The REIT market has lagged the S&P 500 since mid-2016, but three signals suggest this trend may be ready to reverse. Based on the evidence below, it may be time to take REITs off the bench and put them in your starting line-up.
• REITs in October traded to a 10% discount to NAV – similar periods over the last 10 years have led to REIT returns of over 20% during the following 12 months
• REIT NAV’s are moving up for the first time since 2015, while earnings growth for the S&P 500 is peaking
• Current ISM readings point to stronger forward returns for REITs than cyclical sectors
REITs own some of the highest quality real estate in the world and are the only real estate investment option that offers daily liquidity and the ability to buy high-quality assets at a discount to their private market value. The REIT market has out-performed the S&P 500 since 1990, and REITs historically increase risk-adjusted returns when added to a 60/40 portfolio of stocks and bonds. In this piece, we explore a few key signals currently being sent by one of the best performing asset classes over the past 30 years.
Premium/Discount to NAV: History says buy high quality real estate when it is on sale
Some charts are powerful in their simplicity. They present data in its stark reality, independent of prevailing narratives and popular opinion. When I first generated the chart above, my immediate reaction was that I must have made a mistake. The correlation between large discounts to net asset value (NAV) and stronger than average REIT returns looked too strong. The fit was too clean…despite the fact that it made intuitive sense. I had a hard time believing that such a simple signal could be so historically powerful.
As I continued to explore the data, however, it became increasingly clear that there was no mistake. Using daily data over this period, the average forward 12-month return of the REIT universe is 12.8%. During periods in which REITs traded at a 10% or higher discount to NAV, these forward 12-month returns average 22.5%.
This means that the best time to buy REITs historically has been when they are the most out of favor. NAV represents the estimated value of a REITs real estate, so when REITs trade at a discount (when their stock prices are below their NAV’s), that means investors have an explicitly negative view of the companies. As many seasoned value investors know, these periods tend to be the best times to buy, but also the most difficult.
Today’s environment is no exception. As of the end of October 2018, the REIT market traded at a 6.9% discount to its NAV, up slightly from mid-month when it traded to a 9.9% discount. Said another way, REIT stock prices are almost 10% below the break-up value of their portfolios. Investors are skeptical that real estate companies will be able to navigate a rising interest rate environment and have little interest in defensive sectors in a strong economy. History, however, is sending a clear message. REITs are cheap, and with NAV growth rising again after falling for almost three years, we could be on the cusp of a new bull market for REITs.
REIT NAVs 5.4% higher in October year over year – Growth is increasing while S&P 500 earnings growth peaks
While valuation levels for REITs are flashing green, without positive developments in their underlying businesses they are just as likely to move sideways as upwards. In the REIT industry, the best reflection of overall fundamental strength tends to be growth in the sector’s net asset value (NAV). As discussed earlier, NAV represents the total value of a REIT’s portfolio based on current real estate prices, and what is most important to professional REIT investors is that REITs grow their NAVs over time. From early 2016 until late 2017, REIT NAV’s fell due to fundamental challenges in multiple REIT property types. In the past year, however, NAVs have begun to move upwards just as earnings growth may be peaking in the S&P 500.
The driving force behind the REIT markets renewed NAV growth has been improving fundamentals after a dismal two-year stretch for multiple REIT property sectors. Retail REITs in 2018 have seen much less disruption from bankruptcies than they did in 2017. Similarly, the healthcare REITs have begun to recover from supply pressures that peaked in 2017, as well as the challenging reimbursement environment that has plagued many healthcare operators for the last two years. While challenges remain for both of these property types going forward, they are no longer dragging down the entire industries NAV. Some retail and healthcare REITs have even begun to see renewed NAV growth.
At the same time growth remains robust in other property sectors. Warehouse companies saw their NAV’s increase 15% in 2017, 11.8% so far in 2018, and show no signs of fundamental deceleration. Data center REITs can still not build fast enough to satisfy demand and have seen NAV growth of 62% since early 2016. Same-store revenue growth in apartment REITs has recently ticked up slightly, which could move NAV’s higher over the next six months, and supply peaks may be in for the office and lodging sectors.
This myriad of moving pieces has translated into NAV growth for REITs that has gone from about flat in January of 2018, to +5.4% at the end of October. If growth stays stable at +5% for the foreseeable future, and REITs simply converge to the value of their NAV’s over the next year, the entire sector could be up 15% over a period of 12 months (5% NAV Growth + 10% discount to NAV).
The problem for REITs has been that all of this is occurring against a backdrop of much stronger headline growth in S&P 500 earnings. As of this writing estimated EPS growth for the S&P 500 is north of 20%. With such strong headline numbers, it’s easy to ignore a sector that’s going from 0% growth to 5% growth. We would argue, however, that what really matters in this instance is the rate of change. S&P earnings growth has already begun to slip, and with a stronger dollar, the tax-cut tailwind fading, and much more difficult comps, the path of least resistance for S&P 500 earnings growth is unequivocally lower. The question investors face in this instance then, is do you stick with the S&P as earnings growth moderates, or look to the REIT space as NAV growth accelerates?
The Macro Data: Growth is good, why be defensive?
Another argument commonly used to justify ignoring REITs at this juncture lies in the strength of recent economic data. GDP growth, inflation, and interest rates are all at multi-year highs, so why on earth would I want exposure to such a defensive sector? This narrative assumes that strong growth readings are associated with weak REIT returns. The data, however would suggest that this may not be the case.
To test this premise, let’s examine one of the most used barometers of economic strength and inflation; the ISM manufacturing index, and one of its sub-components called the “prices paid” series. The ISM manufacturing index has increased over the past two years from 47.8 in Q1 2016 to 57.7 currently. The prices paid series has risen from 33.9 to 71.6. Any reading over 50 in these data series indicates expansion.
The ISM is used by economists as a proxy for GDP growth, while the prices paid series can be viewed as a proxy for inflation. Since 2016 these series have moved steadily higher along with interest rates, as the S&P 500 has outperformed REITs and other defensive sectors. A REIT bear would point to the strength in both of these indicators as evidence that investors should stick with pro-cyclical stocks over REITs.
But what does history say about forward REIT returns when these series hit their current levels? The chart below shows forward 6-month sector returns during periods when the ISM manufacturing index is over 55 and the prices paid series is over 70.
For investors still over-weight cyclical sectors within the S&P 500, this chart should be discomforting if not frightening. Forward returns with ISM readings this strong are far superior for REITs than they are for other sectors using data going back to 1989. The financials sector, one of the most pro-cyclical sectors in the market returns on average just over 1% in the 6 months following data this strong, while REIT returns are 8%. This suggests that ISM readings of this magnitude, while indicative of a healthy growing economy, are more likely to occur at the peak of the cycle than the beginning. Said another way, when the data is this good, the probability that it gets even better is not high.
Piecing things together: Separate from the crowd by adding REITs
What often separates great investors from the rest is their ability to understand when the past and the future look meaningfully different. The past two years have seen the REIT market struggle, as fundamental headwinds have been met with rising interest rates and a compelling set of more attractive opportunities. As the landscape changes, however, there is ample evidence to indicate that the next twelve months may look meaningfully different. REIT NAVs are increasing, S&P 500 earnings growth is peaking, and macro-economic data is warning that the probability of growth continuing higher is low.
Could the cycle re-ignite higher while REIT NAVs abruptly stop rising and invalidate our entire thesis? Possibly, but it would take renewed catalysts for cyclical economic growth, a wave of real estate supply, or some massive deterioration in fundamentals that would be de-coupled from strength in the economy. Put another way, macro-data that is hitting all-time highs would have to go higher, while apartment renters, office users, and shoppers would simultaneously have to stop renting and shopping.
Adding to REITs in a strong growth environment may not make you popular at cocktail parties, but it may make your portfolio an all-star over the next 12 months. Valuation, growth, and the macro-backdrop all favor a sector that derives its cash flows from extremely high quality institutional commercial real estate. Those with exposure to REITs over the past decades have out-performed, and those that have added to the space in times of distress have out-performed meaningfully. REITs deserve a place in your starting line-up, but my guess is that they are currently on your bench.
It is the fourth quarter; time to lean on a sector that has historically out-performed most others as you push for victory.
REITs for the win,
Martin D Kollmorgen, CFA
CEO and Chief Investment Officer
Serenity Alternative Investments
Office: (630) 730-5745
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