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Video: Rate Reaction Opens a REIT Opportunity

 

Transcript

Tom Bohjalian: Despite a generally healthy real estate market, REITs have underperformed in recent years and have pulled back significantly at the start of 2018.

We believe there are several factors at play here.

First, REITs have been unusually sensitive to interest rates, coming off historically low levels.

Investors are also anticipating faster rate hikes in response to U.S. tax cuts, tight labor markets and rising inflation.

At the same time, REIT fundamentals are slowing, and that coupled with the fact that corporate tax cuts won’t directly benefit REIT earnings has put additional pressure on REIT shares.

But let’s step back and remember that interest rates are rising because the economy is improving, and that should translate to better real estate fundamentals, with a bit of a lag.

Interest rates could remain a factor for a period of time. However, compared with stocks, bonds and private real estate, we believe REITs look attractive on both an absolute and relative basis.

Consider that over the last five years, earnings multiples for stocks have expanded significantly while multiples for REITs have declined. 

Relative to bonds, the yield spread between REITs and the 10-year Treasury is wider than its historical average.

REITs are also trading more than 4% below the value of their underlying properties. That means investors gain access to real estate for less than what private investors will pay and they get the additional benefit of the company’s management operations. Historically, REITs have averaged roughly a 3% premium to their net asset value. 

Discounts are not a guarantee of future returns. However, we believe a stronger economy and a peak in supply could lead to some acceleration in fundamentals in the second half of the year.  

In this environment, we believe a reasonable framework for return expectations is roughly 9%, consisting of mid-single-digit cash flow growth plus a 4% dividend yield. REITs are also exhibiting strong diversification potential, with correlations to stocks at a 16-year low.

While we can’t know exactly when a bottom will occur, we believe the combination of low relative valuations and improving fundamentals says that this could be a good opportunity to begin legging into higher allocations.

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