REITs: The Rodney Dangerfield of Equities?
Board: Real Estate Investment Trusts
We REIT investors are all licking our wounds, as the share prices seem to have no bottom. In a lame effort to provide some logical explanation, and to offer some topics for consideration, I wrote this post for SNL's "Block Party" last Monday.
Nothing's happened since then, other than the fact that REIT stocks have fallen even further into the cellar as the yield on the 10-year Treasury continues to escalate. Anyway, I reproduce it here in the hope that it may provide a small bit of perspective:
REIT stocks have gained an increasing investor following over the years, and are now widely accepted as equities that can both perform well and reduce the overall volatility of a diversified investment portfolio. But there are times when REITs have been the Rodney Dangerfields of the investment world (“I don’t get no respect”). Right now is one of those times.
REIT shares have been struggling since early May, when the yield on the benchmark 10-year US Treasury note began to levitate. When the 10-year was yielding below 2%, in the middle of May, the MSCI equity REIT index (RMZ) was trading at well over 1,000. But at Monday’s close, when the 10-year closed at a yield of almost 2.61%, the RMZ had drifted down to 937.86, 12.4% off of its May 21 closing high of 1070.38. During that time, most non-REIT stocks held up well, as evidenced by the S&P 500’s 1.2% gain from May 21.
To add insult to injury, REIT stocks are no longer kicked in the head just on days when the yield on the 10-year rises; they are administered such a beating even when the 10-year’s yield behaves itself. For example, for the recent 30-day period ending August 12, the 10 year’s yield has been incredibly stable – creeping from 2.60% on July 12 to 2.61% on August 12, on relatively low volatility. But during that same 30-day period, as measured by the RMZ, REIT shares dropped 4.2%.
Trying to explain this weakness in REIT stocks will be as productive as trying to forecast the flight path of a bumblebee. But let’s toss a few justifications at the wall and see if they stick.
1. “REITs are interest rate-sensitive, and their expenses will rise as interest rates rise, thus reducing profit margins.” But, if this is the most likely explanation, why were REIT stocks down 4.2% during the 30-day period ending August 12, a time when the yield on the 10-year barely budged? It’s also important to note that the vast majority of REIT debt is fixed-rate in nature, so a further increase in interest rates isn’t likely to materially impact REITs’ earnings.
2. “REITs are high-yield stocks, and investors – looking forward towards recovering global economies – have been dumping yield stocks and buying the beneficiaries of more rapid growth.” Hmmm…during that recent 30-day measurement period, while REIT stocks fell 4.2%, the DJ Utility index, comprised of higher-yielding shares, rose 0.3%, not much different from the S&P 500 (up 1.0%). That doesn’t sound as though higher-yielding stocks are being universally taken to the woodshed.
3. “REITs’ earnings season, which just ended, was a dud – so investors have been reacting to disappointing earnings.” No, not even close. The vast majority of REITs have beaten expectations with respect to FFO growth, same-store NOI, and occupancy rates, and many have increased guidance for the balance of this year. Commercial real estate markets continue to benefit from a slow but clear recovery. Simon Property Group (SPG) is, perhaps, a prime example. Q2 FFO was up 11.6%, beating expectations easily. Same-property NOI rose a very strong 5.9%, and occupancy spiked 90 bps. Releasing spreads were up 14.1%. Yet the stock has dropped 4.4%, from $164.54 on the date prior to the earnings release to $157.29 at Monday’s close.
4. “Cap rates are rising with higher bond yields, and the market is discounting lower commercial real estate values and declining net asset values (NAVs).” Well, perhaps, but it is far from clear whether property prices and estimated NAVs will drop very much over the next six to twelve months. Yet this is a key point, and I want to spend the rest of Block Party on it.
It is certainly true that even a modest increase in cap rates can have a significant impact on NAVs. Macerich (MAC) is a mall REIT, with debt leverage that’s just a tad in excess of the REIT industry’s average. If the weighted average cap rate of the properties in MAC’s property portfolio rises by just 30 bps, its estimated NAV would fall by almost 9%. At a recent price of $61.81, rather than trading at an NAV discount of 2%, it would be trading at an NAV premium of almost 8%.
That said, it’s by no means inevitable that – absent another large increase in bond yields – cap rates of the properties in MAC’s (and other REITs’) portfolios will rise by even 30 bps. Questions addressed to REIT management teams concerning trends in cap rates during the late earnings season have been more numerous than competing narratives in our nation’s capitol. But so far there is little or no evidence that commercial real estate values have begun to drop in any meaningful way. Green Street Advisors’ Commercial Property Price Index fell by just 1% in July.
Also, there is still a ton of investment capital chasing good-quality and well-located commercial real estate, much of which does not seek to lever returns with the use of debt. Anecdotal evidence thus far suggests that only lesser-quality properties in secondary and tertiary markets, which are the sandboxes in which levered buyers play, are seeing an upward blip in cap rates. Sure, many property buyers are seeking to use the rise in interest rates to “re-trade” pending deals but, generally speaking, they haven’t yet been terribly successful.
It is also far from certain that projected internal rates of return (IRRs) of property buyers are, or will be, rising much. These IRRs, from which deals are often priced, are still, on average, significantly in excess of the yields on Baa-rated bonds. Green Street estimates that the average spread is about 126 bps, which isn’t much different than the long-term average of 148 bps. So it is likely that the values of most high-quality properties won’t change much unless and until the average yield on Baa-rated bonds rises significantly from its present level of 5.31% at August 9.
So why have REITs continued to underperform even after the 10-year’s yield seems to have stabilized? To paraphrase a character from Dr. Seuss, “I do not know, I cannot say.” Although, over the near term, REIT stocks will probably still be held captive by the bond market hooligans, and will most likely continue to drift lower if bond yields take another hop upwards (and perhaps even if they do not), I believe that any investor who has even a medium-term time horizon – and who doesn’t expect another meaningful upward thrust in bond yields – should be taking advantage of today’s REIT bargains.
I am doing so, even though I often get egg all over my face at the close of each trading day (REIT shares fell in 10 of the past 11 trading days). Whoever said investing was easy?