Spring Showers A Rebalancing Opportunity for REITs?
May and June to date has been a challenging period for REITs and other income-producing asset classes, driven by concerns that the Federal Reserve might start tapering its asset purchases later this year. The MSCI U.S. REIT Index declined 5.94% in May, while the S&P 500® Index gained 2.34%.
The reality is that the REIT sector is no stranger to springtime pullbacks. Chart 1 shows the performance of the MSCI U.S. REIT Index since 2008. Notice how the market peaked in the spring in each of the last four years, indicated by the blue arrows, with year-to-date returns of +18% in April 2010, + 20% in May 2011, +15% in May 2012, and +20% in May 2013.
Chart 1: MSCI U.S. REIT Index
Source: Bloomberg. Performance as of June 20, 2013. Past performance is no guarantee of future results.
Big Picture View
If the cyclical pattern of the last few years holds true for 2013, we expect we could be entering a buying opportunity within the REIT space. The historical evidence supports this possibility. Chart 2 plots the four REIT bull market cycles that have occurred over the last 40 years, including the current Cycle 4 (orange line),which started in 2009 following a two-year down period (2007-2008). Of note, each of the three prior REIT cycles was also preceded by two down years before turning into a bull run that lasted seven years on average. We believe the current cycle could have more room to run when you factor in low supply (Chart 3) and valuation support (Chart 4). Finally, could the recent shake-up in the bond market create an opportunity for REITs as interest rates rise in an improving economy (Chart 5)? Let’s take a closer look.
Chart 2: Comparison of Major U.S. REIT Cycles (NAREIT Equity REIT Total Return Index)
Source: NAREIT, Duff & Phelps Investment Management. Period ending May 31, 2013. Past performance is no guarantee of future results.
Low Supply Tailwind Expected to Propel REIT Sector
Evidence to support a continued favorable view of REITs is provided in Chart 3, which shows how the supply of new construction completions (effectively new competition) has been below average across multiple property sectors and is expected to remain at lower levels for the next few years. For the remainder of 2013, we expect improving global economic growth will facilitate further increases in real estate cash flows, both through higher property occupancy rates, as well as higher rents in cases where occupancy has reached, or will reach, equilibrium. We expect continued low levels of new REIT supply to serve as a multi-year tailwind, with constraints to construction financing, such as Basel III, a key driver.
Chart 3: U.S. Supply Outlook Remains Very Favorable for Landlords
Source: Green Street Advisors Commercial Property Market Outlook – May 22, 2013. Past performance is no guarantee of future results.
NAV Discount Creates Rebalancing Opportunities…
We would also point out that the current net asset value (NAV) of REITs represents a healthy discount to the historical 2% premium to NAV (102% of NAV) that the space usually averages, even more so on a forward basis (Chart 4). As of market close on Thursday, June 20, REITs were trading at an 11% discount to NAV (89% of current NAV), according to ISI data. The trading pendulum has a propensity to over swing in both directions, creating rebalancing opportunities.
Chart 4: Monthly U.S. REIT Premium (Discount) to NAV
Source: ISI Group. Period ending June 20, 2013. Past performance is no guarantee of future results.
Déjà vu? 2004 Treasury Sell-Off, REIT Rebalancing
The recent 10-Year Treasury sell-off is reminiscent of April 2004. Back then, when strong payroll data were released for March of that year, the bond market was surprised and sold off. That pressured the REIT space, much like it has done recently, and created a rebalancing opportunity. REITs powered ahead that year and continued to do so as interest rates rose over the next couple of years.
We also saw a change in property sector leadership from those property sectors with long lease duration and minimal ability to push rents, to those property sectors which could benefit from repricing power in the form of higher rents and greater repricing frequency, à la shorter leases. The ability to raise rents for one’s tenants who benefit in an improving economy and value high quality space, and the opportunity for REITs to do so more frequently, whether for property sectors such as self storage, industrial warehouses, or apartments, as examples, offer the organic growth drivers needed to naturally offset an expected lift in cost of capital as the economy improves.
Chart 5: Bonds and REITs: Moody’s BAA Yield and Implied Cap Rates of Equity REITs
Source: Bloomberg Finance L.P., Citi Research. Period ending June 20, 2013. Past performance is no guarantee of future results.
Our Outlook for Global Real Estate includes several upside drivers and downside risks:
Potential Upside Drivers
- Greater than expected global economic growth recovery, leading to higher demand for real estate space and higher occupancies and rents
- A greater than expected reduction in global real estate implied cap rate spreads relative to corporate bonds and capture of lower cost of capital
Potential Downside Risks
- A rapid and unexpected change in the current term structure of interest rates
- A reversal in the positive sentiment toward real estate specifically or income-oriented securities generally
Past performance is no guarantee of future results.