Real estate investment trusts have gotten absolutely crushed over the past three months and particularly since Donald Trump’s surprise victory in the 2016 presidential election. The perception is that Trump’s economic policy will blow out the budget deficit, fuel inflation and send bond yields higher. And as REITs have become proxies for bonds in the low-yield world of recent years, as go bonds, so go REITs.
That’s the consensus view, at any rate. I have my doubts. To start, surging budget deficits do not automatically lead to higher bond yields. If that were true, Japan would have the highest bond yields in the world. Instead, Japanese yields are essentially frozen at 0% and have been for years. Furthermore, the biggest peacetime deficits in history happened during the 2008-2009 meltdown… when bond yields plunged to lows no one dreamed possible before. And all of this depends on Trump getting his budget through a Tea-Party-controlled House of Representatives that ties its entire indentity to reducing the size of the government.
Nevertheless, REITs are taking it on the chin at the moment. This is the third time in four years that this has happened. The first and second, respectively, were after the 2013 Taper Tantrum and as Janet Yellen first raised the Fed Funds rate above zero this time last year. In both previous cases, REITs dropped about 20% in value before recovering to new highs. This time around, REITs are down by a comparable amount… might a repeat rally be in the cards?
I think it’s highly likely. I’ve argued for years that, even at their current low yields, REITs remain attractively priced relative to bonds and most other income investments. And Evercore ISI, writing for Barron’s, was kind enough to work out the numbers for us. Evercore ISI examines REIT prices relative to:
- price/net asset value (NAV)
- price/adjusted funds from operations (AFFO)
- implied cap rates versus 10-year Treasury yields and corporate bond yields
- a sensitivity analysis looking at upside/downside scenarios based on implied cap rates and spreads to the 10-year Treasury looking out one year from now.
These were their findings:
Price/NAV: Given the steady decline in REIT prices since early August, REITs are now trading at an 11% discount to our current NAV estimates and a 12% discount to our forward NAVs. This 11% discount is the widest we’ve seen since January 2014 (that’s nearly three years).
Price/AFFO: The sector is trading at 20.2 times AFFO on a forward-12 month basis which is two turns below the sector’s trailing three-year average but slightly less than four turns above the sector’s long-term average which is just shy of 16.5 times. However, when we adjust the AFFO multiple for the lower interest rate environment, a 20 times multiple doesn’t look out of place and in fact using historical spreads (AFFO yields minus 10-year Treasury yield) an AFFO multiple of 20 times would imply a 10-year Treasury yield of 2.65% which is 60 basis points above Wednesday’s closing yield.
Implied cap rates versus 10-year Treasury: The spread Wednesday versus 10-year Treasury yield is 370 basis points and is 53 basis points higher than the long-term average suggesting that REITs are modestly undervalued versus Treasuries or are fairly valued assuming the 10-year Treasury yield reaches 2.5% in the near to intermediate-term.
Implied cap rates versus BAA bond yields: The spread Wednesday is 127 basis point and is wider than the long-term average of 42 basis points and roughly double the spread experienced over the past 24 months. What’s interesting to note is that while the 10-year Treasury yield has backed up 55 basis points since June, the BBA bond yield is only up 10 basis points over the past four months implying that credit spreads have narrowed while the base rate has expanded.
While it’s helpful for investors to look at a snapshot of valuation metrics, we also wanted to provide a more dynamic implied cap analysis which allows two variables to move at the same time. In this exercise, we let Treasury yields and future net operating income (NOI) growth fluctuate within a range while keeping the “spread” constant at 311 basis points which is equal to the long-term average. If an investor assumes that the 10-year Treasury yield will approach say 2.75% in 12 months and the REIT sector could generate NOI growth of say 3% one year from now, then REITs should rise about 5% over the next year.
So in a nutshell, REITs are pretty reasonably priced right now. If you’re bearish, you’re essentially betting that the 10-year Treasury yield is going north of 3% within the next year or that earnings ar about to fall off a cliff. While I suppose either of those outcomes could happen, I wouldn’t bet on it. I would expect REITs to enjoy another solid rally… just as they did the last two times they sold off on yield fears.