7.12.2023 Real estate has been a public market pariah thanks to the Fed and inflation. The benchmark 10-year Treasury yield surged more than three percentage points last year in response to the worst inflation environment since the 1980s. Since March 2022, when the Fed embarked on its tightening program, REITs suffered their worst downdraft since the financial crisis, plunging more than 25 percent through June of this year. Is the selloff overdone? Let’s take a closer look.
Cresset examines several factors when evaluating asset class risks and opportunities. Primarily, we look at valuation – is the asset class is cheap or expensive by historical standards? We consider fundamentals – is the environment ripe for profits or are headwinds developing? And we also take into account momentum – is the asset class moving in the right direction? A favorable blend of valuation and momentum, if fundamentals are at least neutral, tends to be a recipe for success. We explore each of these factors in detail below.
Valuation: REITs look relatively cheap by historical standards. Their price-to-FFO (funds from operations) is currently situated below its 15-year median. History has shown that below-median valuations have led to above-median returns one year forward.
To demonstrate this, we divide price-to-FFO into four quartiles based on a 15-year history. Quartile 1 (cheapest) is below its 25th percentile; Quartile 2 is between its 25th and 50th percentiles; Quartile 3 is between its 50th and 75th percentiles; and Quartile 4 is above its 75th percentile (most expensive). The subsequent one-year average performance is striking.
Fundamentals: The impact of borrowing costs on real estate valuations means fundamentals for the sector remain challenging. The plunge we’ve witnessed in the sector has been consistent with the rise in the 10-year Treasury yield last year. The benchmark yield spiked by more than three percentage points in 2022, its most dramatic move in decades, leading to the worst calendar-year performance for REITs since the financial crisis. This year, REITs continue to take their cue from the 10-year yield, which appears to be vacillating sideways.
Banks, the biggest source of real estate financing, have lost more than $700 billion in deposits over the last 18 months. As a result, they are scaling back real estate lending and tightening their lending terms by requiring borrowers to post a greater share of equity against their loans.
Investors remain wary of real estate and have been liquidating their shares. Over the last 30 days, only two asset classes, high-yield bonds and REITs, suffered net redemptions. The number of shares outstanding in the largest REIT ETF has been cut in half since the beginning of 2022.
Momentum: REIT returns tend to be favorable when the Bloomberg REIT index trades above its 200-day moving average, particularly if valuations are favorable. As the chart below shows, momentum is improving – suggesting investors are discovering a cheap asset class.
Bottom Line: While interest rates and liquidity exert enormous influence on the asset class, REIT sectors are as varied as real estate itself and perform differently. As terrible as 2008 was for real estate, the self-storage sector, for example, gained ground that year. History has shown that the average calendar return differential between the best and worst REIT sectors is as high as 50 percentage points. This suggests there’s ample opportunity for sector and security selection through active management to add incremental value over the index.
REITs have been punished by higher interest rates and difficult lending conditions. The asset class has fallen more than 25 per cent from its March 2022 peak. Thanks to the banks, the fundamental backdrop remains challenged. Even though ETF investors continue to sell their publicly traded real estate holdings, momentum appears to have stabilized and is improving. Notwithstanding aggressive Fed policy, a breakout above its 200-day moving average could be the catalyst to add REIT exposure to our Growth strategy.