Economy
The Federal Reserve’s tightening campaign surprisingly has had a muted impact on the broader economy as evidenced by continued expansion despite the highest rate in decades. In terms of the stated goal of curbing inflation, results are mixed as well.
However, the vector which immediately responded to tighter policy is real estate given that affordability has declined due to higher rates. In some markets, activity has simply cooled, while in those with poor fundamentals, prices are falling more precipitously.
Within real estate, commercial real estate (CRE) is the most challenged given oversupply and the recent rise of remote work. For Barron’s, Rob Csneryik covers why some contrarian investors are seeing opportunity in the beaten-down sector.
In essence, it’s a buyer’s market with so many traditional sources of funding out of the picture, leading to more favorable terms and higher returns. Further, there is less risk with values already down so much. Many believe that office occupancy rates will start to gradually rise especially if the economy does weaken which would give employers more leverage to force employees back to the office. CRE would also likely benefit from a mild recession as it would compel the Fed to cut rates which would turn a major headwind into a tailwind.
Finsum: Commercial real estate is the weakest segment of the real estate market. However, some contrarians see opportunities amid the carnage.
Many contrarian investors are certainly interested in buying the dip in REITs given the low valuations, generous yields, and upside in the event of a Fed pivot. Further, many components of the real estate market remain healthy such as healthcare and industrials. However, there are some risks that investors need to consider.
There are secular problems in areas like retail and office buildings due to oversupply, while there have also been significant changes in people’s behavior, affecting demand. Additionally, investors should be aware that every bear market results in a handful of value and yield traps which become plagued by balance sheet and liquidity issues especially in high-rate environments.
Value traps are situations in which stocks look attractive by conventional metrics, however these low valuations are a reflection that the market isn’t optimistic about the company’s prospects. Similarly, ‘yield traps’ are when yields look attractive, but the market is expecting a dividend cut as current payout ratios are not sustainable.
For investors interested in REITs, they must prioritize quality and strong financials. This is especially true in the current situation where the path and trajectory of monetary policy remains highly uncertain. If rates do stay elevated for a long period of time, some REITs will go bankrupt, while many will have to pay their dividends in order to remain solvent.
Finsum: REITs are attracting interest from contrarian investors, but here are some downside risks to consider.
Ever since the Fed embarked on its tightening campaign starting in the early months of 2022, the real estate market experienced the most immediate impact due to rising mortgage rates negatively affecting home affordability.
Initially, publicly traded real estate stocks saw deep drawdowns while private real estate performed much better. Now, this gap is beginning to shrink as private real estate has been following public real estate lower. One factor is that it’s increasingly becoming clear that high rates are not going to disappear anytime soon due to the resilience of the economy and inflation. In fact, inflationary pressures seem to be reigniting given the recent strength in oil and auto workers striking.
In terms of when private real estate will bottom, some indicators to watch are an increase in transaction volume even at lower prices, a change in monetary policy, and increase in lending standards. Currently, all 3 are working against private real estate given that many markets are ‘frozen’ as sellers are unwilling to cut prices, while buyers don’t see many attractive deals at current yields. The Fed’s focus remains on stamping out inflation whether through further hikes or keeping rates ‘higher for longer’. Finally, lending standards are unlikely to loosen especially with so many banks struggling with balance sheet issues and/or an inverted yield curve.
Finsum: Private real estate was immune to the weakness in public real estate for so long. Find out why this is starting to change.
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REITs are in the midst of another leg lower and have effectively wiped out their gains from May and July with a 9% decline over the past six weeks. Year to date, the sector is down by 7% while it was up as much as 9% at its highest point in the year as measured by the Vanguard Real Estate ETF. This follows even steeper, double-digit losses in 2022.
In recent months, the weakness of the long-end of the Treasury curve has hit all types of yield-generating assets like REITs and dividend-paying stocks. Fed fund futures markets are downgrading the chances of rate cuts in 2024 while extending the duration that rates will remain at these levels. There is even increased chatter about how the Fed’s terminal rate must even go higher in order to truly stamp out inflation.
It’s a double-edged sword for REITs as the bulk of the sector continues to deliver impressive financial results with defaults remaining low especially in areas with strong fundamentals like healthcare and industrials. Yet, the stocks are unlikely to rally as long as rates remain elevated at these levels even despite attractive yields.
Finsum: REITs are in the midst of another leg lower and falling to new annual lows due to an uptick in inflationary pressures and the Fed coming out more hawkish than expected.
One of the consequences of tighter monetary policy is to curtail housing demand by squeezing affordability. As a result, all sorts of housing activity has cooled such as mortgage applications, new home construction, renovations, and house flipping. While there are all sorts of losers, it’s presenting an opportunity for many private real estate funds who are finding a buyer’s market.
These funds raise money with multi year holding periods so are less affected by the change in the funding environment at least in the short and intermediate-term. Another factor in the real estate market is that many regional banks are pulling back from extending credit given their balance sheet concerns. Overall, it’s a risk for the broader economic outlook but a unique opportunity for private real estate investors.
And, more money is being allocated to real estate - public and private. In the first-half of the year, 43% of institutions surveyed, increased their allocation to real estate by an average of 76 basis points. Sovereign wealth funds also increased real estate exposure from 6.9% to 7.9%. In terms of geography, private real estate continues to be dominated by North American investors.
REITs have languished in 2023 despite a buoyant equity market due to concerns of cascading defaults in certain segments like commercial real estate (CRE), while high rates continue to pose a significant threat to the group. However, the group is beginning to look attractive from a valuation perspective while offering generous dividend income to holders as well.
From a contrarian perspective, there are some silver linings. For one, yields on long-term Treasuries are hitting levels at which they have found resistance before. The biggest, recent headwinds for REITs has been the increase in long-term rates. If this were to reverse, it would be a major catalyst for the group by lowering their financing costs and making their dividends more attractive.
Additionally despite the challenging operating environment, financials continue to be sound, outside of CRE, and dividends continue to be hiked. According to research, REIT stock prices tend to follow their dividend streams over long periods of time. So far, there is no evidence that dividend payouts will be compromised which increases conviction in buying the dip.
To reduce risk, investors should focus on areas where rents continue to increase such as healthcare and industrials in contrast to areas where rents are slowing or stagnating such as multifamily real estate and office properties.
Finsum: REITs have been one of the worst performers over the last 2 years. Here is a contrarian perspective on why the sector could outperform in 2024.