Dot-Com Take 2? Tech Stock Volatility Has Historically Pushed Investors To Undervalued REITs
Popular wisdom suggests REIT performance has lagged behind the broader stock market these past few years due to one primary factor: rising interest rates.
But not everyone is buying that story.
Nareit Senior Vice President of Research and Industry Information Brad Case said this past year’s sluggish REIT performance had little to do with investors’ irrational fear of rising rates, and a lot to do with investors’ hunger for major tech stocks.
REITs have been overlooked, Case said, though he believes investors will once again rally behind undervalued REITs for safety as they did after the dot-com boom.
“The market situation is one in which REITs have become undervalued, and the story behind that is that investors are concerned about increasing interest rates. I don’t think that story holds water,” Case said. “The story that seems to fit the facts better is that investors just didn’t have time to think about REITs because they were so focused on the bright lights in the tech sector. That’s where I think there is the first of several strong parallels with the late 1990s.”
The FTSE Nareit Equity REITs index closed out last year with 2.7% in compound annual total returns, compared to the S&P 500’s 14.38% in returns. Year-to-date, FTSE Nareit Equity REIT returns were a negative 2.8% as of May 31, compared to 2.02% in returns by the S&P 500.
Though publicly traded REIT stocks are still trailing the broader market year-to-date, on a month-to-month basis REITs are making a comeback.
“Rising interest rates indicate strong underlying economic fundamentals, which sets off a positive chain of events for real estate,” BDO Real Estate & Construction Practice National Leader Stuart Eisenberg said via email. “After investors’ initial knee-jerk worry over rising rates wears off, they’ll likely find REITs have weathered the interest rate storm. The bigger picture is that increased rents and occupancy rates might offset the steeper cost of financing and impact of rising capitalization rates on valuation brought about by higher interest rates.”
Will REITs Gain Favor In Another Dot-Com Bubble Burst?
U.S. equity markets and large tech stocks have experienced a lot of volatility this year.
Tech stocks, in particular companies that have a market cap of more than $10B, have experienced a flood of investment from buyers anxious to own shares in companies like Facebook, Apple, Amazon, Netflix and Google parent Alphabet — all of which are traded on the Nasdaq and account for a market cap of more than $3 trillion combined.
But a culmination of factors — rising interest rates, a heated political environment, trade war talks and concerns that corporate earnings and economic growth will soon peak — caused the massive pendulum of the Dow Jones Industrial Average to swing down 1,175 points in February and then up 600 points in March.
That volatility has persisted much of this year, with the Dow shedding nearly 400 points at the end of May. Though the market has had more up days than down this year, when it fell it fell hard. Single-day drops typically were about 20% larger than single-day gains, Bloomberg reports.
Case said this current volatility, coupled with the exorbitant value of tech shares, greatly resembles the late 1990s when investors were going crazy for tech stocks. Concerns regarding the inflated value of tech stocks compared to companies’ underlying earnings are growing, with some analysts and academics wary tech stock prices are more bloated now than they were prior to the dot-com bubble's burst.
“The early warning for the end of the tech bubble in the late 1990s was an increase in volatility among those large-cap growth stocks — volatility is a measure of uncertainty about what assets are worth,” Case said.
“You had stock prices at very high multiples to actual earnings [during the late 1990s], and that could only make sense if earnings continued to grow very strongly. They didn’t," he continued. "Investors were far too optimistic about earnings growth, and when they realized that, they got worried that maybe stock prices were too high, and after a while, that worry turned into selling behavior, and the bubble burst and over the next year REITs outperformed by 90%. That’s the situation that I think is fairly similar to where we are now.”
The FTSE Nareit All REITs Index rose 4.1% in June compared to the S&P 500’s gain of 0.6% during the same time period, according to data from Nareit. That was the fourth consecutive month REITs have outperformed the broader stock market, and the first week of July was more of the same.
“We have started to see it since the beginning of March. REITs have been performing better relative to the rest of the stock market,” Case said. “We’ve already seen the start of the process by which investors are starting to look elsewhere. They’ve been pulling themselves away from the large-cap growth stocks.”
The Misconception Of REITs And Rising Rates
In a recent “Perception Becomes Reality” report, Green Street Advisors also suggests the connection between REIT stock performance and rising interest rates is somewhat exaggerated. The firm writes it wasn’t until 2012 that REIT stocks became particularly sensitive to increases in the 10-Year Treasury yield.
When the 10-Year increases 100 basis points, REIT stocks tend to underperform by 1,400 basis points compared to the S&P 500, Green Street reports. However, the month after a sharp rise in interest rates, REIT shares tend to outperform the broader stock market by 400 basis points.
“The market’s overreaction to interest rate changes does little to dispel the notion that REITs have become highly interest-rate sensitive, but it does provide the basis for placing smarter interest-rate-based bets. The traditional approach, based on forecasts of future rates, is only as good as those forecasts, and the historical record of rate forecasters is so woeful that it is a game best avoided,” the report reads.
One trend that continues to persist in response to underperformance is REIT managers are selling properties in an effort to combat sluggish stock prices and to not have to sell shares at a discount. By offloading assets, REITs can free up capital needed to reposition their portfolios or even buy back shares to firm up stock prices. Mergers, acquisitions and privatization have also been trending up as of late.
REITs offloaded more properties than they acquired last year. In 2017, REITs sold $60.9B in assets and purchased $56B. Through the first three months of 2018, REITs acquired $5.38B and sold $6.91B, according to Nareit.
Also, to further insulate themselves from the effects of interest rates, REITs have restructured their balance sheets to become less exposed to debt by increasingly lowering their leverage and taking on more fixed-rate loans.
“REIT leverage right now is at about 32%, it’s about the lowest we’ve ever seen. And on top of that, more than 80% of their debt is fixed-rate debt — and guess what happens to the value of fixed-rate debt when market interest rates go up? The value of fixed-rate debt goes down,” Case said. “So, a major piece of the liability side of their balance sheet has actually declined in value — the companies are worth more because the debt they owe is worth less.”