I. From 2010 to 2016 REITs returned 14.6% on an annualized basis, outperforming all asset classes in 5 out of those 6 years.
II. Falling credit spreads and accelerating economic growth drove REIT NAV’s higher by 15% per year over this period.
III. While fundamentals are still slowing, a dovish federal reserve has set the stage for another extended bull market in REITs once economic growth returns.
“When should I own REITs?”
That question is easily in the top 5 list of frequently asked questions when running a REIT hedge fund. Frankly, it is a HARD question. When should you own stocks? When should you own bonds? Market timing is notoriously difficult…which is why the received orthodoxy is you should ALWAYS own those two asset classes in some form or another.
So it’s tempting to equivocate, and say that REITs should always occupy a place in your asset allocation. Simple, easy, straightforward, and semi-justifiable.
That is just not that exciting, though. Can’t we do better than ALWAYS?
In the following piece we blend REIT history with financial theory to tackle this difficult topic. The period spanning 2010 to 2016 was a recent period of extended outperformance for REITs relative to other asset classes, with the sector outperforming stocks and bonds for 5 out of 6 years.
What propelled the sector higher during that period? And what are the odds of that environment recurring in the near future?
A Little REIT History – The great bull market of 2010-2016
One of the most impressive bull markets in REIT history occurred following the great financial crisis of 2008-2009. A unique combination of favorable monetary policy and accelerating fundamentals powered REITs higher at a pace well ahead of private equity real estate and other publicly traded companies. The sector grew drastically and matured over this time period, culminating in its recognition by the Global Industry Classification System (GICS) as a stand-alone sector in 2016. The REIT market currently has a market cap of over $1 trillion (that’s trillion with a T), and is comprised of over 200 individual REITs across 19 different property types.
If you invested in REITs at the bottom in 2009 and held until the end of 2015, your annualized return would have been 26.5% per year. That is the equivalent of compounding a $100 investment to just above $450 over a 6.5-year period! Unfortunately, as we know, very few people went all-in at the bottom of the last crisis. Let’s be more realistic with the time period we are examining and assume an investor got on board with REITs at the end of 2009 when the market had started to recover and there was good evidence to suggest that fundamentals had bottomed. This is a more realistic view of achievable returns following the great financial crisis.
From 2010 to 2016, REITs returned 14.4% on an annualized basis, a multiple of 2.3x invested capital over a six-year period. Not only are these returns excellent on a stand-alone basis, but they were consistently better than almost all other asset classes over that time period. The chart below highlights the fact that REITs led all asset classes in returns for 5 out of the 6 years following the financial crisis. While it may sound strange in today’s market, there was actually a time when investors had FOMO for REITs: 5 of 6 years in the pole position will do that for an asset class.
What propelled REITs higher during the early innings of the prior recovery? In addition, could investors enjoy a similar environment prospectively? Is there a scenario in which REIT investors can capture mid-double digit returns in the near future?
Let’s start with the first of those questions and discuss what catalyzed the great REIT bull market of 2010 – 2016.
NAV Growth – REIT rocket fuel
The short answer to the above question is that Net Asset Value (NAV) growth propelled REITs higher. NAV is exactly what it sounds like. It represents the value of an individual REITs underlying commercial real estate portfolio, less all liabilities and preferred equity claims. NAVs and REIT share prices tend to be highly correlated over time, with the trajectory of NAV holding particular importance. Said more simply, when the real estate value of a REIT’s portfolio goes up, the share price tends to go up as well.
Now for the important question – what makes NAV’s go up?
Let’s dig into some basic financial math to uncover the secret sauce that powers REIT growth. Most investors will recall the basic equation for Net Present Value (NPV).
As a quick recap, the formula states that the Net Present Value of an asset is equal to the sum of its future cash flows, discounted back to the present using a discount rate. There are two key components, cash flows and the discount rate. We can think of REITs similarly, in that each REIT portfolio generates a stream of future cash flows (essentially rents less operating expenses and debt costs), with a cost of capital, which can be thought of as the discount rate. It follows that there are two ways to increase the NPV of a REIT. To increase the amount of future cash flows, or to reduce the REITs cost of capital (the discount rate).
REIT NAVs increased dramatically during the recovery from the great financial crisis because both of these components were moving in the right direction for the REIT industry. Cash flows were increasing as the economy recovered and rents rose, and an accommodative policy stance by the federal reserve kept a lid on interest rates that drove REIT’s cost of capital down. Lower cost of capital and increasing cash flows drove NAV’s higher at a 15.3% annual clip from 2010-2016, catalyzing a REIT bull market that led all asset classes in terms of performance.
**Source: Bloomberg, LP, S&P Capital IQ, and Serenity Alternative Investments
We fondly refer to this environment as “REIT Nirvana”. Capital costs are falling while cash flow growth is increasing. NAVs move rapidly higher, and REIT share prices follow. You will notice REIT share prices have not moved significantly higher since NAV’s peaked for the industry in 2015 per the chart above. While REITs have still delivered competitive returns through dividend payments since that time, periods of NAV growth are much more beneficial to the average REIT investor.
So NAV growth is important, and NAV’s tend to grow fastest when interest rates are falling/low and economic growth is inflecting/accelerating. From 2010 to 2016 this exact scenario created extremely attractive returns in REITs. It would follow then that investors should be on the lookout for another period of accommodative monetary policy and accelerating economic growth.
Fast Forward – Should we be bullish on NAV growth heading into 2021?
That brings us to our current environment and the prospects for the REIT market going forward. While 2020 has been a devastating year for the world from a health and economic perspective, REIT investors can take some solace that REITs were well prepared for a downturn and are poised to emerge from the current recession stronger than ever.
One of the great lessons that REITs took from the 2008-2009 crisis was the importance of having a balance sheet that can withstand dislocations in the capital markets. High levels of leverage challenged many of the largest REITs, forcing them into large dilutive equity raises at un-favorable prices. Since that period, the entire industry has significantly reduced the amount and structure of debt on REIT balance sheets.
The chart above illustrates the transformation that has occurred in REIT capital stacks. Interest coverage ratio is a measure of how much cash flow a REIT has relative to the level of interest payments that it owes on its debt. Higher is better, as the more money a REIT has coming in the door relative to the amount it is paying in interest indicates financial strength. As can be seen from the chart, interest coverage ratios have increased from their nadir near 2x in 2008-2009, to almost 5x today – a significant, constructive improvement.
Said another way, REITs generate more than twice as much cash flow relative to their interest payments now than they did in the last crisis. REIT balance sheets reflect less debt relative to total assets, and much better-laddered maturities than in the past, all a reflection conscious, persistent, enhanced balance sheet management over the past 10 years.
So why does this matter? Balance sheet strength is important during a recession because it allows a company not just to survive but to thrive. Instead of struggling to fund their day to day operations and payback large lump sums of debt as they did in the prior crisis, the typical REIT should be able to navigate near term economic pressures, while simultaneously beginning to look for opportunities. The ability to buy properties, at attractive returns over their cost of capital, is an advantage well-capitalized companies can exploit to drive growth, especially following periods of economic dislocation. Higher acquisition and development volumes tend to lead to higher growth for the REIT industry, and after years of declining volumes of net acquisitions, REITs could pivot to external growth over the next few years.
The chart below illustrates the difference in net acquisition levels between the 2010-2016 time period and the 2016 – 2020 time period. It is no coincidence that NAV growth moved lower at the same time acquisition activity for REITs slowed meaningfully. With strong balance sheets, construction activity slowing, and possible distressed opportunities arising in the coming quarters, REIT external growth could be set to accelerate meaningfully, mirroring behaviors that followed the prior recession.
So to recap, REIT balance sheets are in great shape, which could lead to a significant increase in acquisition and development activity over the next few years. This is an important aspect of NAV growth that has been mostly absent since 2015. Coupled with a monetary policy regime that is dovish (mega-uber dovish may be a better description) and restrains capital costs, and suddenly you have the recipe for an extremely friendly REIT environment. While it is impossible to say with certainty that REIT Nirvana Redux is on the horizon, critical components of such an economic regime are certainly in place.
Process & Preparation: How to ride the next REIT wave
As the saying goes, history does not repeat itself, but it does rhyme. The next bull market in REITs will likely diverge from the last bull market in REITs, but some of the vital catalysts are currently in place. With an explicitly dovish federal reserve committed to keeping rates low for an extended period, we can be confident that well-capitalized REITs will benefit from lower funding costs for the foreseeable future.
The missing requisite ingredient to ignite another period of REIT nirvana is economic growth, a component of the equation that has an incredibly murky outlook at the current time. With unemployment still stubbornly high, coronavirus cases still growing, and bankruptcies increasing, it is too early to call the start of a new bull market at the current juncture.
Investors that are equipped with the right tools, however, can wait and watch as the economic situation evolves, confident that our economy will eventually find its footing and begin to sustainably recover. At the point when growth re-emerges, it will be off to the races for well-capitalized REITs.
Martin D Kollmorgen, CFA
CEO and Chief Investment Officer
Serenity Alternative Investments
Office: (630) 730-5745
Serenity Alternatives specializes in systematically uncovering REIT opportunities on both the long and short side. Our process is built on the bedrock of modern quantitative investing techniques and is enhanced by deep industry knowledge. We look forward to the next multi-year bull market in REITs, but in the meantime continue to focus on creating value and preserving capital by investing in REITs uniquely suited for today’s economic environment. For more information on Serenity’s current market outlook, quantitative framework, or historical hedge-fund returns contact Martin Kollmorgen at Mdkollmorgen@Serenityalts.com
**All charts generated using data from Bloomberg LP, S&P Global, and Serenity Alternative Investments
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