Real Estate Investment Opportunities in a Rising Interest Rate Environment

 

The Challenges of REITs, Rising Interest Rates, and Inflation

Investment in real estate securities and real estate investment trusts (REITs) have been seen as a diversifying opportunity to a well-balanced portfolio and one that can generate income. REITs, given that they own or operate real estate assets and typically generate income, can offer benefits of both income and capital appreciation in a portfolio. However, despite the benefits, REITs can also be correlated to equity and fixed income markets, due to their exposure (and dependence) on both.

In particular, REITs can be highly sensitive to interest rate changes. It can be observed that, over the short-term, prices of REITs may be inversely correlated to interest rate yields [FIGURE 1].

REIT Blog


Diversification does not ensure profit or protect against loss in a positive or declining market.

P/NAV  is an industry standard metric that shows valuation levels in real estate. Correlation is a statistical measure of how two securities move in relation to each other.


Why is this? A few fundamental reasons:

  • Leverage. Many REITs are levered, and thus depend on debt to boost returns. As the cost of servicing the debt rises, the income generating potential is diminished.
  • Rising rates. More importantly, even REITs that have low leverage can still be affected by rising rates or inflation. This is because not only are bonds impacted by rising interest rates, but, in fact, all bond-like instruments are impacted. That is, any instrument with an up-front capital cost and fixed dividends with no adjustment for growth or inflation will see a drop in value in a rising rate environment. Real estate fits this category very well, as the cost of properties is typically paid up front, and although lease amounts can be adjusted, the landlord’s ability to adjust the rent is proportional to lease length, which may be several years long.
  • Higher yield requirement for risk. When interest rates rise, REIT investors also require a higher rate of return. Because there are additional risks in investing in REITs versus corporate bonds rated BBB- (which are the lowest investment grade tier, and typically used as a reference point for REITs), then REIT dividend yields must be higher to accommodate for this risk premium. Since the REIT yield cannot be adjusted upwards, the REIT price thus adjusts downwards to create a higher dividend yield.1

Because of a combination of these reasons, REITs can be hit in a rising interest rate or inflationary environment.

Can any REIT lessen the impact?

So how does one find opportunities in the REIT space that mitigate the effects of interest rates or inflation? We believe that AACA’s real estate strategy seeks such investment opportunity. Broadly speaking, AACA’s investment philosophy is centered on seeking investments where the landlord has leverage over tenants. This leverage manifests itself via more favorable lease terms for the landlord, and such investments by their nature have fewer of the characteristics previously mentioned.

Real estate companies that AACA seeks to buy have adjustments for inflation and should be less impacted by rising rates. For example, the largest cell phone tower company, which leases its network to mobile phone companies, has clauses in their contracts that adjust the lease amount by either 3% or an inflation index. As inflation in the U.S. has consistently been at or below 3% for the last 10 years, this company has benefitted from the higher 3% rent escalation. If inflation exceeds 3%, we believe that they will be protected, nonetheless.2

There are real estate companies that either reinvest a portion of their income, are growing faster than the economy and their cost of debt, or both. For example, the sole public property company that leases laboratory space to pharmaceutical companies has experienced same store net operating income growth of 5% per year for the past 10 years.3


Past performance is not indicative of future results. There is no guarantee that any investment will achieve its objectives, generate profits or avoid losses.

1 Dividend yield is only one component of REIT returns, along with the dividend growth rate and capital appreciation. In this example, we use them interchangeably as the yield is a large component of returns. 2 Source: Public company filings. 3 Source: SNL Financial.


AACA’s real estate investment strategy

Thus, AACA’s investment strategy is to be both better insulated from the impact of rising rates, and to demonstrate other characteristics beneficial to generating investor returns. More specifically, AACA seeks real estate investments with several unique, growth-oriented characteristics:

Monopolistic characteristics. For example, there are only three companies that have cellular tower networks. Competition is light in this subsector, especially when compared to the residential leasing subsector, which has hundreds of residential apartment providers.

Barriers to participant entry. A cell tower start-up would need to have the infrastructure, capital, and technological know-how to build 60,000 new cellular towers. By contrast, most anyone with a pick-up truck and an easily obtainable construction license can build apartments in Texas.

Barriers to tenant exit. The largest wireless phone provider has a strong marketing campaign based on the strength and reliability of their network. We believe that they are unlikely to switch tower providers for marginal lease savings, especially if it puts their reliability (and reputation) at risk.

Secular tailwinds/demand drivers. Consumers are voraciously data-hungry; Cisco recently did an analysis and estimated that data consumption in the US will increase 20% year-over-year for the next five years.4 Increasingly, consumers are using their mobile devices to consume this data, which subsequently increases demand for data centers. In contrast, residential apartments typically grow in the long term at about the US economic growth rate of 2%-3%.

In addition to those mentioned, there are multiple sub-sectors within real estate that meet most or all of these characteristics, such as infrastructure, gaming, and ski resort companies, that can help to lessen the effect of interest rate rises.


Past performance is not indicative of future results. There is no guarantee that any investment will achieve its objectives, generate profits or avoid losses.

4 Source: Cisco.


Overall, current prices in the real estate sector present an opportunity that has historically favored investors. A key metric, price/net asset value (or P/NAV), has historically shown marked cyclicality.

When P/NAV of the SNL Equity REIT Index has been low, subsequent returns have historically been positive [FIGURE 2].

 

REIT Blog 1

 

More specifically, the forward six-month returns of the REIT Index were positive 90% of the time during these discounted periods [FIGURE 3]. Alternatively, when P/NAV has been high, subsequent returns have been mixed—some have been positive (57% of the time), while others were negative (43% of the time).

Capture

 

Although this is no guarantee of future performance, all else being equal, we believe it to be prudent to invest in REITs when they are trading at a discount P/NAV.

Opportunistic Real Estate

The unique, growth-oriented and inflation-protected characteristics of real estate investments exhibiting the qualities discussed above may prove to be useful in a rising rate environment. Furthermore, the current discount within the real estate sector has proven beneficial in the past to investors who have purchased at these lower P/NAV valuations.


Index Descriptions

SNL Equity REIT Index. A market capitalization-weighted index that included all U.S. domiciled publicly traded (NYSE, NYSE MKT, NASDAQ, OTC) Equity REITs in SNL’s coverage universe.

KEY RISKS: Stock market risk—stock prices may decline; Industry risk—adverse real estate conditions may cause declines; Interest rate risk—prices may decline if rates rise.

 


 

 

Burl East on Special Edition of STA Money Hour

Burl East, CFA, Chief Executive Officer of American Assets Capital Advisers, was interviewed on a special edition of STA Money Hour. Mr. East talks about the current outlook on real estate in general and where AACA sees value and risks. Mr. East also talks about his current “long-short” real estate securities strategy. If you are interested in real estate as an investment, this interview will be well worth your time.

Click here to listen now.

 

Burl East on Strategic Investor Radio

Burl East, CFA, Chief Executive Officer of American Assets Capital Advisers, speaks on Strategic Investor Radio with Charley Wright. Mr. East discusses AACA’s unique long short strategy focused on companies believed to have monopolistic pricing models, barriers to exit for the tenant, limited new suppliers, and other key indicators.

Click here to listen now.

Burl East on a Special Edition of STA Money Hour

Burl East, CFA, Chief Executive Officer of American Assets Capital Advisers, was interviewed on a special edition of STA Money Hour by Michael Smith and Luke Patterson. Mr. East talks about the current outlook on real estate in general and where AACA sees value and risks. Mr. East also talks about his current “long-short” real estate securities fund that he subadvises for Altegris Advisors, LLC. If you are interested in real estate as an investment, this interview will be well worth your time.

 

Click here to listen now.

 

AACA fund named Best 40 Act Equity Fund* at the 2016 U.S. Hedge Fund Performance Awards.

American Assets Capital Advisers, LLC (“AACA), is proud to announce that the real estate focused 40 Act fund AACA manages was named the Best 40 Act Equity Fund at the 2016 U.S. Hedge Fund Performance Awards. Presented by HFM, a leading publisher dedicated to the hedge fund market, the U.S. Hedge Fund Performance Awards recognize funds that have outperformed their peers over the past 12 months.  For more information please see the official press release here.

 

*A panel of judges comprised of independent industry professionals, appointed by HFM, determined the winners based on a combination of quantitative and qualitative data. For additional information, visit the following link.

REITs vs. Your Home

Many people don’t have an investment allocation to real estate investment trusts (“REITs”) because they believe they already have “enough” exposure to “real estate” through ownership of their home. REITs and your home are very different asset classes with very different characteristics. REITs invest primarily in commercial real estate, which is any non-residential property used for commercial profit-making purposes. Your home is an investment in residential real estate, which is a type of property, containing either a single-family or multifamily structure, which is available for occupation and non-business purposes.

Performance

Over the past 20 years publicly-traded REITs have returned an annualized 11.23% total return and homes have returned 3.47%, or just a little more than inflation. Over these 20 years, REITs returned more than 7x (740%) while homes didn’t quite double (98%). Publicly-traded REITs have been one of the top performing asset classes and homes have been one of the worst over the past 20 years.

fig1_reits_vs_homes_08-2016There are many differences between REITs and your home that contribute to this notable difference in performance. The largest contributor is that commercial real estate can generate positive cash flows but the residential home you live in cannot. By living in your home, you are effectively consuming the market rate rent that your home might have procured. If you forgo rent, as you do by living in your home, the return profile changes to be basically little more than an inflation hedge. Performance of real estate follows the following formula: Total Return = price change + rent collected

fig2_tbl-reitvshome_080116

Diversification

With your home, 100% of the asset is in one property type and in one geographic market – this is concentration in its purist form, the opposite of diversification. On the other hand, with publicly-traded REITs, investors can choose from dozens of property types (including, but not limited to, specialized real estate sectors such as data centers, cell phone towers, casinos, medical research labs, infrastructure, prisons, ski areas, etc.) across any market in the U.S. and most major markets in the world. The opportunity for diversification in publicly-traded REITs vastly exceeds that of a single home.

Liquidity

Homes are relatively illiquid compared to public REITs that can be traded every day the stock market is open and settle to cash virtually immediately. This is in stark contrast to the home market, which may be illiquid for months, seasons, or even years, and can take months to settle to cash.

Transaction Costs

Transacting a home is much more costly than transacting in publicly-traded REITs. When you sell a home, the typical transaction cost is more than 6% of the home’s sale price (for perspective, based on data from the last 20 years as shown in the Total Return chart above, this is equal to about five years’ worth of your home’s price appreciation after inflation). In contrast, it costs little more than pocket change to trade shares of a public REIT ($7.95 per trade at Fidelity[1] and $4.95 per trade at Scottrade[2]).

Flexibility

Home ownership is not flexible. The entry price for a home is typically six-figures and you can’t really buy or sell a percentage of a home – it is binary: either you are in all the way or you are completely out. With publicly-traded REITs you can buy almost any amount you wish in single share increments (typically $20-$50/share) on the stock market. With public REITs you can trim, add or change a position in almost any amount on almost any day.

Supply & Demand

Perhaps the single most impactful factor that undermines home price appreciation is the ability of developers to add new product to the market. In our opinion, homes are the type of real estate most likely to be oversupplied because we believe they are the cheapest, smallest, quickest and least complicated real estate product type to build. AACA also believes that whenever the cost to build new homes is below the current market value of existing homes, builders will build new homes, which could create a price ceiling on the appreciation of your home. Additionally, in recessions, construction costs (materials and labor costs) decrease, which makes building new homes less expensive and creates additional new supply. This combination of factors could dampen your home’s price rebound out of a recession relative to public REITs, as shown in the historical graph below.

Volatility

Let’s look at volatility of publicly-traded REITs and homes. Below is a graph of the past 10 years, which includes the financial crisis. Since public REITs trade on the stock market, the share price of these REITs are subject to fluctuation in the stock market and as such experience volatility. However, we would argue the underlying physical real estate owned by the REITs can’t be much different in volatility than your physical home. The difference is that your home isn’t bought and sold every day and marked to that market price. That being said, in the graph below we see that homes sold off -32.81% and public REITs sold off -58.89% in the financial crisis. However, looking at a longer period of time, homes captured 56% of the downside and 8% of the upside of public REITs over the past 10 years – homes have been asymmetrical to the downside. And public REITs have since gone on to return 105.17% over the past 10 years while homes have returned 8.56% in that same time period.

fig3_reits_vs_homes_08-2016

Final Thoughts

We believe you should think of your home first and foremost as the place you and your family live and second as an inflation hedge for your invested principal – nothing more than that. You should not think of your home as an investment in real estate (as history shows there has been almost no meaningful return after inflation). Publicly-traded REITs and your home are very different asset classes with very different characteristics.

But what if I rent my home out?

But what if I buy a home and rent it out? That would be good, right? Sure, you will grab the warranted rent (assuming you can find a good renter), but you may also be the one grabbing a plunger to fix the toilet on Christmas Eve when your renter calls. Also, you still need a place to live so you will presumably either be buying or renting a home to live in. Additionally, it is probably unlikely that you can rent one house as efficiently as a public REIT that has professional leasing, revenue optimization software, economies of scale, expert experience, market knowledge and real-time industry data. Lastly, if you want to buy a home and rent it out, there are several publicly-traded REITs that do that.

 

This is a summary and does not constitute an offer to sell or a solicitation of any offer to buy or sell any securities or to participate in any investment strategy. This material is for information purposes only and its content should not be relied upon in making any investment decisions. The information provided is not a complete analysis of the market, industry, sector, or securities discussed. While the statements reflect the author’s good faith beliefs, assumptions and expectations, they are not intended as research and are not guarantees of future or actual performance. Furthermore, American Assets Capital Advisers, LLC (“AACA”) disclaims any obligation to publicly update or revise any statement to reflect changes in underlying assumptions or factors, or new information, data or methods, future events or other changes. This document may contain forward-looking statements that are based on current expectations, forecasts and assumptions that involve risks and uncertainties that could cause actual outcomes and results to differ materially.

[1] https://www.fidelity.com/trading/commissions-and-margin-rates?s_tnt=76947:8:0

[2] http://welcome.tradeking.com/scottrade-comparison/?engine=google&campaign=ckws+-+scottrade+-+phrase&adgroup=scottrade+-+phrase&network=g&device=c&model=&keyword=scottrade&matchtype=p&position=1t2&adid=112556498471&ADTRK=sgo+ckws+-+scottrade+-+phrase+-+scottrade+-+phrase&gclid=CjwKEAjw5cG8BRDQj_CNh9nwxTUSJAAHdX3fPoZt6xE0DtdNphAY9XH6vkU3v3Kz-Yvhl8TO8_aeGRoCNW_w_wcB

The Wave of Private Capital Behind Public REITs

Flush with record levels of cash, many private capital real estate managers are buying up publicly traded real estate investment trusts (“REITs”) to take advantage of the gap between public REITs and private real estate valuations. Historically, commercial real estate in the private market has usually transacted at, or near, fair value (or else the property doesn’t trade), while shares of REITs often trade at a discount or premium to their underlying net asset value (“NAV”) in the public markets. This is because REIT share prices fluctuate in the public stock market while the underlying real estate NAV remains relatively constant (in the same way private real estate’s NAVs do).

Most of the REITs recently acquired by private capital have been trading at a material discount price to NAV in the public market; however, when these discounted REITs are acquired, it is at a price closer to NAV. These REIT acquisitions have been readily agreed to because they can create value for the private capital (who may get institutional-quality real estate relatively quickly, easily, and less expensively) and for the REIT shareholders (who may get a nice return from the substantial share price increase from the pre-deal share price). This activity of private capital buying beat-up REITs can effectively create a put option for the holders of the publicly traded REITs – if the price drops enough, the REIT may be taken out closer to NAV, and certainly at a premium to the discounted pre-deal share price. In addition to creating a price floor for individual REITs, this buying activity can also create a supporting tailwind bid for the entire REIT asset class.

  • The current market cap of domestic public REITs is about $1 trillion[1]; the total value of underlying real estate assets is about $1.5 trillion, assuming 33% leverage, which is typical for public REITs[2].
  • As of 6/30/15, private real estate managers had a record $249 billion[3] in unspent capital commitments (this is equal to about 25% of the total public REIT market cap!). Private capital typically employs meaningfully greater levels of leverage than REITs do, which only further increases its REIT-buying power.
  • It is generally faster, easier, and less costly for private capital real estate managers to buy public REITs than private real estate.
    • Private capital can buy a large REIT portfolio in one bite. For example, Excel Trust was recently acquired by Blackstone for approximately $2 billion. The Excel Trust portfolio included 38 retail shopping center properties across 18 states. If Blackstone had to buy these properties in one-off transactions, they would have had to travel to every property, conduct their own data gathering and due diligence, review and audit financials and every lease contract, and successfully create and close potentially 38 separate deals with 38 different parties. It is much easier, faster and less expensive for Blackstone to buy an institutional quality portfolio, already equipped with GAAP accounting, lease abstracts, financial audits, and publicly available granular property level data, in one fell swoop. Not only are transactional costs less, but it may be getting it at an arguably cheaper price.
  • In the past year, a number of REITs have been purchased by private capital, including but not limited to the following list:

tbl_blog_reit_072816v2_sansstockcolumn

  • Investors sometimes pose the question, “Why buy the goods when you can buy the store?” In effect, private capital is answering that question by buying discounted REITs instead of individual properties. We expect this trend to continue as long as REITs trade at material discounts to their NAVs and as long as private capital is looking for ways to deploy nearly $250 billion in unspent capital commitments.

This is a summary and does not constitute an offer to sell or a solicitation of any offer to buy or sell any securities or to participate in any investment strategy. This material is for information purposes only and its content should not be relied upon in making any investment decisions.The information provided is not a complete analysis of the market, industry, sector, or securities discussed. While the statements reflect the author’s good faith beliefs, assumptions and expectations, they are not intended as research and are not guarantees of future or actual performance. Furthermore, American Assets Capital Advisers, LLC (“AACA”) disclaims any obligation to publicly update or revise any statement to reflect changes in underlying assumptions or factors, or new information, data or methods, future events or other changes. This document may contain forward-looking statements that are based on current expectations, forecasts and assumptions that involve risks and uncertainties that could cause actual outcomes and results to differ materially.

[1] https://www.reit.com/data-research/data/industry-snapshot

[2] https://www.reit.com/data-research/data/industry-snapshot

[3] http://www.pionline.com/article/20150907/PRINT/309079983/managers-snap-up-market-battered-reits