With REITs already trading below the ‘bear case’ laid out in the Chilton 2018 REIT Forecast published on January 2, 2018, we felt it appropriate to comment on the year-to-date performance and re-affirm our positive outlook. Based on multiple metrics, REITs are trading at the most inexpensive valuations since the recession. While we are considered ‘REIT-dedicated’ investors and maintain a long-only porfolio (no short positions), we attempt to present only historical factual evidence to support our assertion that REITs are attractively priced for long term investors.
Understanding that REITs have exhibited a high correlation with long term interest rates over the past five years, the variable between the bear, base, and bull case scenarios presented in the 2018 Chilton REIT Forecast was the US 10 year (or yr) Treasury yield at the end of the year. The bear case scenario called for a total return within the range of -5% to +1%, predicated on a US 10 yr Treasury yield between 2.8-3.0%. As of February 23, the US 10 yr Treasury yield was 2.9%, up 50 bps from December 31, 2017, and the RMS had produced a total return of -9.7%.
The main difference between the bear case and the year to date performance is time. Whereas the full year forecast incorporates four quarters of dividends and estimated dividend growth of +5.7%, many REITs have yet to pay their first dividend of 2018. One can tell REITs are being ignored by investors considering that the index yield was 4.8% as of February 23, up 50 bps from December 31, and at least 40 REITs have increased dividends year to date.
Remarkably, the correlation between the US 10 yr Treasury yield and REITs has been almost perfect, as shown by the lack of change in the difference between the REIT dividend yield and the US 10 yr Treasury yield, also referred to as the ‘spread’. For example, with a REIT dividend yield of 4.3% on December 31, 2017 and a US 10 yr Treasury yield of 2.4% as of the same date, the spread was 190 bps. Similarly, with a REIT dividend yield of 4.8% as of February 23, 2018 and a US 10 yr Treasury yield of 2.9%, the spread was also 190 bps. When compared to the 25 yr average of 120 bps, the US 10 yr Treasury yield would need to rise 70 bps (or the REIT dividend yield to fall by 70 bps) to trade inline with the historical average.
As shown in Figure 1, the dividend yield spread has been above the historical average for the past five years, though has shown extended periods historically of trading below the average. We believe the current elevated spread reflects the assumption of future Fed Funds Rate hikes due to increasing economic growth plus some uncertainty of how markets will digest the unwinding of eight years of quantitative easing (or QE) in both the US and in other mature economies around the world.
Much of the above information was widely expected before the start of the year, and thus should have been reflected in the US 10 yr Treasury yield on December 31, 2017. So what changed? In January and February, the Bureau of Labor Statistics released several better-than-expected jobs reports, showing 17-year low unemployment and 8-year high wage growth. Coupled with increasing inflation, the reports stoked fears of faster-than-expected rising inflation, which could result in more interest rate hikes at a quicker pace.
Although it hasn’t always been the case, there is a perception that rising interest rates should result in higher capitalization rates (or ‘cap rates’) for real estate, and thus lower property values. We are closely monitoring private real estate transactions, and, as of yet, cap rates have not moved significantly higher to coincide with increase in interest rates and decrease in REIT prices.
Inflation is tracking around 1.8% year-over-year based on the core consumer price index (or CPI, less food and energy) report as of February 14, 2018. Although it is below the Federal Reserve (or ‘Fed’) Board of Governors’ target rate of 2%, it has risen from 1.7% in September 2017. Therefore, the market is anticipating a continued increase in inflation above 2%. If inflation stabilizes at or near current levels, we would not expect the pace of rate hikes to change from the pre-2018 assumption of three. It is worth noting that the core CPI reports in January 2016 and January 2017 were both above 2%, and REITs were able to produce total returns above 5% in both of those calendar years.
Many of the periods with rising rates in which REITs performed well coincided with rising inflation. Whereas a change in ‘real’ (interest rates minus inflation) interest rates would reflect a change in cost of capital and risk, a change in nominal interest rates (interest rates including inflation) merely reflects the increase in costs. Notably, shelter (or rent) is the largest component of the core CPI calculation. Thus, if nominal interest rates are rising due to rising rents, real estate can provide excellent protection from inflation. Furthermore, rising construction costs and borrowing costs due to higher inflation has historically slowed construction, which could further tip the scales in favor of current landlords across all property types.
Another reason REITs may have fallen out of favor is the perception that the tax reform bill helped traditional C-corp equities more than REITs, thus decreasing the relative benefit of REITs’ tax status. However, this isn’t entirely true. While the headlines cite reduction in the corporate tax rate from 35% to 21%, most companies were not paying 35%. As a result, the consensus 2018 earnings estimate for the S&P 500 is only up 7% as of February 23 when compared to estimates as of December 15, 2017 (before the tax reform bill). In contrast, the reduction in the tax rate to individuals’ REIT dividends classified as ordinary income results in a savings of up to 14%! While not all investors are taxable and the comparison is not perfect, we believe any theory that REITs and the S&P 500 should be moving in opposite directions due to the tax reform bill is not supported by facts.
Warranted or not, the fact is that REITs have sold off significantly. While we cannot say whether the market has reached a bottom, we are able to present valuation statistics that can objectively be compared to history. It is a fact that REITs are the most inexpensive they have been relative to bonds, stocks, and private real estate in at least eight years. It is also a fact that REITs have produced double-digit total returns following the occurrences when REITs have flashed such ‘cheap’ signals. It is our belief that a REIT market trading at the valuations presented below would be at or near a bottom; however, what is warranted is not always what occurs.
Defined as the recurring cash flow available after paying for maintenance capital expenditures, AFFO is the REIT equivalent of net income for equities. Thus, the REIT ratio most comparable to a P/E (Price to Earnings) ratio for equities is P/AFFO (Price to AFFO). Over the past 10 years, REITs have traded at an average 5.6x premium to the S&P 500. We believe this is warranted due to the contractual nature of REIT cash flows, which makes REIT earnings more predictable and less volatile. However, as of February 23, the REIT AFFO multiple was 19.4x, while the S&P 500 multiple was 16.8x, resulting in a spread of 2.6x. Remarkably, August 2009 was the most recent period in which the spread was at such a low level.
While the spread of the REIT dividend yield to the US 10 yr Treasury yield is useful, there is an argument that investment grade bond yields are a better measure for REIT valuation. In fact, the correlation between the REIT dividend yield and the Moody’s Corp Baa Average Yield (Bloomberg: MOODCBAA) is 90% over the past 25 years, which compares to only 70% between the REIT dividend yield and the US 10 yr Treasury yield. During that period, the average REIT dividend yield was 5.4% and the average yield on the investment grade bond index was 6.6%, which results in a spread of -120 bps. However, as of February 23, 2018, the spread stood at +20 bps. Similar to the signal flashing with equities, the last time the spread was at such levels was November 2008, as shown in Figure 2.
Finally, in our opinion, the most practical valuation metric for REITs is Net Asset Value (or NAV). NAV measures the expected value if all of a REIT’s properties were sold on the private market at values estimated by using comparable transactions. While the dividend yield and earnings multiple spreads have to be compared to historical averages, NAV is anchored by concurrent transactions occurring on the private market that give a realistic ‘liquidation value’. REITs can trade at premiums or discounts to NAV based on the market’s perceived direction of values or risk.
However, REITs have traded at average 1% premium over the past 21 years. In contrast, as of February 23, REITs were trading at a 17% discount to NAV. As shown in Figure 3, this is the largest discount to NAV since February 2009. We believe that this discount is unsustainable as private investors will take advantage of the arbitrage opportunity between public and private valuations by selling assets and buying REITs, perhaps resulting in a wave of privatizations. Notably, there was over $28 billion of public REITs taken private in 2015 when the NAV discount approached double digits.
Similar to many other asset classes following the 2008-2009 period, REITs enjoyed a dramatic recovery from the Great Recession. However, REITs stood tall among most of them, producing an annualized total return of +16.8% from 2010 to 2014, which compared to +15.3% for the S&P 500.
Interestingly, one has to go back to 2003 to find another time before 2008 when the investment grade bond yield spread to the REIT dividend yield and the AFFO multiple spread to the S&P 500 P/E ratio was at the February 2018 levels. In similar fashion, REITs went on to produce excellent total returns. From 2003 to 2006, REITs (as measured by the FTSE/NAREIT All Equity REITs Index (Bloomberg: FNER)) produced an annualized total return of +21.9%, which compared to the S&P 500 at +14.6%.
Finally, REITs do not often have months where they are down 5% or more, and even less often have months where they underperform the S&P 500 by 800 bps or more. In the past 30 years, REITs have done very well in the 12 months following months where those occur, as shown in Figure 4. In addition, they have outperformed the S&P 500 in the 12 months following a month of such extreme underperformance.
By observing the rare periods in the past that show similarities to February 2018, we are trying to propose the most reasonable scenario to occur today. However, we can also project scenarios using variables implied by the prevailing negative market sentiment. For example, if the US 10 yr Treasury yield rose to 4.0% overnight from 2.9% on February 23 while maintaining the dividend yield spread of 190 bps, REIT prices would drop by 19%. At these prices, REITs would be trading at an AFFO multiple of 15.7x and an implied cap rate of 7.5%, both of which would be the most inexpensive since July 2009. The 20 year average REIT implied cap rate is 7.2%, and the 25 year average P/AFFO is 16.6x. In addition, the NAV discount would increase from 17% to a whopping 36%, the highest discount on record!
Over a longer time horizon, the projected REIT dividend growth could more than make up for the rising interest rates, despite the draconian assumptions. With REIT dividend payout ratios at all-time lows around 70% of cash flow, we feel confident that REITs can grow dividends by 4-5% per year for the foreseeable future through cash flow growth and increasing payout ratios toward historical averages. Looking out seven years, assuming 5% dividend growth and a US 10 yr Treasury yield of 4%, along with a 190 bps spread (resulting in a REIT dividend yield of 5.9%), the annualized total return would be +8%.
We believe the more likely scenario would be that the dividend yield spread would compress as interest rates actually do rise toward 4% and investors feel more certain that it won’t continue to rise. If the spread compresses back to the historical average of 120 bps after seven years, the annualized total return would be closer to +10%.
In our opinion, the current pricing of REITs assumes a draconian scenario only experienced in the two most recent recessions. Given the positive performance of equities, it’s not likely that the sellers of REITs are assuming a recession in the near future. In fact, we believe the strong economic growth will only fuel demand for REIT properties, creating an even stronger supply-demand environment for landlords.
While the pricing of properties can be influenced by factors such as interest rates, we believe that it is unwarranted for REITs to be trading at recession-like valuations at a time when they boast all-time high occupancy, positive rent growth, and a path to dividend growth of 4-5% per year. Unless a recession becomes more likely, we believe the current valuations have created an asymmetric opportunity where the upside to REIT prices is disproportionately higher than the downside.
The main catalyst to a recovery in REIT prices should come in the form of stability in interest rates. Unfortunately, we cannot predict when that will happen! Nevertheless, we believe that REITs, trading at bargain basement prices and offering an average dividend yield of almost 5% while employing historically low payout ratios, present an attractive entry point for long term investors.
Matthew R. Werner, CFA, firstname.lastname@example.org, (713) 243-3234
Bruce G. Garrison, CFA, email@example.com, (713) 243-3233
Blane T. Cheatham, firstname.lastname@example.org, (713) 243-3266
Parker Rhea, email@example.com, (713) 243-3211
RMS: 1770 (2.28.2018) vs 2000 (12.31.2017) vs. 346 (3.6.2009) and 1330 (2.7.2007)
Previous editions of the Chilton Capital REIT Outlook are available at www.chiltoncapital.com/reit-outlook.html.
An investment cannot be made directly in an index. The funds consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use.
The information contained herein should be considered to be current only as of the date indicated, and we do not undertake any obligation to update the information contained herein in light of later circumstances or events. This publication may contain forward looking statements and projections that are based on the current beliefs and assumptions of Chilton Capital Management and on information currently available that we believe to be reasonable, however, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements. This communication is provided for informational purposes only and does not constitute an offer or a solicitation to buy, hold, or sell an interest in any Chilton investment or any other security.
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