How quickly things change. REITs are traditionally seen as a way to get into real estate, though still featuring risky equity-like characteristcs. After all, REIT ETFs plunged 70-80% during the Great Financial Crisis. Massive rallies took place in the early-mid 2000s and again from the March 9, 2009 bottom through the early part of 2020.
Then COVID-19 struck... and REITs basically went from defensive asset to covid asset.
Thus, REITs are now becoming a proxy for life normalizing in a post-COVID-19 world. Retail spaces, hotels & leisure activity businesses make up a decent chunk of the asset class. Tenents unable to pay their rents due to economic shutdowns obviously crushes the businesses of REITs who usually have reliable cash flow and make big dividend payments to their investors. Looking at daily price-action of late, you’ll see that REIT funds are either among the top gainers and biggest losers – it’s all or nothing.
What’s more, fundamentally, lending standards have tightened. Sure, interest rates are essentially at record lows, but if banks are unwilling to take on risk, it doesn’t matter much. It will take time for the credit environment to loosen even with the Fed stepping in to back significant areas of the debt market. In fact recent data from the latest bank loan officer survey suggests credit conditions have tightened.
It’s not all dire though. Some REIT niches have held up nicely. Industrial & Specialty REITs are flat to even higher from a year ago. The hard hit spots include Retail & Hotel/Resort/Leisure REITs – those are down some 60% year-on-year.
That’s the narrative and performances, but what about the current valuations?
As noted in the latest Weekly Macro Themes report, REIT valuations are still elevated versus their long-term average. Keep in mind that the 40-year bull market in bonds has certainly been a tailwind for anything to do with real estate or just plain yield for that matter. REIT valuations have been trending higher for decades. Compared to more recent history though, their multiples have eased to about the lowest level since Q3 2011 and could present an opportunity. But other areas of the equity markets are trading much cheaper.
In our valuation analysis, we find that REIT valuations are still about half a standard deviation above their long-term average, though significantly down from levels earlier this year. Perhaps pricing higher than average is justified with current interest rate policy set forth by the Fed.
Another way to analyze REIT valuations is to look at dividend yield spreads. That’s the beauty of the asset class – with equity-like and bond-like features, there are many tools we can use. Comparing the yield on REITs to the 10-year Treasury, it would suggest REITs are a buy. And the same case can be made versus the yield on investment grade credit and that of the S&P 500.
Behaviorally, it is often tempting to look for investments with a juicy dividend yield. Investors often have a bias toward income rather than capital gains. There are two risks to realize though – 1) is the dividend safe? After all dividend yields are derived from historical, not necessarily prospective, paid dividends; and 2) where is price going to go? If the price return is lousy, the overall return comes into question... Bottom line – be a total return investor.
I will leave you with the bottom line from our report: REITs have switched from bond proxy to covid proxy, and continue to face a few uncertainties, yet yield support, Fed easing, and extreme pessimistic sentiment help underpin the sector. After turning bullish REITs in March, we have pulled back to neutral as the outlook becomes increasingly complex.
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