REIT Market Outlook

Viewpoint

June 29, 2015

SUMMARY

  • Historically, REIT performance has followed cycles which do not seem to correlate strongly with the direction of interest rate movements. Rather, we believe that the inflections and lengths of these cycles are more meaningfully driven by the fundamentals of real estate supply/demand, and the discount/premium to historical levels on key valuation metrics.
  • The fundamentals of real estate supply and demand are favorable given the economic backdrop and are supportive of 6% to 8% FFO (Funds from Operations – the REIT equivalent to Earnings per Share) growth for the sector over the next 2-3 years.
  • In our view, current valuation levels do not properly discount the possibility of a rapid and more substantial rise in interest rates. We believe that an additional 30 bps of cap rate expansion (~5% of multiple compression) would embed a more reasonable margin of safety.
  • Coupling these with the current dividend yield of ~4% leads to an estimated total return range of 5% to 7% over the next 12 months for a base-case scenario consistent with a backdrop of benign interest rate movements and tepid yet positive economic expansion.

Introduction

Approximately 50 years ago, the U.S. Congress passed legislation that resulted in the creation of real estate investment trusts, or REITs, bringing the benefits of commercial real estate investment – previously available only to large institutions and wealthy families – to all market participants. The benefits are plenty: Publicly listed REITs present a liquid way to gain exposure to the real estate asset class, allowing for tactical asset allocation and portfolio rebalancing. Because of their relatively low correlation with other asset classes, REITs provide investors with increased diversification, which in turn can improve an overall portfolio’s risk/return profile. Since rental cash flows from properties tend to be predictable and because of the REIT structure’s income distribution requirement, REITs tend to be good yield vehicles and can possess downside support. Last, because REITs own real assets, they provide an element of inflation protection. Over time, investors have responded and the REIT space has today grown to a ~$1T equity market capitalization and almost $2T in real estate assets.

Interest in REITs has been particularly strong over the past ~5 years because global central banking policies of accommodation and quantitative easing have provided a significant tailwind to performance. With a backdrop of low rates, cheap global liquidity was drawn to the properties described above (especially the seemingly safe yield profile), in turn attracting others chasing yield and performance. This dynamic contributed to REITs posting total returns substantially above those of the broader markets during the recovery from the financial crisis: In the U.S., the NAREIT All Equity REIT Index is up 305% versus 201% for the S&P 500; globally, the S&P Global REIT Index is up 250% versus 161% for the S&P Global 1200 Index from 3/31/2009 through 5/31/2015. Much of that outperformance was supported by the considerable improvement in the space’s underlying fundamentals, such as a positive inflection in demand and the refinancing of long-term debt at extremely favorable rates. However, part of the outperformance was also clearly due to distortions resulting from unprecedented levels of central bank accommodation. The extent of this latter component can be deduced from the sector’s disproportionate sell-off following the “taper tantrum” of May 2013. The REIT Index dropped 14% from 5/22/13 to 6/20/13 with the S&P falling only 4%, a period over which the 10-yr Treasury rate rose very rapidly.

Today, with the U.S. Federal Reserve seemingly on the cusp of its first rate hike in almost a decade, we are seeing another unwind of the “REIT easy-yield trade” in anticipation of the end of cheap money. After a robust January when REITs returned 6.2% (versus -3.0% for the S&P) with 10-yr Treasury rates sinking, it has been downhill since. With investors’ focus shifted to the timing and extent of the tightening campaign, 10-yr Treasury rates rallied hard, and the sector is down 10.1% from the end of January (with the S&P up 6.3%).

Interest Rates

In following the recent zigs and zags of REIT performance, one is left with the notion that Treasury yields seem to be the primary driver – as they go up, REITs go down and vice versa. While it is true that Treasury yields are a key input in determining REIT valuations, a more extended historical look shows that the correlation between 10-yr Treasury yields and REIT performance is not very strong. Exhibit 1 shows the annual performance of the NAREIT All Equity REIT Index as well as the 10- yr Treasury yield going back to 1972. Note that all four of the possible pairings have occurred (REITs up and interest rates rising: 1976-1980, 2003-2005; REITs up and interest rates falling: 1983-1986, 1991-1993, 2009-2010; REITs down and interest rates rising: 1998-1999; REITs down and interest rates falling: 2007-2008). In fact, the 40+ year correlation between REIT performance and 10-yr Treasury rates is actually positive, albeit small, indicating that the more recent inverse relationship is more anomaly than norm in the broader historical context.

Exhibit 1: Historical REIT Total Returns and 10-yr Treasury Yields

Source: NAREIT, Raymond James Research

Rather than a strong correlation, what stands out from Exhibit 1 is that there are very clear up-cycles, tending to last approximately 6-8 years, during which REIT performance is robust and sustained. These are followed by equally clear down-cycles, tending to last 1-2 years, where the correction can also be quite sharp. Note that the timing of the down-cycles correlates better with recessionary periods (i.e., 1990, 2008…) than the backdrop of 10-yr Treasury movements.

One may argue that the data from the mid/late 1970s may be masking the correlation. Inflated REIT performance in a rising rate backdrop during a time when inflation was rampant seems less relevant today. Exhibit 2 below partially corroborates this view. The table shows that, on average, the performance of REITs, while positive, lagged that of the S&P during periods of rising 10-yr rates over the past 20 years (shaded areas in the graph). Note however that the experience since the financial crisis skews the results: rising rates have come to portend the end of cheap money, the unwind of the “REIT easy-yield trade.”

Exhibit 2: REIT and S&P 500 Total Returns During Periods of Rising 10-yr Treasury Yields

Source: NAREIT, Raymond James Research, TCW Income Equities

Still, it seems clear that while interest rate movements contribute to REIT relative performance versus the broader equity markets, they alone are not responsible for triggering the more meaningful up-cycles and corrections. We are of the view that the inflections and lengths of these cycles are more meaningfully driven by the fundamentals of real estate supply/demand, and the discount/premium to historical levels on key valuation metrics.

Supply/Demand

The real estate supply/demand picture is favorable. Because of a lack of confidence in the sustained strength of the economic recovery, construction spending did not rebound meaningfully following the financial crisis. As a result, inventory growth, which fell sharply in 2010 due to the crisis, has generally remained muted (with the exception of apartments and lodging – more on this later), as can be seen in Exhibit 3 below. This level of supply growth has allowed landlords to sustain pricing power even in the face of anemic demand growth, and is suggestive that the current up-cycle may still be supported from a fundamental standpoint for another few years (the lead time for new supply). We thus believe that occupancy levels will remain high and FFO and dividend growth in the sector are likely to remain strong. We envision FFOs and dividends sustaining their 2010-2015 growth rates of ~8% and ~10%, respectively, over the next 2-3 years.

Exhibit 3: Inventory Growth by Sector

Source: REIS, Raymond James Research, TCW Income Equities

Valuation

The valuation picture is more mixed. Exhibit 4 shows that while REITs are currently trading at a modest discount to NAV (whereas they were trading at a premium of approximately 10-15% around the mid-point of the previous up-cycle), current NAVs are more interest rate sensitive (i.e., a 50 bp increase today is more impactful since it would come from a lower base). Furthermore, the caprate (top graphs) and dividend yield (bottom graphs) to 10-yr Treasury spreads are in line with their historical levels at a time when the 10-yr Treasury is low relative to historical norms. Note however that during an up-cycle, these spreads can compress meaningfully. In 2004-2005, spreads got as low as ~100 bps for the cap rate and even negative for the dividend yield prior to the last major down-cycle in the space. Still, to us, the current spreads do not seem to embed a reasonable margin of safety for the real possibility of a rapid and substantial rise in interest rates, leaving the space vulnerable to that scenario. While the fundamental impact of higher interest rates is less pronounced with most REITs having locked in low fixed rates and reduced risk by staggering maturities, we believe that some level of multiple compression is probable going forward, especially if interest rates continue to rise.

Exhibit 4: Historical REIT Valuation Metrics

Source: NCREIF, SNL Financial, Raymond James Research

Outlook

Integrating the factors above, we believe that the fundamentals of supply and demand with the current economic backdrop will be supportive of 6% to 8% annual REIT FFO growth over the next 2-3 years. Factoring 30 bps of cap rate expansion from current levels to provide a more reasonable margin of safety against positive rate movements would result in approximately 5% of multiple compression. Coupling these with the current dividend yield of approximately 4% leads to an estimated total return range of 5% to 7%. Of course this forecast should be viewed as a “base-case” scenario, consistent with a backdrop of benign interest rate movements and tepid yet positive economic expansion. We would not expect positive total returns from the REIT space in the case of an economic recession, a credit crisis, or if interest rates suddenly spike – all scenarios which we view as unlikely in the near-term.

From a sub-sector standpoint, we currently like the fundamentals in the healthcare REIT space. Healthcare REITs invest in hospitals, nursing facilities, laboratories, and generally all real estate associated with the healthcare sector. The sector benefits from the robust demographic tailwind of the aging of the population. Demand for healthcare is almost certain to increase, so the tenant base for this group of landlords will likely remain strong and financially sound. The space is dominated by three players (Ventas, Health Care REIT, and HCP), which all are well managed. Furthermore, each of these companies has a substantial cost-of-capital advantage over others in the sector. As a result of this advantage and due to the operational efficiency provided by their scale, healthcare properties will simply be more profitable in their hands than those of their present owners. Yet all three companies have been disciplined stewards of shareholder capital and have been deliberate and opportunistic in pursuing acquisition targets. Due to the long-term nature of the lease terms, the sector is rightfully viewed as having a high degree of interest rate sensitivity – which is why the stocks have recently sold off. Ventas and Health Care REIT both currently trade at ~13x-15x Price to FFO, which we find attractive given their prospects and competitive positioning.

We would proceed with caution in apartment REITs and the suburban office space. We view the current demand dynamic for multifamily as being inflated. One of the effects of the financial crisis was to adversely impact the sentiment of young adults toward housing and homeownership. The percentage of 25-34 year-old married renters started to ascend in 2009 and now sits near a historical high. Over time, as home prices stabilize or ascend, we believe that young adults will regain confidence and leave rentals in favor of fulfilling the American dream of owning their own home. Furthermore, the apartment space has witnessed elevated levels of construction activity, which we foresee as an additional overhang. Last, there was over-development in the suburbs for office space prior to the financial crisis. We believe that the level of sustained economic growth required to absorb this excess capacity is unlikely to occur in the near- to medium-term.

As a parting thought, consider Exhibit 5 below. Recent attempts to jawbone the market notwithstanding, the Federal Reserve has historically not been renowned for its prescience or its decisive pro-active moves. Usually, the Fed trails the markets, and by the time the tightening campaign begins, the impacted sectors have already discounted the action. Exhibit 5 shows that going back to June 1999, REITs have on average historically substantially outperformed the S&P in the 3 months following a rate hike (6% versus 2% for the S&P). With REITs having underperformed the broader markets YTD as investors digest the precise timing and extent of the tightening campaign, we envision that the table is set for a similar result this time around.

Exhibit 5: REIT and S&P 500 Total Returns for 3 Months Following U.S. Fed Rate Hike

Source: UBS Research

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This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2018 TCW