We believe that conditions are ripe for continued outperformance from the REIT sector, as a period of slowing economic growth shifts the Fed from a three-year tightening cycle to the cusp of an easing cycle. At first glance, history tells a mixed story of REIT performance during easing cycles, with examples of both outperformance and underperformance over the last 20 years. However, a closer look suggests that today’s investment backdrop has a lot of the same ingredients as past cycles that demonstrated solid REIT performance.
REIT Outperfomance vs. Equities During Fed Easing Cycles
Source: Bloomberg as of July 1, 2019. REIT outperformance is the difference between the FTSE NAREIT Equity REITs Index and the S&P 500® Index.
During the global financial crisis, REITs did not live up to their reputation as defensive ballast for portfolios, but conditions are very different today. Firstly, the crisis was a housing-led slowdown which spilled over to the commercial real estate market, and the housing market is on firmer footing today. Secondly, real estate pricing in 2007 was irrational, with cap rates nearly in line with debt costs and REIT balance sheets vulnerable to any correction in values. Today, however, the spread between the 10-year bond yields and cap rates is approximately 330 basis points (bps)*, which is one of the highest spreads in recent history, and REIT leverage levels are conservative (see table below).
In fact, we believe the current investment context bears many similarities to the business-led slowdown of 2001, with the subsequent easing cycle leading to significant REIT outperformance against an equity market that had experienced a multi-year late cycle bull run. REIT balance sheets were in a good position then and cap rates' spreads to debt costs were high, much like today. While valuation discounts vs. equities were more attractive in the early 2000s, today the relative multiple between REITs and equities is also toward the cheap end of where this metric has traded this cycle.
The other easing cycle we examine in the graph above is that of the late 1990s, which saw the Fed start cutting rates to sustain the economic cycle. This is also not a good reference point for today’s situation and, in fact, we believe a similar dynamic already happened this cycle, with the Fed pause followed by fiscal stimulus over 2016-2018 having already driven equity prices into the last stage of the bull market this cycle.
|Debt to Asset Value||33%||44%||46%||31%|
|Debt to EBITDA||6.3x||5.5x||8.0x||5.4x|
|Dividend yield spread (10 year bonds)||-0.16%||1.58%||-1.05%||1.80%|
|Real Estate Pricing|
|Cap rate spread (10 year bonds)||3.56%||3.03%||1.05%||3.30%|
|FFO multiple/S&P PE||47%||32%||100%||89%|
Source: Bloomberg, Green Street Advisors and Citi Bank data as of 7/1/2019. Data covers a 21-year period between 1998 and 2019.
The cusp of a rate easing cycle can create an uncertain investment environment given that it is usually correlated with a slowdown in growth, which in a late cycle environment can expose weaknesses in the economy. This cycle, however, we believe there is good reason to expect that the strength of the underlying fundamentals for REITs positions them for continued outperformance.
Scott Crowe is the chief investment strategist of CenterSquare. The statements and conclusions made in this presentation are not guarantees and are merely the opinion of CenterSquare and its employees. Any statements and opinions expressed are as of the date of publication, are subject to change as economic and market conditions dictate, and do not necessarily represent the views of CenterSquare.
*A basis point (bps) equals 0.01%.
Because certain investment strategies concentrate their assets in the real estate industry, an investment in such strategies is closely linked to the performance of the real estate markets. Investing in the equity securities of domestic and foreign real estate companies, which includes listed real estate investment trusts (“REITs”) and listed real estate operating companies (“REOCs”) whose principal business is the ownership, management and/or development of income producing and for-sale real estate, entails certain risks and uncertainties. These companies experience risks similar to those associated with investing in real estate directly. Real estate is a cyclical business, highly sensitive to general and local economic developments and characterized by intense competition and periodic overbuilding. Real estate income and values may also be greatly affected by demographic trends, such as population shifts or changing tastes and values. Companies in the real estate industry may be adversely affected by environmental restrictions. Government actions, such as tax increases, zoning law changes or environmental regulations, may also have a major impact on real estate. Changing interest rates and credit quality requirements will also affect the cash flow of real estate companies and their ability to meet capital needs.