Real Asset Strategy

Timely discussion of the recent commodity, REIT, and real asset markets and what it may mean for investors.

July 20, 2017

John LaForge, Head of Real Asset Strategy

REITs—Still Overweight, But We Have Concerns

  • REIT fundamentals remain intact, but technicals look concerning.

What it may mean for investors

  • We remain overweight REITs. If key technical levels are breached, however, we may have to remove the overweight.

As we noted in this week’s Investment Strategy report, WFII is tactically (6-18 months) overweight Real Estate Investment Trusts (REITs) in 2017. (For more detail on our overweight, please see our Global Real Assets Reports titled, “REIT Values Look Appealing to Start 2017” (February 16, 2017), and “Five Reasons Why We Like REITs” (May 3, 2017).)

So far in 2017, the main global REIT index that WFII follows (FTSE EPRA/NAREIT Developed Index) has gained 5.9 percent. While this is not bad, there are other assets (stocks in particular) that have performed better. While we are not panicked by the lackluster relative performance, some concerns have us questioning our overweight position. We’ll discuss these concerns, and some REIT positives, in today’s report.

REIT fundamentals still appear to be decent, so our concerns largely revolve around the technicals. The technicals, to be clear, are not horrible—they have not broken below key support levels. Yet, they do sit at critical junctures that must be watched. Technicals are an important perspective, because they tell us how an asset class “is” performing, versus fundamentals, which tell us how the asset “should be” performing. And importantly, technicals often lead fundamentals. When technicals breach key support levels, it signals to us that fundamentals likely will break down soon too.

Chart 1 shows two different technical REIT perspectives, which we are watching closely. The top panel highlights a main U.S. REIT index. The bottom panel shows the same U.S. REIT index versus a hypothetical model portfolio. Panel two is a gauge to see how REITs are performing versus other major assets in a general portfolio. The technical support levels that we are most concerned about are drawn in red. Should they both be broken, we likely will remove our overweight positioning.

Chart 1. Domestic REITs versus a Hypothetical Model PortfolioChart 1. Domestic REITs versus a Hypothetical Model PortfolioSources: Bloomberg, Wells Fargo Investment Institute. Daily Data: 1/2/2014 – 7/12/2017. Ratio is the FTSE NAREIT All Equity REITs Index (Total Return) divided by the hypothetical model portfolio. Model portfolio is constructed using static weights of the following indices: S&P 500 Index (Total Return) (18%), Russell Midcap Index (Total Return) (7%), FTSE EPRA/NAREIT Developed Index (Total Return) (3%), Russell 2000 Index (Total Return) (5%), Dow Jones Private Equity Index (Total Return_ (6%), RCA CPPI Composite National Index (5%), Bloomberg Barclays U.S. Aggregate 5-7 Year Bond Index (Total Return) (12%), Bloomberg Barclays U.S. Aggregate 10+ Year Bond Index (Total Return) (5%), Bloomberg Barclays U.S. Treasury Bills Index (Total Return) (3%), Bloomberg Barclays U.S. Corporate High Yield Index (Total Return) (6%), JPMorgan EMBI Global Index (Total Return) (6%), JPMorgan Non-U.S. Global GBI Hedged Index (2%), HFRI Relative Value (Total) Index (3%), HFRI Macro (Total) Index (3%), HFRI Equity Hedge (Total) Index(2%), HFRI Event-Driven (Total) Index (2%), MSCI Emerging Markets Index (Total Return) (4%), MSCI EAFE Developed Market Index( Total Return) (6%), Bloomberg Commodity Index (Total Return) (2%).

How We Got Here

Driving much of the jerky REIT behavior in 2017 has been a combination of choppy long-term interest rates and weak retail REITs. Retail REITs make up a decent chunk (about 20 percent) of the REIT marketplace. They also can sway how investors feel about REITs generally: because retail is a high profile area (it gets lots of press mentions). Retail REITs cater to (as you would guess) retail stores. And retail stores have been under pressure from the “Amazon Effect,” which is a kind way of saying that online shopping has been stealing sales from physical stores. The Amazon Effect is not new—as it has been going on for years—but it appears that the pace of online sales “stealing” sales from physical stores hit a critical point in investors’ minds in mid-2016.

This can be seen with the red line in Chart 2, which shows the performance of retail REITs versus the returns of other REITs. Notice how much ground retail REITs have ceded to other REITs since 2016.

Some Potential REIT Positives

So, is Chart 2 telling us that things are about to get better or worse for REITs in general? While we certainly don’t have a crystal ball, we’d lean toward “better.” There are two potential positives hidden in Chart 2. First, the red line has stopped going down—retail REITs have stopped falling versus other REITs, and look to be bouncing. Should this bounce continue in the coming months, we believe that investors will warm up to REITs as a family. The poor retail REIT performance, so far in 2017, has had a dampening effect on how investors feel about the REIT family. This could change should retail REITs start outperforming again.

The second potential positive in Chart 2 is the blue line, which represents retail stocks in the S&P 500 Index versus other stocks in the S&P 500 Index. The red and blue lines usually move in the same direction, which simply says that—as retail stocks go, so go retail REITs. But, in the last year, this has not been the case—retail REITs have performed much worse than retail stocks. The potential positive we take from this is that retail REITs may very well have overshot to the downside. Should retail REITs continue to bounce, as we’ve seen recently, we suspect that sentiment toward REITs as a family will get a lift.

Chart 2. Retail REITs’ Relative Strength versus Retail StocksChart 2. Retail REITs’ Relative Strength versus Retail StocksSources: Bloomberg, National Association of Real Estate Investment Trusts (NAREIT), FPL Advisory Group, Wells Fargo Investment Institute. Monthly data: 12/31/1993 - 6/30/2017. Ratio of Retail REITs/All REITs is the FTSE NAREIT Equity Retail Index divided by the FTSE NAREIT All Equity REITs Index; Ratio of Retail Stocks/S&P 500 is the S&P 500 Retail Index divided by the S&P 500 Index. Dates were selected to show all available data from the source.

Another angle that might help improve investor sentiment toward REITs is how real estate insiders feel. Chart 3 shows The Real Estate Roundtable polls, which track how real estate insiders feel about real estate conditions. While the mood is not as upbeat as it was a few years back, it is positive, and much better than what we witnessed throughout 2016.

Chart 3. Real Estate Sentiment IndexChart 3. Real Estate Sentiment IndexSources: Real Estate Roundtable, Wells Fargo Investment Institute. Quarterly Data: Q2 2008 - Q2 2017. Readings above 50 indicate sentiment is improving and readings below 50 indicate worsening sentiment.

REITs Have Typically Outperformed During Stock Declines

Lastly, we’d like to share with you another reason, albeit a quirky one, to think twice before bailing on REITs. Our equity team has been signaling to investors that domestic stocks appear due for a correction. Should this happen, we believe REITs likely will outperform U.S. stocks. REITs have both stock and bond characteristics, which has made REITs more defensive than stocks, during past stock declines. Table 1 shows REIT performance results during 5, 10, 15, and 20 percent declines in the S&P 500 Index. REITs routinely perform better than stocks during stock declines.

The bottom line today is that we remain overweight REITs. Key technical levels are quickly being approached, however, which has us a bit worried. Should these key levels be breached, we likely will have to remove our overweight positioning on REITs.

Table 1. REIT and S&P 500 Index Performance around S&P 500 Index DeclinesTable 1. REIT and S&P 500 Index Performance around S&P 500 Index DeclinesSources: Bloomberg, Ned Davis Research Group, Wells Fargo Investment Institute. Daily Data (monthly prior to 1999). Full date range analyzed: 12/31/1972 - 7/17/2017. Dates selected to analyze full range of available data as measured by the FTSE NAREIT All Equity REITs Index.

Risk Factors

All investing involves risk including the possible loss of principal.

There are special risks associated with an investment in real estate, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities. Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility.


Bloomberg Barclays U.S. Aggregate 5-7 Year Bond Index is unmanaged and is composed of the Bloomberg Barclays U.S. Government/Credit Index and the Bloomberg Barclays U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 5-7 years.

Bloomberg Barclays U.S. Aggregate 10+ Year Bond Index is unmanaged and is composed of the Bloomberg Barclays U.S. Government/Credit Index and the Bloomberg Barclays U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 10 years or more.

Bloomberg Barclays U.S. Treasury Bills Index is representative of money markets.

Bloomberg Barclays U.S. Corporate High Yield Index is a broad-based index that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS ABS, and CMBS.

Bloomberg Commodity Index is calculated on an excess return basis and reflects commodity futures price movements.

Dow Jones Private Equity Index tracks the performance of globally listed private equity stocks and is composed of the 25 largest and most liquid stocks of private equity companies listed on the world’s stock exchanges. Dow Jones Indexes is responsible for the selection of the index components, the index calculation, the ongoing maintenance and the index dissemination. To ensure that the Private Equity Index is always accurate and is calculated with the most up-to-date constituent data, the component data (i.e. number of shares, free float factor, weighting factor) of the Private Equity Index is reviewed on a quarterly basis. The resulting changes to the index are implemented after the closing on the third Friday in March, June, September, and December and are effective the next trading day.

FTSE EPRA/NAREIT Developed Index is designed to track the performance of listed real-estate companies and REITs in developed countries worldwide.

FTSE NAREIT All Equity REITs Index, a subset of the All REITs Index, is designed to track the performance of REITs representing equity interests in (as opposed to mortgages on) properties. It represents all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets, other than mortgages secured by real property that also meet minimum size and liquidity criteria.

FTSE NAREIT Equity Retail Index is a free float adjusted market cap weighted index that includes all tax qualified retail REITs listed in the NYSE, AMEX, and NASDAQ National Market. Total return accounts for dividends reinvested in the index.

J.P. Morgan Emerging Markets Bond Index (EMBI Global) currently covers 27 emerging market countries. Included in the EMBI Global are U.S. dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issues by sovereign and quasi-sovereign entities.

J.P. Morgan Non-U.S Global GBI Hedged Index is an unmanaged index market representative of the total return performance in U.S. dollars on an unhedged basis of major non-U.S. bond markets.

MSCI EAFE Developed Market Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.

>MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance markets.

RCA CPPI Composite National Index measures property price at a national level. It is based on repeat-sales transactions that occurred at any time up through the month prior to the current report. Because CPPI allows for backward revisions and incorporates any new data we receive subsequent to publishing, full history (from inception to current month) of future indices will reflect adjustments due to additional transaction data.

Real Estate Sentiment Index. The Real Estate Roundtable Sentiment Survey is the industry’s most comprehensive measure of leading real estate executives’ confidence in financial and real estate markets. The survey, conducted by FPL Advisory Group, captures the perspectives of senior real estate executives, including CEOs, presidents, board members, and other executives from a broad set of industry sectors including owners and asset managers, financial services firms and operators.

Russell Midcap Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represents approximately 25 percent of the total market capitalization of the Russell 1000 Index.

Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately eight percent of the total market capitalization of the Russell 3000 Index.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market.

S&P 500 Retail Index is a capitalization-weighted index of domestic equities traded on the New York Stock Exchange, American Stock Exchange and NASDAQ. The stocks in the Index are high-capitalization stocks representing a sector of the S&P 500.

HFRI Strategy Definitions

The HFRI Relative Value Arbitrage (Total) Index tracks funds that attempt to take advantage of relative pricing discrepancies between instruments including equities, debt, options and futures. Managers may use mathematical, fundamental, or technical analysis to determine misvaluations. Securities may be mispriced relative to the underlying security, related securities, groups of securities, or the overall market. Many funds use leverage and seek opportunities globally. Arbitrage strategies include dividend arbitrage, pairs trading, options arbitrage and yield curve trading.

The HFRI Macro (Total) Index tracks managers that trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets. Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top down and bottom up theses, quantitative and fundamental approaches and long and short term holding periods.

The HFRI Equity Hedge (Total) Index consists of a core holding of long equities hedged at all times with short sales of stocks and/or stock index options. Some managers maintain a substantial portion of assets within a hedged structure and commonly employ leverage. Where short sales are used, hedged assets may be comprised of an equal dollar value of long and short stock positions. Other variations use short sales unrelated to long holdings and/or puts on the S&P 500 index and put spreads. Conservative funds mitigate market risk by maintaining market exposure from zero to 100 percent. Aggressive funds may magnify market risk by exceeding 100 percent exposure and, in some instances, maintain a short exposure. In addition to equities, some funds may have limited assets invested in other types of securities.

HFRI Event Driven (Total) Index is also known as "corporate life cycle" investing. This involves investing in opportunities created by significant transactional events, such as spin-offs, mergers and acquisitions, bankruptcy reorganizations, recapitalizations and share buybacks. The portfolio of some Event-Driven managers may shift in majority weighting between Risk Arbitrage and Distressed Securities, while others may take a broader scope. Instruments include long and short common and preferred stocks, as well as debt securities and options. Leverage may be used by some managers. Fund managers may hedge against market risk by purchasing S&P put options or put option spreads.

An index is unmanaged and not available for direct investment.

Global Investment Strategy (“GIS”) is a division of Wells Fargo Investment Institute, Inc. (“WFII”). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company.

The information in this report was prepared by the GIS division of WFII. Opinions represent GIS’ opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

Additional information is available upon request. Past performance is not a guide to future performance. The material contained herein has been prepared from sources and data we believe to be reliable but we make no guarantee as to its accuracy or completeness. This material is published solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or investment product. Opinions and estimates are as of a certain date and subject to change without notice.

Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors.

Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company.

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