REITs: Poised for Outperformance?

Viewpoints


Why REITs?

Publicly traded real estate investment trusts, or REITs, offer investors the benefits of commercial real estate exposure along with the liquidity of publicly traded stock, facilitating the use of the real estate asset class in 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. Also, because REITs own real assets, they provide an element of inflation protection.

While the U.S. remains the largest market, listed real estate is becoming increasingly global with growth being driven primarily by the appeal and adoption of the REIT structure. As of the second quarter 2017, the FTSE EPRA/NAREIT Global Index (listed real estate’s most common global index), included 483 companies in 36 countries with an aggregate market capitalization of approximately 1.6 trillion. The expanding global reach of the REIT market is a draw for investors looking to diversify exposure across geographies.

Since rental cash flows from properties tend to be predictable and because of the REIT structure’s income distribution requirement, REITs tend to be excellent yield vehicles. The current yields on the major REIT indices are approximately 4%, which compares favorably to most credit or other equity income investments. The long-term visibility and historical reliability of the dividend stream – particularly at a fund or index level – has been extremely appealing to income investors. Given these factors, it should not be surprising that REITs have outperformed other major asset classes over the past 25 years.

REITs Have Outperformed Other Major Asset Classes Over the Past 25 Years

Source: Bloomberg
Data from 10/31/92 to 10/31/17. REITs, Stocks, Bonds, and Commodities are represented by the Dow Jones Select REIT Index, the S&P 500, Bloomberg Barclays U.S. Aggregate Bond Index, and the S&P GSCI, respectively. We use the Dow Jones Select REIT Index rather than the more popular MSCI U.S. REIT Index (RMZ) because of length of history.

Why Now?

Over the past year, there has been a significant divergence in performance between REITs and the broader equity markets. From 10/31/16 through 10/31/17, the S&P posted total returns of 23.6% vs. only 5.6% for the MSCI U.S. REIT Index (RMZ), the sector’s most widely adopted domestic index, for an eye-popping underperformance of 18.0%. For perspective, over the past decade, there have only been two other periods of significant underperformance by the REIT market. REITs lagged during the depths of the financial crisis (late 2008 – early 2009). Heading into the financial crisis, REIT valuations were relatively high. With the crisis came funding concerns – investors fled the space as it became unclear if REITs facing a wave of maturities would be able to roll debt. However, as order was restored to the capital markets, REITs rebounded and caught up to the broader equity markets by 2011. In 2013, there was another bout of underperformance during the so-called “taper tantrum.” REIT multiples compressed, tracking more closely to Treasury yields (which had spiked for a brief period at the time) than equity multiples. Again, markets calmed and REITs recovered, subsequently posting new highs by the end of the following year. The relative underperformance this time around has now surpassed a full year (the longest period this decade), and the disparity is as extreme as it has been since the financial crisis.

Relative Performance of the RMZ and S&P 500 Indices Since 2007

Source: Bloomberg

There are a number of factors accounting for the large performance gap over the past year. The middle of 2016 marked a time when global equity markets began to price in an acceleration in economic growth (and as governments looked for an opportunity to reduce quantitative easing, the potential for higher interest rates – more on this below). It thus made sense for the more beta-rich sectors to rally relative to more defensive segments of the market. Since November 2016, the outperformance of the stock market has been further fueled by the election of President Trump, and the potential for incrementally higher growth through deregulation, corporate tax reform and infrastructure spending. In this environment, it was clear that lightly regulated tax-exempt REITs would not benefit as much from the new administration as more cyclically exposed, heavily regulated or tax-paying companies. Additionally, a substantial portion of the S&P’s recent gains has been driven by the flows to the technology space.

For example, consider that Apple, Microsoft, Amazon, Facebook and Google make up approximately 14% of the S&P and are up an average of 41% over the past year (44% YTD). The sub-sector composition of the RMZ is not helpful in this regard. The exposure to technology tenants and end markets – primarily through Data Center and Tower REITs – is small compared to the exposure to pressured areas like retail (which is close to 20% of the index). Finally, the continued gains of passive investing over active management have also contributed, differentially benefitting broad market indices.

Of all of these, we believe that the primary factor responsible for the substantial lag in recent relative performance relates to the extent of the sector’s perceived interest rate sensitivity. The assertion is that REITs are destined to underperform as interest rates are sure to rise: Cap rates move commensurately with Treasury rates, and as both increase, valuation multiples will compress and REITs will lag. This is the “REITs are just bond proxies” view. Setting aside the validity of the underlying assumption that interest rates will rise and ignoring the simple fact that markets tend to be anticipatory (so high probability events tend to be discounted prior to their occurrence), an examination of the historical record largely debunks the misconception that REITs will necessarily underperform. Although interest rates certainly do affect real estate values, rising rates do not always lead to poor outcomes for REIT equities.

REIT Performance During Sustained Periods of Rising Interest Rates

Source: Bloomberg The U.S. Treasury Yield Curve Rate T Note Constant Maturity 10 Year.
Periods of sustained rising interest rates are shown in red.

Over the past 25 years, there have been seven periods during which U.S. 10-year Treasury Bonds rose significantly. In three of these periods, REITs earned robust positive total returns, and in two periods, REITs actually outperformed the S&P 500. While the space has lagged, on average, by ~6% during periods of rising rates in aggregate, relative performance has actually been favorable since 2000, with REITs on average outperforming the S&P by 7%. These data show that at the very least, interest rate movements alone do not predestine REITs to lag; they may not even be their key driver of performance.

This fact should not be surprising as the negative impact of multiple compression from higher cap rates can be more than offset by the benefits of stronger operational results such as increases in property occupancy and robust rent growth. Rising interest rates are frequently associated with economic growth and rising inflation, both of which are positive for real estate investments. To the extent that rising rates today may be the outcome of a reduction in the degree of monetary stimulus rather than the result of an active effort by the Fed to slow the economy, the backdrop is well suited for REITs. For reference, the Fed shifted from a stimulative policy stance to a more neutral position during the 2003-2006 period by raising target rates from 1% to 5.25%, a pace that is likely to surpass the current experience. REITs performed quite well under those conditions. The economic upside capture of REITs is generally under-appreciated.

Also compelling is the fact that REIT income return has historically exceeded the rate of inflation, as real estate owners typically have the ability to increase rents at least commensurately. As depicted below, the income component of REIT returns has exceeded inflation in 14 out of the past 15 years. Real estate tends to outperform stocks during periods of rising inflation.

REIT Income Has Outpaced Inflation

Source: S&P Dow Jones Indices LLC; Bureau of Labor Statistics. Data as of 12/31/16.
REIT income is calculated as the annual difference in return between the Dow Jones Select REIT Index total return vs. price return.

Furthermore, consider that there are a number of sub-sectors within the REIT universe with significant leverage to the broader economy. These include Industrial REITs which benefit from e-commerce trends, Timber REITs which are levered to U.S. housing demand and construction growth, and the aforementioned Data Center and Tower REITs (categorized under Infrastructure and driven by the secular trends of big data and mobile video). These REIT sub-sectors have been able to keep up – Industrials, Timber, Data Center, and Infrastructure REITs are up 22%, 20%, 34% and 26% year-to-date respectively. This of course means that the sub-sectors with less economic leverage such as Triple Net, and Healthcare (which are characterized by long lease durations and are indeed more similar to bonds) or those with challenged fundamentals like Retail, have fared considerably worse. Still, the point is that the breadth of the space spans areas which can work irrespective of the interest rate backdrop, and active managers can allocate accordingly.

Finally and most importantly, real estate fundamental metrics like occupancy and inventory growth, as well as valuation metrics such as NAV premiums/discounts and transactional implied cap rates remain favorable or balanced for the space.

REIT Fundamental Metrics

Source: Raymond James, SNL Financial, NCREIF, REIS, Price Waterhouse Coopers. Data as of September 30, 2017.

REIT Fundamental Metrics

Source: Raymond James, SNL Financial, NCREIF, REIS, Price Waterhouse Coopers. Data as of September 30, 2017.

Over the near- to medium-term, we believe that conditions are set for REITs as an asset class to rebound significantly relative to broader market equities. In our view, this will be driven by two primary factors: (i) expectations for growth and tax reform in the US are now likely to be meaningfully priced in to the valuation of stocks, and (ii) REIT valuations in many sectors are attractive from a relative standpoint, setting the stage for a wave of flows seeking reliable income with a potential for growth. Many of the concerns of the past (such as lumpy debt maturity schedules) have been largely addressed this cycle. Overbuilding has not been as big of an issue as, (i) construction spending did not follow the financial crisis in a typical post-recessionary spike because of a lack of confidence and buy-in to the sustainability of a recovery based primarily on monetary stimulus, and (ii) lending institutions have been cautious in their approach to speculative projects. The prospect for rental income growth driven by a potential acceleration in the economy seems to be underappreciated. Technological disruptions will help many REIT sectors in ways that currently are not fully incorporated in the stock prices.

Over the long term, income investing is unlikely to remain out of favor for long and investors looking for safety and yield will be increasingly drawn to REITs. Real estate rental income is much more predictable than more discretionary sources stemming from the sale of products or services. With the demographic trend of the aging of the population fueling an ever-expanding appetite for retirement income, it is safe to conclude that REIT investing will be a main area of focus for decades to come.

Why TCW?

Because real estate is perceived as a very stable industry, most dedicated real estate analysts or managers rarely focus on long-term secular trends. Yet, the pace of technological innovation and technology adoption curves have never been faster. We believe that the impact on real estate over the medium- to long-term will be profound – more significant than at any other time in recent history. It is clear to us that the historical criteria for selecting portfolio companies in the past could soon undergo major revisions as they may not reflect the realities of the future of real estate.

Technology Adoption in the U.S.

Source: Singularity.com, Blackrock

As an example, consider mobile data usage. While it took 20 years to achieve mass adoption of cell phones, widespread smart phone adoption happened in less than one fifth of the time. By 2015, the amount of data created in the previous two years was more than the total data created over the entire previous history of the human race. New innovations often piggyback on some pre-existing (but still recent) technology, and the outcome is an accelerated rate of adoption for those winning platforms/inventions. Social media also has a hand in fueling faster growth – we are much more quickly aware of what is becoming popular. Social acceptance therefore is much faster and oftentimes occurs in real time. The fear of being left out can be a strong behavioral influence.

Effective analysts in the Technology and Telecom industries anticipated the impact of the data revolution well before real estate analysts appreciated (and began to price-in) the differentiated growth profiles of winning real estate companies in the Data Center and Tower REIT sub-sectors. The difference in performance has been pronounced – real estate investors who had identified the secular winners early fared quite well, outperforming the index by close to 10% per year over the past 10 years.

Performance of Leading Data Center and Tower REITs Companies Over the Past 10 Years

Source: Bloomberg Companies shown are Equinix (EQIX), Digital Realty Trust (DLR), and American Tower (AMT), as compared to the MSCI U.S. REIT Index (RMZ).
Note that American Tower and Equinix became REITs on 1/1/12 and 1/1/15 respectively.

Other ongoing secular trends with major implications on real estate include artificial intelligence and autonomous vehicles. For driverless technology in particular, the stakes are very high and both the number of players involved and resources devoted to research and development is staggering. While the impact of these trends on real estate are not immediately obvious today and may take years to play out, we believe that they will be pronounced as they begin to occur. For illustration, consider that driverless technology may eventually lead to increased consolidation of retail and grocery resulting in less demand for strip malls, a repurposing of previous retail/strip/parking space resulting in altered supply/demand dynamics in other property types, less traffic resulting in an altered relative attractiveness of suburban vs. central business district (CBD) locations, and car fleets resulting in less demand for Triple-Net gas stations. Again, we acknowledge that these effects are likely to impact the space over the long-term; our points are that they are likely to (i) slowly impact demand trends and valuations in the short term, (ii) be highly disruptive longer-term, and (iii) catch the majority of players in the REIT space by surprise when the threat finally becomes readily apparent – the boiling frog phenomenon.

We therefore believe that uncovering value in real estate today requires a new, holistic and forward-thinking approach. Even a thorough focus on asset quality, which is currently primarily based on location or metrics such as traffic and existing/historical rent rolls, may no longer be enough without context derived from the impact of dynamics outside of the sector. An investment platform with substantial breadth of expertise across different market verticals will be a tremendous advantage in evaluating long-term outcomes for many REIT sub-sectors. At TCW, we benefit considerably from a multifaceted approach to real estate investing. In order to understand how industrial warehouse demand will evolve over time, we rely on sector specialists in retail and e-commerce; to predict the speed and impact of driverless vehicles on assets such as strip malls and office buildings, we use the insights of our technology specialists. While a high degree of multi-disciplinary diligence is required to understand the potential impact of long-term secular trends, a clear understanding of the risks can also produce a view into unappreciated opportunities.

 

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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. © 2017 TCW