We received a request to discuss our view on U.S. REITs, so we thought we would dedicate this week’s commentary to that very topic.
Now, before we start, it should be said that as a rules-based, quantitative firm, our individual views as portfolio managers are trumped by what our models dictate. Our models are designed to react to changes in the market environment: how our portfolios are positioned in the future will ultimately be dictated by the changes in market currents that our models identify as significant, emerging trends.
Nevertheless, one of our roles as portfolio managers is to constantly be thinking about risks and considering conditions that are historically unprecedented to determine if there are latent risks lurking within our portfolios. What can go wrong? is the question we frequently ask ourselves.
Let’s start with the basics: what are REITs?
Real Estate Investment Trusts – or “REITs” – are securities that sell like a stock on a major exchange but invest in real estate directly, either through properties or mortgages. There are two major types of REIT businesses:
Equity REITs invest in and own property directly and revenue principally comes from rent.
Mortgage REITs deal in mortgages (either through loaning money, purchasing mortgages, or purchasing mortgage-backed securities) making their revenue interest-driven. So why would someone invest in a REIT?
The first reason is thematic: people want exposure to real estate as an asset class or want to diversify their existing real estate exposure.
The second reason is economic: evidence suggests that real estate, and REITs, serve as an excellent hedge to inflation.
The third reason is outcome oriented: since REITs are seldom taxed at the trust level and are required to pay out 90% of their income as dividends, they typically offer a high yield than traditional equities, making them favorable as an income generating exposure. This is how we utilize REITs at Newfound.
One thing to take careful note of: by being forced to distribute 90% of their income, REITs often have to take on debt to expand.
Therefore, equity REITs tend to finance property purchases and development with debt – particularly long-dated debt. Generally speaking, this means the biggest risks to equity REITs are:
Real estate valuations
Increased cost of borrowing
Mortgage REITs, generally speaking, are going to borrow money at short-term rates and lend at long-term rates. Therefore, the biggest risks to mortgage REITs are:
Mortgage prepayment risk
Mortgage default risk
Increased cost of borrowing
Interest rate risk
As we can see, both types of REITs are sensitive to economic growth expectations as well as interest rates.
Since both are borrowers – all else held equal – “rising rates” are bad for both types of REITs.
As long-dated rates rise, future financing for equity REITs becomes more expensive, meaning future profits will decrease. Furthermore, as Treasury yields increase, the dividend yield of equity REITs becomes less attractive from a risk-adjusted stand-point.
For mortgage REITs, as rates rise, the cost of financing goes up as well. Furthermore, the mortgages held in their portfolio will lose value on a mark-to-market basis.
The problem with such broad analysis is that the “yield curve” is actually made up of several unique rates. When people speak of a rising rate environment, they mean the federal funds rate. Typically, this gets generalized to the entire yield curve – but it need not be the case. From 3/2004 to 12/2004, short-rates rose over one-hundred basis points while long-rates did nothing.
So how the yield curve evolves in a rising rate environment, and what the economic conditions are of that rising rate environment, will ultimately determine how both types of REITs perform. Trying to predict exactly those conditions is an exercise in folly, in our opinion.
At Newfound, we utilize equity REITs and mortgage REITs within our Multi-Asset Income portfolio, so our view on REITs is primarily driven by an objective of generating strong risk-adjusted income.
Currently, momentum remains positive for both types of REITs (we utilize VNQ and REM as the ETFs to implement our positions). Our model has identified that both, however, are less than a 1 standard deviation move from turning negative (it should be noted that a standard deviation move for equity REITs is currently about twice as large as a standard deviation move for mortgage REITs). Therefore, while we remain invested in these asset classes today, a rapidly rising rate environment, without offsetting economic growth to bolster revenues, could lead to their removal from the portfolio.
In measuring their relative attractiveness for a strong risk-adjusted income objective, our preference is strongly towards mortgage REITs at the moment, as their risk-adjusted yield is about 8.4x that of equity REITs. However, a portfolio driven more towards a growth outcome may have a preference towards equity REITs, as we expect them to be more sensitive to economic growth expectations.
For those considering investing in REITs, we would urge you to consider your objective and how REITs fit within a framework of reaching that objective. Higher yielding assets, while attractive, are often higher yielding because they are riskier. REITs, in particular, are sensitive to a variety of risk factors that have a very complicated relationship. For example, while rising rates may increase the cost of debt, it may also signal the return strong economic growth, which may increase revenue expectations. These factors are easy to rationalize in isolation, but rapidly becomes an overwhelming exercise when you have to consider the multitude of possible realizations.
Instead of trying to forecast both the probability and magnitude of each possible future event, we take a reactive approach to managing risk, waiting for the relationships between risk factors to play out in the price and utilizing momentum as our key indicator to take risk off the table. We believe this allows us to continue to participate in the benefits of holding REITs – including diversification, income, and growth – without being naked to the many unknown future environments that could be detrimental to such a position.
In Our Models
We rebalanced our Risk Managed Global Sectors portfolio this week.
Currently 9 of 11 sectors have positive signals, with materials, telecom and infrastructure turning positive in the last few weeks. The persistence of those positive signals led to the rebalance, increasing their allocations within the portfolio.
Energy remains negative despite its nearly 15% run-up in the last several weeks – which has been a large performance drag in our portfolio. Off the backdrop of five 10%+ swings in the last five months, our models identified the majority of this recent move as still being potentially market noise with the potential to revert. However, the continued re-test of the $34 level over the last several months has also led to consolidation of price levels in our momentum model. Combining those facts together, if price does not revert as it has in the past several months, we would expect a positive signal in our model.