Record-high stock markets, near record-low credit spreads and continued low interest rates (despite the recent Fed hikes) leave investors little room to generate outsized returns via beta exposure to the related asset classes. But the current risk-on environment has left one asset class behind: real estate investment trusts (REITs). Total returns for the Dow Jones U.S. Select REIT Total Return Index are lagging the S&P 500 by nearly 1,100 basis points (bps) this year. The upshot? REIT valuations are looking attractive relative to other liquid financial assets.
Bottom-up alpha still rules the day, but beta is hard to ignore
PIMCO’s coupling of top-down macroeconomic views with deep bottom-up fundamental analysis supports our view that within REIT investing, the lion’s share of alpha generation comes from harvesting the significant dispersion of returns across the REIT universe. Over the past 23 years, the dispersion of returns between the top and bottom quartiles has been 2,900 bps by sector and 4,300 bps by company. Accordingly, we view active security and sector selection within a risk-adjusted framework as paramount. However, given the sector’s significant underperformance in 2017, we view REIT beta as attractive at current levels relative to U.S. real yields, equity risk and credit risk premiums.
Valuations: REITs versus bonds
One (of many) valuation metrics we use in our real return relative-valuation framework is a comparison of REIT pricing versus other liquid financial assets. At a high level, REITs are basically long-term real assets: They own commercial properties that collect long-term streams of rental payments, and their prices generally rise with inflation. Looking at the private transaction market, the expected unlevered return on a typical U.S. commercial real estate (CRE) asset owned by public REITs is roughly 6% today based on Green Street Advisors data, or about 130 bps above the yield on a basket of investment grade and high yield bonds, compared with the 105-bp historical average (as measured by an equally weighted allocation to the Moody’s Corporate Baa Bond Index and the Bank of America Merrill Lynch High Yield Index). This indicates that while capitalization rates are low on an absolute basis (i.e., asset values are at or near record highs), U.S. CRE valuations still look reasonably attractive versus bonds. What does this mean for public REITs? While there are variances by sector, REITs in aggregate currently trade near parity to net asset value (NAV), based on consensus estimates. So all told, the public markets expect generally stable pricing on REITs’ underlying assets over the next year or so.
REIT real yields: more than the sum of their parts
Another way to look at expected yields on REITs is as a function of the real yield available in other financial assets, which can be benchmarked by Treasury Inflation-Protected Securities (TIPS), plus a credit spread and an equity risk premium. The chart below shows the results of this valuation approach. When the adjusted funds from operations (AFFO) yield on REITs is materially above the sum of these three components, we view REITs as undervalued relative to broader financial markets. (U.S. readers can learn more about how we value REITs in “Finding a Real Return With REITs”). Over the past 20 years, for every 10 bps of “cheapness” or “richness” in this model, subsequent REIT returns over the next 12 months have been 180 bps higher and 70 bps lower, respectively, all else equal. The current spread of roughly 80 bps is solidly above the 15-bp long-term average, and with the exception of the 2008-2009 financial crisis, is near the widest level since June 2004 – at which point REITs returned 35% over the next 12 months, outperforming the S&P 500 by more than 2,500 bps.
We think a big chunk of REITs’ underperformance in 2017 owes to the languishing retail REIT sector. (Although retail real estate in desirable locations likely isn’t going anywhere, it will indeed evolve faster than in the past (away from apparel and toward entertainment, food and experiential spaces) – resulting in higher-than-historical redevelopment cap-ex and thereby creating both winners and losers. But this is a topic for another day!) A risk-on environment turbocharged by U.S. tax reform expectations is another key contributor. So while active REIT alpha is still key, we think when analyzing REITs in a real asset framework, the current risk/reward for REIT beta is looking favorable.
For PIMCO’s views on inflation and its investment impact in the U.S. and globally, please visit our inflation page.
Ray Huang is a PIMCO credit analyst focused on REITs and hotel companies, and Nicholas Johnson is a PIMCO portfolio manager focused on real assets. Both are contributors to the PIMCO Blog.