Our conviction in the attractive risk-adjusted return for REITs is based on six key points. First, the lack of yield around the world and in most asset classes has made REITs and other yield alternatives a ‘hot’ asset class. In fact, in the year-to-date period ending July 31, REIT mutual funds and ETFs have experienced net inflows for the first time since 2014. Second, REITs are inexpensive compared to fixed income and equities. Third, REITs should be a beneficiary of the out-of-control fiscal stimulus actions ramping the reopening of the economy. The continued loose monetary policy should keep interest rates low, but could create above average inflation over the next few years. In our almost 50 years of investing in equity REITs, we have witnessed that real estate has offered a good hedge against inflation. Fourth, the rapid increase in construction costs should weigh on new construction, preventing any oversupply risk for the foreseeable future. Consequently, this should result in an attractive supply and demand dynamic for the near to intermediate term for virtually all property types. Fifth, predictability of above average dividend growth is near an all-time high. The extremely low payout ratios at a time will give REITs the flexibility to increase payouts while still retaining a significant amount of free cash flow. When coupled with cash flow growth that will be among the highest we have seen due to the economic recovery underway and the capture of deferred rent from 2020 (due to the shutdown), risk of dividend cuts is nearly zero, and many REITs will increase the dividend higher than historical averages just to maintain the current payout ratio. Sixth, the typical real estate cycle lasts seven years, and we are barely one year into this one.
As of July 31, 2021, the dividend yield on the MSCI US REIT Index was 2.9%. This compares to the Russell 1000 Value Index yield of 2.0%, the S&P 500 yield of 1.4%, the S&P Utilities Index yield of 3.2%, and the US Corporate BAA 10 yr Index yield of 3.2% (as shown in Figure 1). With a commitment to low interest rates by central banks across the globe, investors have become desperate for current income. Financial advisors and institutional asset allocators, and especially, retired individuals have had the difficult task to find suitable income substitutes given the lackluster yield environment today. As a result, REIT mutual funds and ETFs have had net inflows of approximately $7 billion after six consecutive years of net outflows. We estimate net outflows over the six-year period from 2015-2020 totaled over $56 billion, so $7 billion is a nice start but REITs have a long way to go just to get back to 2014 levels.
Despite the positive inflows in 2021, we are continually surprised by the almost universal rejection of equity REITs by many investment “think tanks” and pension fund consultants. From our experience, many of them recommend zero to only modest allocations to a sector that should be enjoying halcyon acceptance since it appears to us to offer the correct solution to a wide range of investors at the absolute right time. As a reminder for investors, US equity REITs now have a market capitalization above $1.4 trillion and own about $2 trillion of high-quality commercial real estate assets spread across multiple property types and geographies. Accordingly, equity REITs should prove more than adequate to fill that important income role, especially given the potential for rising interest rates that would likely generate negative returns for fixed income. The growing yield of REITs should provide protection should that scenario arise. Notably, our internal models suggest 6% or more in annual dividend growth for the next three years from the REIT composite holdings as of July 31, 2021.
Even though REITs are trading near cyclical high multiples, albeit on earnings in recovery mode from the 2020 recession, REITs present an attractive valuation relative to other asset classes such as fixed income and equities. We discussed the valuation versus fixed income in our February 2021 REIT Outlook, and the thesis remains intact. As of July 31, 2021, the spread between the REIT dividend yield and the US Corporate BAA 10 yr Index was -35 basis points (or bps), which compares to the historical average of -105 bps, as shown in Figure 2. Therefore, the REIT yield would have to fall by 70 bps to equal the historical average, which would result in a REIT price increase of 31%. As such, we highly recommend investors reduce fixed income and look at REITs instead.
Similarly, though REITs have outperformed the S&P 500 year to date, it is the first time since 2015 that this has happened. In fact, despite the 975 bps of outperformance in 2021, the S&P 500 still has outperformed REITs by 7,700 bps cumulatively since 2015, meaning that REITs have a lot more catching up to do (as shown in Figure 3).
REITs are trading at an AFFO (or adjusted funds from operations, the most conservative measure of REIT cash flow) multiple of 24.1x as of July 31, 2021, which compares to the S&P 500 earnings multiple of 21.3x. Since 2005, the average ratio between the two has been 1.4x, which compares to today’s ratio of 1.1x. Therefore, REIT prices could increase 27% (or the S&P 500 could decline 21%) to be in line with the historical average. As such, we recommend equity investors consider investing in REITs for relative value.
Historically, when the economy is in recovery mode, there is a ramp-up in new construction in anticipation of the growing demand. This cycle appears to be different, as the banks have been extremely disciplined on lending for speculative projects and inflation of construction costs has created a pause in new construction. Even in the ‘white hot’ property types such as industrial and multifamily, construction is only barely above the historical average and is still not able to meet demand. This most certainly will lead to a supply-demand imbalance across many property types and geographies.
As we wrote in our May 2021 REIT Outlook, we are experiencing inflation that the country has not seen in thirty years. Since that piece was published, the core personal consumption consumer price index (or Core PCE) has had year-over-year increases of +3.4% and +3.5% in May and June, respectively (as shown in Figure 4). This should not be a huge surprise given the actions of politicians and the Federal Reserve over the past year. Jerome Powell, the Chairman of the Federal Reserve, has been on record that inflation should be ‘transitory’, but several Fed voting members have recently moved up their timelines for the first interest rate hike.
If inflation continues, fixed income should prove among the worst places to be due to the ‘fixed’ nature of bond interest payments. Just looking at history, interest rates, which have essentially been falling for the past 40 years, have provided a tailwind for investors in fixed income. However, going forward, with rates at or near a current level where the real return (return net of inflation) is practically zero, the direction upward seems more likely. Equities, in contrast to fixed income, have the ability to increase cash flow as inflation can increase sales, which then should flow through to dividends. This sometimes is not the case however as costs of goods sold also tend to increase, which can hurt margins depending on the industry. Real estate, with high-profit margins, usually is able to maintain its margins in inflationary times, and thus can be one of the biggest beneficiaries. In addition, the increase in replacement costs, which includes land prices and construction costs, usually increases values on a lagged basis and ultimately flows through to higher rents.
The unprecedented pandemic of 2020 led to dividend cuts and suspensions unlike we had seen since 2008-2009. By our account, roughly 30% of participants took swift action to reduce or temporarily eliminate dividends. These REITs had tenants that were impacted by the nationwide shutdowns and not deemed ‘essential’ and therefore, could not collect rent. As we have mentioned often in our Chilton REIT Outlooks, equity REITs offer amazing diversification for investors due to the over 15 different property sectors that are not homogenous with respect to fundamental drivers. Many participants maintained dividends and a few REITs even increased dividends last year due to growth in earnings. As a result of these actions and the corresponding cash flow growth, dividend payout ratios now sit at 72% of adjusted funds from operations (or AFFO), a record low.
REITs that have reported second-quarter earnings as of July 31 are demonstrating excellent growth rates. Many have raised full-year guidance and have begun to increase dividends in a commensurate fashion. As of July 31, 96% of the REITs that had reported earnings beat consensus estimates for the quarter. The broad-based recovery in fundamentals is translating into improved occupancy and rent that will allow increasing cash flow over the next few years according to our estimates, which will either drive payout ratios down further OR more likely allow REITs to increase dividends at an above-average rate.
We want to remind our readers how important payout ratios are when using dividend yield for valuation purposes. For a true apples-to-apples comparison with historical averages, we have to adjust today’s dividend yield to the historical average. Thus, today’s 2.9% dividend yield would actually be 3.2% if REITs were paying out 79% of AFFO (the historical average) as dividends instead of the current payout ratio of 72%. The spread between the adjusted dividend yield of 3.% and the 10 yr Treasury yield of 1.2% equates to 200 bps, which compares to the historical average of 130 bps, indicating REITs are attractive relative to the 10 yr US Treasury. REIT prices would have to increase 32% for the spread were to compress to the historical average if the 10 yr US Treasury yield remained at its current level.
We understand that the massive total returns in the past fourteen months could be construed as a negative for prospective investors, especially those who missed out and have been on the sidelines. But, when one compares where REIT prices were in February 2020, before the Covid shutdowns, and today, REITs are up only 5.4% excluding dividends based upon the MSCI US REIT Price-Only Index. Accordingly, we believe this cycle is just getting started. We have reviewed all the previous cycles for the past 30 years coinciding with the modern REIT era and they all range from 7-11 years, implying there is considerable upside left for REIT investors today as we are only one year into the latest cycle.
Again for historical perspective, in the last 20 years ending in April 2021, equity REITs have produced an average total return of +13.4% versus the S&P 500 total return of +9.9% and also bested the Russell 2000 and Nasdaq Composite over the same period. We believe REIT investors who have enjoyed this excellent ride in the past year (or 20 years) should NOT be thinking about selling or trimming exposure. The next few years could prove to be strong, and importantly better than other alternatives such as equities and fixed income. Even worse, the decision to sell and go to cash could prove a huge mistake given the historically high inflation that we are currently experiencing, and are expecting to experience over the next few years.
Matthew R. Werner, CFA
Bruce G. Garrison, CFA
RMS: 2836 (7.31.2021) vs 2220 (12.31.2020) vs 346 (3.6.2009) and 1330 (2.7.2007)
Previous editions of the Chilton Capital REIT Outlook are available at www.chiltonreit.com/category/library/reit-outlook/.
An investment cannot be made directly in an index. The funds consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use.
The information contained herein should be considered to be current only as of the date indicated, and we do not undertake any obligation to update the information contained herein in light of later circumstances or events. This publication may contain forward looking statements and projections that are based on the current beliefs and assumptions of Chilton Capital Management and on information currently available that we believe to be reasonable, however, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements. This communication is provided for informational purposes only and does not constitute an offer or a solicitation to buy, hold, or sell an interest in any Chilton investment or any other security.
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