Reits, Real estate investment trust concept, cube wooden block with alphabet combine the word Reit… [+]
Getty
Excerpts from this article appeared in the February 2020 edition of the Forbes Real Estate Investor.
Dividend investors love real estate investment trusts, or REITs, and with good reason. In fact, I’d ask who doesn’t love them… out of everyone who actually knows they exist and what they can do, that is.
Equity REITs – those that directly acquire physical property – have been shown to be the easiest and most profitable way of investing in commercial real estate. They beat even private equity funds and privately listed REITs.
Since 1972 equity REITs have outperformed every major index. Every. Single. One.
And since 1989, REIT volatility relative to the S&P 500 has been 45% less, another major mark of long-term profitability. Moreover, that was all while they enjoyed generous, safe, and growing income over time.
This excludes the historical anomaly that was the financial crisis, when 87% of REITs were forced to cut dividends due to their high debt levels… proving that you need a diversified portfolio of stocks, bonds, real estate, and precious metals. Together, they’re meant to balance each other out and maintain the steadiest long-term portfolio growth possible.
But back to historical data. It’s very useful in determining how to construct a sleep well at night (SWAN) portfolio. There’s a reason – more than one, actually – why we cite the informative above.
With that said, we can’t forget that few people truly have 40+ year time frames to work with. So let’s just focus on a sizable slice of that time to see how well we can fare.
For instance, in the decade that just ended, REITs did well, posting 12.6% compound annual growth rate (CAGR) total returns. However, they slightly underperformed the tech-heavy S&P 500.
To help REIT investors prepare and profit from the decade that’s just begun… let’s look at three important facts about the 2020s that can hopefully prepare you well
1. Economic Growth and Inflation
This new decade began like the last one ended: with all eyes on trade talks between the U.S. and China.
[Editor’s Note: Admittedly, there’s also the coronavirus to account for. But, in terms of the markets, we don’t see that being more than a really good buying opportunity or two.]
Following the surprise Trump election in 2016, CEO confidence exploded higher. And through mid-2018, deregulations and tax cuts kept that optimism near-record levels…
Before it fell off a cliff as the tariff conflict escalated and global growth slowed.
Fortunately, the phase-one trade deal, which Trump signed mid-last month, has alleviated a good bit of trade uncertainty so far. Phase one is far from perfect though, and the administration has acknowledged that more needs to happen to really resolve the situation.
Moody’s estimates a 15% probability of the trade war ending this year, which I consider a reasonable estimate. Though the coronavirus might end up slowing things down even further.
Fortunately, the trade war will likely settle eventually. It’s just a matter of when. That and who ends it.
No doubt taking that into consideration, the Fed’s long-term forecast calls at the very end of 2019 were for about 2% growth – both mid-term and over the longer run. And for those predicting a recession based on how good of a run we’ve had so far, well…
Looking at Recession Risk
According to a 2016 study by the San Francisco Federal Reserve, there’s no statistically significant correlation between how long an economic expansion lasts and the probability of a recession beginning in the short-term.
In other words, expansions don’t die of old age. In the words of former Fed Chair Ben Bernanke, they’re instead “murdered” by something… typically by aggressively raised rates due to fears that inflation will run above the Fed’s 2% long-term symmetrical target.
Over the next 10 years and even over the next 30, the bond market is forecasting 1.8% inflation. If those prove accurate, then so might the Fed’s long-term plan to hike short-term rates at a modest and accommodative pace.
This would mean:
- No hikes in 2020
- One hike in 2021
- One hike in 2022
- One final hike in 2023 or later.
A Fed funds rate of 2.25%-2.5% would be what we had back in December. That would mean this “lower for longer” world of historically low-interest rates is set to persist for the foreseeable future.
So does that mean the 2019-style “Goldilocks” economy will continue into 2020 and beyond, keeping REITs boosted? Annoying though it might be, the answer is both yes and no.
Let me explain.
2. Short-term interest rates vs. long-term fundamentals
The incorrect idea that REITs are a “bond alternative” often make their investors afraid of rising interest rates. They specifically look at the 10-year yield, which is the proxy for long-term interest rates, with fear and trepidation.
In reality, from 1992 to 2017, these stocks generated positive returns 87% of the time when 10-year yields were rising. That’s because rising long-term rates generally mean strong economic conditions.
Besides, REITs are NOT bonds. As stated above, they’re stocks. And, like any stock, a REIT’s value is a function of dividends and cash flow.
So the stronger the economy, the faster a REIT can grow its:
- Funds from operations (FFO)
- Dividends
- Intrinsic value for shareholders.
REIT cash flow multiples haven’t actually been strongly affected by historically low 10-year yields. That shows in the sector’s average 17 price/FFO over the past decade.
It only looks like REIT multiples averaged higher because they were depressed by the tech bubble. Besides, they began 2000 at around eight, an absurd level that saw rapid mean reversion over the following decade.
Of the dozens of REITs I’ve researched via FAST Graphs, the difference between our modern low rate era and 2007 – when 10-year yields peaked at 5% – was zero to two times FFO.
In other words, REIT multiples don’t significantly expand just because long-term rates are low. What matters is fundamentals.
Which means there’s good and bad news for REIT investors in the coming decade.
That Good and Bad News, As Promised
Let’s begin with the bad news.
As a sector, the REIT development backlog is now at record highs. Following the financial crisis crash, net operating income boomed through 2015. In short, steady economic growth resulted in demand for REIT properties outstripping new supply.
Today, as supply has finally caught up to demand, organic same-store net operating income (NOI) growth has leveled significantly. One percent to 2% NOI growth and 3%-5% FFO/share growth – as created by merger and acquisition (M&A) activity – are what’s normal for REITs.
As such, that’s what investors should expect over time.
No here’s the good news. Low rates do benefit REITs that have used the lowest interest rates in history to strengthen their balance sheets.
As a percentage of market cap, REITs have the lowest leverage in sector history. And the interest coverage ratio for equity REITs is also at record highs.
Meanwhile, weighted interest rates are at record lows. So unless inflation expectations increase significantly (which isn’t likely given the secular headwinds the U.S. faces going forward), historically low long-term rates should persist.
Of course, this doesn’t mean REITs can expect M&A to fuel much faster FFO/share growth either.
While strong REITs with low costs of capital will always prosper… cap rates on new properties have fallen steadily over time. Recessions are a time when cap rates spike, and the strongest REITs prosper most coming out of recessions.
With no recession visible on the horizon, it is possible REIT investors will face below historically normal FFO and dividend growth rates for the next few years, as that record development pipeline comes online.
3. A Diversified REIT Portfolio is the best approach to take
REITs aren’t a monolithic sector. They’re represented by over a dozen industries, from hospitals and apartments, to industrial, data, storage, and shopping centers.
At the end of December, Nareit reported the REIT average yield at 3.8%. Assuming the historically normal 3%-5% FFO/share growth over the coming decade… these stocks (stocks, not bonds) should deliver about 7%-9% CAGR total returns.
(That’s based on the Gordon Dividend Growth model, which has been doing a great job predicting long-term (5+ year) total returns since its creation in 1956.)
The S&P 500 should therefore deliver about 4%-7% CAGR total returns. Ipso facto, as a sector, REITs should resume their outperformance in the next 10 years.
Of course, it’s impossible to predict a full decade out which exact industries will perform the best. In fact, we never really know what areas will be the hottest and what the market will be excessively bearish on.
So opportunistically buying up a diverse collection of REITs in various industries is a reasonable and prudent approach to take… both as part of a prudent risk-management strategy and to achieve better returns.
Obviously your optimal risk management rules should be based on your personal needs and risk profile. But REIT industry limits of 10% and a sector cap of 25% work well for most investors.
A broad-based approach could include owning 5% in each of the the following focuses:
- Industrial REITs
- Cell towers/data centers
- Shopping center/mall/retail
- Triple-net lease REITs (which can include retail, healthcare and/or industrial names)
- Apartments/student housing.
Naturally, you would want to achieve that allocation over time. You wouldn’t have to buy into all of them right away.
Risk, Risk, More Risk – and Even More Rewards (When Handled Wisely)
Never forget that risk doesn’t just involve fundamental risk. There are actually three kinds to consider when deciding where to entrust your hard-earned savings.
The valuation and volatility varieties, admittedly, go hand in hand. You don’t ever want to ignore dangerous valuations just to “check a box” and achieve exposure to a particular industry.
Fortunately though, just as with the broader market, something great is always on sale.
Put simply, REIT industries go in and out of favor as their short- to medium-term macroeconomic fundamentals shift. It really all depends on supply and demand (with some panic and greed thrown in there as well).
Thus, the patient REIT investors can achieve a prudently diversified and risk-managed sector allocation. And they can do that without ever having to overpay for even the highest quality names in any particular industry.
Always remember that great long-term investing requires focusing on three things:
- Quality first
- Valuation second
- Prudent risk management always.
That’s your secret to ultimate success.