Baby Health in Winter
“Recover and Rebuild” was the theme of the real estate sector throughout the 2010s, and few could have imagined that many REITs may be facing a similar re-build in the early stages of 2020 amid the coronavirus crisis. While the majority of REITs enter this period of significant uncertainty on solid footing, many of the more highly-levered REITs in the most at-risk property sectors may not make it into 2021 after a historically violent sell-off that has been quicker than that seen during the financial crisis. In this report, we make some sense of the brutal price action seen over the last month which may reveal potential opportunities for patient investors looking to scoop up higher-quality REITs trading at historically large discounts.
Earlier this year, we published ‘Cheap REITs Stay Cheap‘ that analyzed the “factors” that exhibited persistent outperformance in the REIT sector over the past several decades. Key takeaways from this report included the observation that higher-yielding, higher-leveraged, and “inexpensive” REITs tended to produce inferior total returns over most measurement periods while lower-yielding, lower-levered, and more expensive REITs tended to outperform over time. These findings are broadly consistent with the theory that “growth” and “quality” have been persistently undervalued within the REIT space while “yield” has been persistently overvalued and underscores the critical importance of cost of capital for the underlying operations of the REIT.
While we had originally planned on revisiting and updating this analysis at the end of 2020, extraordinary times and extreme price action within the REIT sector warrants a mid-year check-up. For the commercial and residential real estate sectors, this time should be different relative to the struggles faced by the sector during the financial crisis based on underlying balance sheet fundamentals, but the market clearly thinks otherwise. The broad-based Commercial Real Estate ETF (VNQ) has plunged by more than 44% over the last month while single-family homebuilders (ITB) have dipped nearly 50% in moves that are more sharp and sudden than those seen during the financial crisis. The S&P 500, meanwhile, is lower by nearly 35% over the last month from recent highs back in February, the sharpest 30% drawdown in history.
There’s a reason that we dedicate so much time and resources to analyzing (and sharing) our property-level and macro-level sector fundamental analysis: property sector selection is the single most important determinant of performance in real estate investing, and this has been especially true amid the massive disruptions associated with the coronavirus crisis. Below, we present a framework for analyzing these property sectors based on their direct exposure to the anticipated CV-19 effects as well as their general sensitivity to a potential recession and impact from lower interest rates. Within the CV-19 sensitivity chart, we note that while most of the medium-to-high risk categories are shutdown-related, the healthcare and manufactured housing sector ranks higher on the risk chart due to potential health-related risks, as these sectors typically serve an older/elderly demographic group.
The performance of the diversified market-cap-weighted REIT index funds like VNQ, interestingly, significantly understates the pain felt by the “average” equity REIT. While the broad-based index is lower by 37% YTD, the median REIT among our universe of 150 equity REITs has experienced a decline of more than 46% so far in 2020, reflecting the “bigger is better” factor that we’ll discuss in more detail below. Seven of the eighteen REIT sectors are now lower by at least 50% YTD and fifteen individual REITs are lower by at least 70% in 2020. Besides Taubman Centers (TCO.PK), which surged following the announcement of the planned acquisition by Simon Property (SPG), all 150 REITs are lower by at least 10% so far in 2020. Among REIT sectors, the technology and residential sectors have been relative outperformers this year while the retail, lodging, and billboard REITs have been the worst performers.
This year’s dramatic plunge in REITs has effectively erased five years’ worth of total returns for the broad-based REIT average. On a ten-year cumulative total return basis, REITs have returned 6.4% per year, down from the 12.6% annualized return at the end of 2019. Shopping centers, regional malls, and lodging/resorts, meanwhile, are trading back to values last seen in 2010. At the real estate sector-level, three themes dominated the 2010s: 1) The Housing Shortage, 2) The Retail Apocalypse, and 3) The Internet Revolution. In the early stages of the 2020s, one theme has dominated: Coronavirus.
Sector selection, however, explains only part of the dramatic and violent moves over the last month. Our recent analysis, REITs: This Time Is Different, centered around a fundamental evaluation of the average REIT balance sheet, which had never been healthier than they were at the end of 2019. Owing to the harsh lessons learned during the financial crisis, most REITs have been exceedingly conservative with their balance sheet and strategic decisions in the post-recession period. With the scars still visible enough to be daily reminders of more dismal times, most REITs had been “preparing for winter” for the last decade, and entered 2020 with historically strong balance sheets across essentially every metric.
Debt as a percent of the market value of assets accounted for less than 32% of the average REIT’s capital stack, down from an average of roughly 45% in the pre-recession period. EBITDA coverage ratios ticked higher to over 5x entering 2020 compared to the sub-3x average in the pre-crisis period. Most REITs had obtained investment-grade bond ratings, enabling them to issue longer-term debt, limiting the exposure to short-term liquidity disruptions. Many of the largest REITs – particularly those in the residential, industrial, and technology sectors – are among the most well-capitalized REITs.
Unfortunately, not all REITs had been “preparing for winter” and the broad-based averages are not necessarily representative of the experience or portfolio characteristics of REIT investors that select individual REITs. We noted that pockets of stress would undoubtedly emerge if the COVID-19 outbreak intensified and lingered for longer than expected, which appears increasingly more likely given the past two weeks of data from around the world. Using official NAREIT data, we compiled and ranked the debt metrics of the most highly-levered companies based on data at the end of February before the dramatic plunge in the market value of many of these REITs.
We speculate that highly-levered REITs, particularly in the REIT sectors taking the most direct hits from the coronavirus-related shutdowns, will be in a fight for survival in the early stages of 2020 and that many may not survive to see 2021. As a result, these highly-levered REITs have been hit especially hard over the last month, consistent with our earlier finding that REITs that used higher leverage – as measured by NAREIT’s Debt Ratio – lagged over the past decade as balance sheet quality continues to be one of the more reliable outperforming factors. So far in 2020, REITs that were in the highest third in the debt ratio metric have plunged by an average of 52% compared to the 38% decline among REITs in the lowest-third of leverage.
Two other inter-related factors – dividend yields and market capitalization -have also been on full display at extreme levels amid the violent volatility related to the coronavirus shutdowns. Like the sirens from Homer’s Odyssey, the allure of high dividend yields has led many REIT investors astray over the past decade, and “yield chasers” have been punished especially hard over the last month. Splitting the universe of 150 equity REITs into thirds, our analysis indicates that the highest-yielding REITs at the start of 2020 have plunged more than 60% this year compared to the 32% decline among the lowest-yielding REITs and the 42.4% declines from the middle-third of REITs.
Roughly a dozen REITs have announced dividend suspensions or cuts over the last two weeks, primarily in the hotel and lodging sector. So far, Hersha Hospitality (HT), Diamondrock (DRH), RLJ Lodging (RLJ), Ryman Hospitality (RPH), Chatam (CLDT), Park Hotels (PK) have announced dividend cuts and it’s reasonable to assume that all of the hotel/lodging REITs will eventually follow suit. Outside that sector – besides a handful lower-productivity retail REITs including Macerich (MAC), Pennsylvania REIT (PEI), and Washington Prime (WPG), we think it’s too soon to assume that there will be widespread dividend cuts across the REIT sector. Removing the hotel REITs, we note that there are more than two dozen REITs currently paying dividend yields in excess of 15%.
Bigger has certainly been better in 2020, a slight departure from the trends that we observed over the last decade in which REITs in the “upper-midcap” tier have delivered the strongest relative performance. Performance this year, however, is consistent with the trends that small REITs have tended to stay small, which underscores the “access to capital” growth theory: REITs that are too small have more difficulty raising growth equity, but once they reach a certain threshold, the differences in access to capital between mega-cap REITs and larger mid-cap REITs is minimal. Small-cap REITs are lower by an average of 57% in 2020 compared to the 37.7% decline among large-cap REITs.
The market-cap “leaderboard” has been reshuffled considerably over the last month. Five of the seven largest REITs are now in the technology sector, led by cell towers REITs American Tower (AMT) and Crown Castle (CCI) as well as data center REITs Equinix (EQIX) and Digital Realty (DLR.PK). Mall REIT stalwart Simon Property Group dipped out of the top ten for the first time in more than two decades after losing nearly two-thirds of its market value over the last four weeks. Industrial REIT Prologis (PLD), self-storage REIT Public Storage (PSA), apartment REIT Equity Residential (EQR), and senior housing REIT Welltower (WELL) round out the top-10.
The factors that we outlined in Cheap REITs Stay Cheap have been on full-display amid the brutal price action within the REIT sector in early 2020. Consistent with the persistently “winning factors” exhibited by the REIT sector over the last decade discussed in the prior report, higher-yielding, higher-leveraged, and “inexpensive” REITs have plunged nearly twice as much as their lower-yielding, lower-leveraged, and more “expensive” counterparts.
While the majority of REITs enter this period of significant uncertainty on solid footing, many of the more highly-levered REITs in the most at-risk property sectors may not make it into 2021 after a historically violent sell-off that has been quicker than that seen during the financial crisis. Roughly a dozen REITs have announced dividend suspensions or cuts over the last two weeks, primarily in the hotel and lodging sector. We think it’s too soon to assume that there will be widespread dividend cuts across the REIT sector outside of the hotel and retail sectors and noted that there are now more than two dozen REITs currently paying dividend yields in excess of 15%.
While the allure of high yield REITs can be tempting, we stress that while there are no shortcuts in REIT investing, that one can indeed “tilt the playing field” in their favor by having the discipline to focus on high-quality names and long-term dividend growth. We’ve observed some clear “baby out with the bathwater” trends over the last two weeks, presenting opportunities to rotate or allocate incremental capital into higher-quality, lower-levered REITs in more resilient sectors such as the apartment, industrial, single-family rental, and manufactured housing sectors that should continue to have favorable supply/demand fundamentals when the dust settles.
If you enjoyed this report, be sure to “Follow” our page to stay up to date on the latest developments in the housing and commercial real estate sectors. For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Apartments, Homebuilders, Manufactured Housing, Student Housing, Single-Family Rentals, Cell Towers, Healthcare, Industrial, Data Center, Malls, Net Lease, Shopping Centers, Hotels, Billboards, Office, Storage, Timber, and Real Estate Crowdfunding.
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Disclosure: I am/we are long AMT, DLR, PLD, SPG, PSA, WELL, EQR, PK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: It is not possible to invest directly in an index. Index performance cited in this commentary does not reflect the performance of any fund or other account managed or serviced by Hoya Capital Real Estate. All commentary published by Hoya Capital Real Estate is available free of charge and is for informational purposes only and is not intended as investment advice. Data quoted represents past performance, which is no guarantee of future results. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy.
Hoya Capital Real Estate advises an ETF. In addition to the long positions listed above, Hoya Capital is long all components in the Hoya Capital Housing 100 Index. Real Estate and Housing Index definitions and holdings are available at HoyaCapital.com.
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