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Today, we believe REIT fundamentals remain generally healthy: occupancy is still in the low 90% range, supply is still muted overall, access to capital has been easy and cheap, and the economy is chugging along; REITs tend to be GDP-plus returning businesses. However, cap rates are near historical lows, higher interest rates will put upward pressure on cap rates, net operating income is showing signs of slowing, lending standards are beginning to tighten, and valuations still don’t appear (absolutely) cheap. (Though REIT yields are now up to 4.4%, which is still historically low but starting to get more interesting.)
One question we have is how REITs will perform in a rising rate environment. The global pursuit of yield we’ve seen over the last several years has muddied the REIT tactical-allocation decision for us, and put REITs in a “tougher to call” bucket. It’s our opinion that there have been recent periods where sharp runups in REIT prices were not justified by the fundamentals and seemed to be driven more by their relatively higher yield in a period of low or negative global yields.
Looking ahead, it’s widely expected that interest rates could rise (perhaps meaningfully), and predicting how rate hikes will impact demand for REITs in the short term is hard to say. When looking at past interest rate tightening cycles (most of which occurred before the financial crisis), we see that REITs have generated gains over the subsequent 12 months following the first hike. We’re not arguing that interest rates are the driver of REIT returns, but in today’s environment, our confidence in how REITs will perform is low. Will we have another 2013 (taper tantrum period) where REITs dramatically underperformed equities in the second half of the year as rates moved higher?
Tactical allocations to REITs (or any asset class) will rest largely on our opinion of the attractiveness of the asset class’s fundamentals and valuation relative to their funding source. In the case of REITs, that funding source is domestic equities. As you can see from the chart to the right, the performance of REITs relative to domestic equities (our funding source) can vary meaningfully over a short-term period. It’s not uncommon for REITs to underperform equities by 20 percentage points or more in a 12-month period.
The point of this commentary and chart is to provide context around the short-term performance disparity that can exist between REITs and stocks, and explain why our longer-term return estimates, in and of themselves, do not drive portfolio allocation decisions. The uncertainty around REITs’ short-term downside potential forces us to require an even larger margin of safety when considering a tactical allocation to the asset class.
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