Economy
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.
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2023 has seen a modest rebound for REITs despite rates continuing to move higher, no indications of an imminent Fed pivot, and a serious crisis in commercial real estate. One factor is that overall revenues have stabilized and balance sheets remain healthy. Another factor is that healthcare and industrial REITs are seeing revenue growth at a nearly double-digit rate despite the headwind of higher rates.
During Q2 earnings season, funds from operations climbed 4.2% compared to last year’s Q2, totaling $20.6 billion. There is also no compromise in terms of financing with 79% of REITs using unsecured debt with 91% of overall debt locked in at fixed rates, meaning there is less sensitivity to rates.
Another silver lining is that leverage ratios remain below 35% while the average term to maturity is close to seven years. In total for publicly traded REITs, the cost of capital is currently 4%. Given these financials, REITs are also better to take advantage of turmoil in real estate markets as they will be able to access financing at a lower cost of capital than private market operators.
Finsum: Q2 earnings season is over. The much maligned REIT sector continues to see stable revenue growth and healthy financials despite a challenging environment.
Over the last couple of years, REITs have been one one of the weakest parts of the market. REITs own and operate income-producing real estate and are obligated to distribute more than 90% of profits to shareholders.
The biggest headwind has been the relentless rise in rates which makes these stocks’ dividend streams less attractive and ups their financing costs. Higher rates also impact demand for housing by making it less attractive. Finally, there is a crisis in the commercial real estate (CRE) space due to low occupancy rates for offices given the increase in remote work.
While there have been an array of macro and cyclical factors negatively affecting REITs, there are some reasons for optimism that the worst may be over. For one, the odds of a soft landing continue to rise. This is due to recent economic and labor market data which clearly show that the job market is cooling, and wage growth is falling. However, job losses have not been materially rising, indicating a period of slower growth rather than a recession.
This should lead longer-term rates to drift lower which would be a catalyst for REIT stocks to start moving higher. Lower rates should help housing demand. Additionally, a weaker job market could also give employers more leverage to force workers to return to the office.
Overall, many of the negative trends which were impacting REITs are now reversing.
Finsum: Recent economic data is strengthening the odds of a soft landing. Here are why REITs would be a big winner in this scenario.
In recent weeks, REITs like other rate-sensitive sectors have been pummeled as long-term yields have surged higher due to the resilience of inflation, a hawkish Fed, and expectations of substantial Treasury supply hitting the market later this year.
But some contrarians are pointing out that there have been some positive developments for the sector on a long-term basis. First, most of the damage for the sector has come from high rates as earnings have continued to hold steady. This has led to valuations becoming quite attractive.
Additionally while the timing of the Fed’s pivot is unknown, it’s certainly close to the end of its hiking cycle. And just as the start of the hiking cycle led to steep losses for REITs, it’s likely that the start of rate cuts will send shares soaring higher.
Finally, it’s also interesting to note that at the start of the rate hike cycle, the sector was extremely correlated to Treasuries. But this relationship has considerably loosened and has led to a bullish divergence.
Remarkably, the broad-based Schwab US REIT ETF has been making higher lows, while Treasury yields have been making higher highs. This is an indication of demand and that institutions are using the weakness to accumulate shares.
Finsum: REITs are not making lower lows despite the breakout in Treasury yields. Some contrarians see this as a bullish signal from the market.