Real Estate Investment Trusts have been caught in a dilemma recently, or, more accurately, investors in them have. One of the themes of this year has been the real estate recovery; we are constantly told that house prices are bouncing back and that construction is now once again driving a significant part of economic growth. An environment such as this must be good for companies that invest in real estate, right? Well it was, right up until the Fed started to hint at the end of QE.
Whether you look at ETFs in the sector, such as the Vanguard REIT ETF (VNQ) at the top, or individual stocks such as the well known Simon Property Group (SPG) below, the story is the same. Both saw huge gains on the year, culminating in highs achieved on May 22nd, the day Chairman Bernanke first used the “t” word and began to talk of a timetable for tapering bond purchases. A hint at higher interest rates caused a drop, and this rapidly turned into something of a collapse as both VNQ and SPG, along with almost the entire sector, lost all of the year’s gains. The dilemma for investors comes about now.
As far as we know, the housing recovery is intact. Indeed, the latest Case Shiller Index showed that home prices rose 12.1% in April compared to a year ago and posted its biggest ever month on month gain. Couple this with May new home sales handily beating expectations and it would seem that real estate is the place to be. Commercial real estate, which is more important to SPG, which holds primarily retail space, also increased significantly. This has led many to say that the sell-off was overdone, and that REITs represented value at around where they started the year. I disagree. While the real estate recovery is undoubtedly moving apace, much of the increased value was already priced in. This is the nature of markets; they are forward discounting mechanisms, and by May a fairly significant future increase in property values was being factored in to the price of most REITs.
The hunt for yield that has been such a feature of markets for the last 3-4 years had led many people to the asset class, and the prospect of higher asset values sent prices skyrocketing, thus making the yields less attractive. At their May highs, VNQ and SPG were yielding around 3.0 and 2.5 per cent respectively. It is hardly surprising that, when the prospect of higher interest rates loomed, REIT prices collapsed. When the “risk-free” 10 year US Treasury is returning around 2.5% a 2.5-3% return on a REIT doesn’t look so appealing.
As the Federal Reserve actually does begin reducing bond purchases I expect rates to continue to edge higher. For REIT investors, this represents a threefold problem; a triple whammy if you will.
- Higher Treasury rates make REITs comparatively less attractive as a yield instrument.
- Higher interest rates increase the cost of borrowing to purchase new properties, limiting growth and the chance to increase returns.
- Higher interest rates could derail, or at least slow, the housing recovery, causing property prices to falter.
I have many times said that traders, and therefore markets, have a tendency to overreact to news, both good and bad. Given these three negatives, however, it is hard to see a return to January pricing as an overreaction in the REIT market. After a period of consolidation, I would expect to see the decline continue in the second half of the year and beyond. At best, the upside is limited as a result of higher yields on Treasuries so the risk/reward ratio which is so essential to successful investing and trading is way out of whack. Just because something is a lot cheaper than a couple of months ago doesn’t mean it represents value. For REITs it is hard to escape the conclusion that the worst is yet to come.