• With 200+ companies, invested in over 19 different property types, the publicly traded REIT market offers investors the opportunity to tilt their real estate exposure in countless different directions
• As the cycle has matured and growth has slowed from recent peaks, it’s been important to avoid cyclical REITS, and embrace bond-like REITs
• For investors looking to lower portfolio risk this late in the cycle, high quality REITS with strong balance sheets offer a compelling portfolio allocation
You don’t have to look too far in the financial press to find an article about how we are “late in the cycle.” It’s common knowledge that the economic recovery is long in the tooth, as we pass the 10-year mark since the depths of the last recession. But how does that knowledge help us as real estate investors? How are investors supposed to change behavior knowing that the cycle is very mature?
In many cases, unfortunately, real estate investors have limited options. Selling assets can trigger tax events and sitting in cash is not what most clients want from their managers. With high quality assets commanding premium valuations, how can real estate investors add protection to their portfolio if they think the cycle is closer to its end than it’s beginning?
One answer lies in the publicly traded real estate market. Real estate investment trusts, or REITs offer a myriad of different ways in which real estate investors can maintain real estate exposure while protecting their downside. While the REIT market is complex, for savvy investors it represents an opportunity to enhance their returns as we enter the last phases of the cycle.
REIT Property Sectors: What are you betting on?
For investors that are new to the REIT market, it makes sense to start at the property sector level when discussing the real estate cycle. The publicly traded REIT market is comprised of over 200 companies, most of which specialize in a particular property type within commercial real estate. While there are over 15 property sector groups in the REIT space, this article will focus on four that have particular cyclical exposure; Hotels, Apartments, Healthcare, and Free-Standing Retail (also known as Net-Lease).
Hotel (or lodging) REITs are the most cyclical component of the REIT universe. This is because turnover in the Hotel industry is much higher than in any other property sector. Simply put, most people only stay in a hotel for one or two nights, so when the economy starts to slow, hotel owners notice immediately as their occupancies begin to fall. For this reason, when the cycle slows, it’s best to avoid the Hotel REITs.
The Apartment (or multi-family) REITs have a slightly different character than the Hotel REITs. Apartments tend to be tied to the employment cycle, and with leases that average one year in length, they do not immediately feel the impact of the cycle once it rolls over. They are, however, still cyclicals in that their performance will eventually reflect the health of the labor market. Apartments are best to avoid when jobless claims are rising, and employment growth is falling.
On the other end of the cyclical spectrum lie the Free-Standing Retail or net-lease REITs. These companies are almost counter-cyclical. This once-again has to do with the duration of their leases. Free-Standing Retail owners lease most of their buildings for 10 or more years. This means that while Apartment owners are forced to mark down a significant portion of their portfolio to market during a downturn, Free-Standing Retail landlords may only have a few leases rolling over in any given year. The cash-flows from these long-term leases simply have less downside volatility than short-term leases, and thus, less cyclicality.
Our final sector (Healthcare) is also defensive in nature, but it derives its defensiveness less from the term-structure of its leases, and more from its relationship with the bond market. The Healthcare REITs (along with Free-Standing Retail) have some of the highest inverse correlations with the 10-year treasury yield of any of the REITs. That simply means that as the yield on the 10-year treasury goes down, Healthcare and Free-Standing Retail REITs tend to go up. This makes the sector defensive, because as the economy loses steam, the yield on the 10-year tends to fall, and these stocks tend to perform well.
Case Study: When playing defense pays off
As a quick exploration of the cyclicality of these sectors we can examine an episode from recent history, particularly the period from 2018 in which the 10-year treasury yield peaked and began to fall along with expectations for economic growth.
In October of 2018 the yield on the 10-year treasury hit 3.2%. This occurred in an environment in which economic growth expectations were still high, following 9 quarters of sequential acceleration in real GDP growth. Investors will likely remember the turmoil in the stock market that followed the October peak in yields. Since then, the 10-year yield has fallen to below 2.0% as economic expectations have fallen and estimates of GDP growth have been trimmed.
Over that same time period, the Bloomberg REIT Healthcare index has returned 23.9%, while the Bloomberg REIT Single Tenant (Free-Standing Retail) index has returned 26.6%. Apartment REITs returned 19.2%, while the Hotel sector has returned -20.6%.
The gap between cyclical and counter-cyclical REITs could not be more evident than in the 30% spread that has occurred over the course of 9 months between Hotels and bond-like REITs. As economic data has deteriorated, investors have flocked into Healthcare and Free-Standing Retail names, while simultaneously trimming exposure to Hotel REITs.
The Apartment sector is the notable exception as employment data had remained mostly positive until very recently. The Apartment REITs are still cyclical, however, and it’s safe to assume that investors are eyeing the employment statistics carefully if they own Apartment REITs.
Not a sector picker? Enhance your balance sheet.
While it’s clear that sector performance can create large return opportunities, sector timing is notoriously difficult. For investors that prefer not to choose favorites amongst property types, the REIT market still offers options for enhancing the risk profile of a portfolio.
The REIT market allows investors to very easily assemble a portfolio of high-quality real estate assets that is diversified across both geographies and property types. While this is a compelling value proposition in itself, a key component of REITs that is less-often discussed is the quality of their balance sheets.
Anyone that invested in real estate through the downturn of 2008 knows how important leverage levels are, and how dangerous it can be to carry excess leverage into a cyclical slow-down. After 10 years of favorable market conditions and low rates, it may be time to carefully consider the amount of leverage real estate portfolios are carrying.
Private real estate investors tend to lever their assets at 50% or more (on debt/asset value), however, the REIT universe tends to run closer to 35% leverage. This higher base of equity capital limits the risk of REIT portfolios relative to higher levered investments of the same quality.
The relative safety of REIT balance sheets can also act as a self-reinforcing mechanism during a downturn, as investors flock to real estate investments with low leverage. This flight to safety bid further enhances REITs cost of capital relative to their private peers, and allows them to better take advantage of any opportunities a down cycle will offer.
Putting it all together: Diversify and de-lever to fight the cycle.
Timing the real-estate cycle is near impossible, but after a 10-year bull market in most risk-assets it has become clear that the current cycle is losing steam. As economic growth has slowed over the last 9 months, defensive exposures have outperformed both in the broad stock market and in the REIT market. For real estate investors looking to tilt their portfolio in a new direction, adding REITs could make the difference between outperformance and under-performance during the next cyclical downturn.
By assembling a diversified REIT portfolio with low leverage, investors can maintain exposure to high quality, cash flowing, commercial real-estate, while insulating themselves from swings in the cycle. These swings will be magnified in real estate carrying high leverage levels. Add to this the fact that well capitalized companies (REITs) will be in the best positions to buy distressed assets during the next downturn, and the case for adding REITs to a portfolio late in the cycle becomes compelling.
- Intro – After 10 years of economic expansion post GFC, many real estate investors are wondering how long this cycle can last.
a. Everyone knows the cycle is long in the tooth, but the playbook for navigating the next 12-18 months is very much up for debate.
b. What options do most RE investors have…go to cash? Sell? What happens if you miss another move higher?
c. The REIT market offers solutions via the sheer # of expressions a REIT portfolio can take.
- Sector Tilting – how cyclical versus defensive REITs can add defense or offense
a. Highly cyclical REIT sectors – Hotels, Billboards, Apartments, c-corps
b. REITs with low-cyclicality – Net lease, Healthcare
c. High duration REITS have been on a tear – watch Apartments for degradation in the employment data
d. Counter-cyclicality – look for REITs with secular tailwinds (Data, Warehouse) and avoid those with headwinds (Retail/Mall).
- Risk Tilting – how investors can reduce risk by adding low-levered, high quality REITs
a. For those worried about carrying cash, high quality diversified REIT portfolios offer a compelling allocation option
b. REITs are not without risk, but tend to recover from downturns very rapidly
c. REITs have almost 0 risk of bankruptcy – it’s much higher for private real estate with high leverage.
- Conclusion – use REITs to tilt a RE portfolio in the right directions
a. With growth slowing, we are tilting defensively
b. Look for sectors with secular tailwinds (DC, IND)
c. For shorts – find high leverage names with cyclicality levered to slowing property sectors and watch the Apartments
Martin Kollmorgen, CFA
CEO and Chief Investment Officer
Serenity Alternative Investments
Cell: (630) 730-5745
**All charts generated using data from Bloomberg, LP, S&P Global, and Serenity Alternative Investments
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