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