave similar to bonds.” What makes the cash flows of REITs different from bonds is they are growing cash flows and not constant like coupons. Therefore, inflation (which typically causes rates to rise) is not cutting away at the real value of those cash flows as it does with bonds.

Other fallacies on REIT weakness in high-rate environments include:

1. REITs are extremely dependent on external financing, having to pay out 90% of their taxable earnings as dividends, making growth challenging in a high-rate environment.

2. REITs are highly levered due to the 80% loan-to-value (LTV) rule of thumb used by lenders in the real estate space. The >20% buffer narrows with increasing rates that cause the value of the asset to fall.  

The reality of the matter is that the taxable earnings for REITs are generally significantly less than adjusted funds from operations (AFFO) from which dividends are paid. The main differentiator is depreciation, which, owing to investment properties making up the bulk of a REIT’s assets, is a big part of their expenses. AFFO pay out can be as low as 20%, leaving ample cash to retain and grow from.

As one testament to the fallacy, 2022 investment by REITs were still healthy, with net acquisitions coming in 28% higher than the 2011-2021 average (a period over which short term rates were mostly close to zero).

As for the 80% LTV bugaboo, high leverage is much more common in the private real estate space. The LTV of the REIT sector, as of the end of 2022, stood at a low 33.7%, and funds from operations per share growth (the REIT earnings equivalent) came in at 16%, hardly bitten by interest rates.

Referring to the historical record of REIT behaviour in rising rate environments, we see mixed results in terms of performance:

Exhibit 1: REIT Performance During Sustained Periods of Rising Interest Rates

Source: S&P Dow Jones Indices LLC, Bloomberg, The Federal Reserve. REIT total returns are based on the FTSE/NAREIT Equity Index from Dec. 31, 1971, to Dec. 31, 1986, and they are based on the Dow Jones U.S. Select REIT Index after Dec. 31, 1986.  Stock total returns are based on the S&P 500.  Past performance is no guarantee of future results.

Since the seventies, including the most recent rate increasing cycle, REITs have mostly performed positively, and have outperformed equities in 3 of the 7 cycles.

The current “pathogen issue” of CRE is another concept REITs have been wrongfully sucked into. The issue is a function of highly levered private operators, low quality assets, and severe operational challenges. Chucking REITs like chum in the water alongside these issues has been a gross misstep by the market.

Seventy-five percent of REITs in the US have the characteristics to warrant an investment grade credit rating which opens them to various channels of debt financing that is typically cheaper, with longer duration, and less restrictive covenants. Furthermore, their portfolios are generally well diversified and of a high quality.

Office REITs are indeed guilty of facing operational challenges, but I ask the reader: “So what?” People can be up in arms, proclaiming “Real estate is in a slew as office and retail is dead!” If so, these property types didn’t simply drop dead in the street.

As natural selection would have it, “cannibals” self-storage, industrial, and residential saw themselves the direct beneficiaries of its partial dissipation. The demand for space did not supposedly die with these sectors, it was simply reconfigured.

As a result of such phenomena, office and retail saw themselves become a smaller part of major REIT indices and should by no means be used as a de facto proxy for the broader REIT universe.

Exhibit 2: Property Sector Market Cap

Note: Industrial includes industrial and industrial/office mixed. Diversified is dissected in the foot note¹_.

Source: FTSE EPRA/Nareit Global equity market capitalization by property sector as of Dec. 31. 2010 & FTSE EPRA/Nareit Global Extended Index equity market capitalization of property sectors as of Dec. 31. 2022.

The GLOBAL REIT space is an evolving, multi-faceted ecosystem with immense depth: 28 sectors and subsectors wide; $1.9 trillion in value.

Market participants talking loosely about real estate’s tight tie to the economy must not be misunderstood for referring to the greater REIT sector. Such talk could easily prompt investors to consider a macroeconomic approach to investing in real estate.

Beyond macro investing being a bad idea in general, unless you’re Ray Dalio, it would be ill-conceived for any investor to take the REIT universe at a correlation close to one with the economy. The greater global REIT sector is not a presence with one cycle and maybe a trend or two; it has multiple property cycles, trends, and sub-sectors with nuanced risk profiles. The sector has evolved into a blend of real estate, infrastructure, technology, and commodities. Risk is available in all shapes and forms— providing investors with a place to hide or a place to ride.

Residential may have seemed hazardous for some when bubble talks of the US housing market started surfacing in 2021-2022 and mortgage rates went soaring. However, the dual structure of the residential market between the for-sale and for rent-market changes the dynamic.

High mortgage rates and property prices push people into the for-rent market, keeping occupancy and rental growth elevated. US single family REITs showed to be a beneficiary of this phenomenon, ending 2022 at an average occupancy of ~97.5% with rental growth of ~11%.

Any bubble deflation would naturally hit the for-rent property market, but the public market is usually ahead of the curve. The US single family REIT sector is trading at a 19.1% discount to private market values as at the end of May 2023 according to Green Street’s estimates^1.

Note: A strong argument against any severe bubble deflation in the US housing market is its deep supply deficit, formed from more than a decade of under-building.

An attractive discount to net asset value can be expected to lure some private market investors into the public market. But as the reality of perception would have it, many real estate investors find it hard to stomach public market volatility, preferring to keep “powder kegs” out of their portfolios, rather opting for the more stable private market, with liquidity and concentration risk as substitutes.

The truth is, property between the private and public market is one and the same, only with more frequent repricing by the public market, and therefore, more volatility. This is in fact not risk, but an inefficient measure of risk for the lack of a better tool.

Risk is the probability of a bad outcome while volatility is the daily price swings of a security. These swings can only hurt you (and thereby become a risk) if you suffer from short-termism and have a gambling problem or if you like playing with margin accounts.

To real estate investors (considering they stay out of margin accounts and utilize the asset class for what it is best suited for: buy-and-hold, with crypto and penny stocks rightfully left to the gamblers) volatility should not matter one bit. Real estate investors that stay out of the public market because of volatility and exchanging it for other risks by opting for the private market, knowingly or unknowingly, are only playing themselves as the greater fool.

A presence in real estate usually too large to sidestep is the phenomenon of over-building during boom times. The most recent boom period was the 2021-2022 run when occupancies and rental growth surged to the point where many REITs saw their operating metrics reach record highs. But a shortage of materials and resources, due to covid-related disruptions, kept a lid on supply.

By the time the shortages had alleviated, the cost of capital had become significantly more expensive, constraining its access, and eroding the feasibility of many investment projects. As a result, over building will have to wait for the next boom.