Global Real Assets
A bi-weekly discussion of the recent commodity, REIT, and real asset markets and what it may mean for investors.
John LaForge, Head of Real Asset Strategy
The U.S. REIT Downgrade
- U.S. REIT fundamentals have started to soften (along with those of international REITs).
- We have reduced our U.S. REIT weighting to evenweight from overweight.
What it may mean for investors
- We recommend that investors realign their asset allocation to an evenweight position on U.S. REITs (Public Real Estate).
- For qualified investors, we recommend reallocating REIT proceeds to hedge funds, specifically private Relative Value (alternative investments). For others, we favor reallocating the proceeds to U.S. Intermediate-Term Taxable Fixed Income.
We downgraded the asset class, Public Real Estate, from overweight to evenweight, on a tactical basis (6-18 months). Public Real Estate is largely made up of U.S. REITs, which is why we will often refer to this change as, “the U.S. REIT downgrade.” This downgrade was highlighted in the September 22, 2016 Global Investment Strategy publication titled “Tactical Strategy Update” in which our investment strategy team also discussed where investors should allocate the REIT proceeds. In today’s Global Real Asset Strategy Report, we would like to review the U.S. REIT downgrade, so investors understand why we did what we did.
Since December 2015, we have been tactically overweight Public Real Estate (mainly through U.S. REITs). The move has worked well for diversified portfolios as U.S. REITs have been one of the best-performing asset classes in 2016. In recent weeks, however, performance has started to slip, and key technical levels have been breached. The weakening price action can be seen in Chart 1. Although we continue to recommend a strategic (10+ years) allocation to U.S. REITs, recent underperformance, key technical breaks, and softening fundamentals have led us to tactically (6-18 months) shift the asset class from an overweight position to evenweight (neutral). (We have been evenweight International Public Real Estate for some time.)
REIT Concern #1 (Charts 2 and 3) — Commercial Real Estate Price Gains Slowing
As for why performance has faded in recent weeks, it seems to be tied to talk about potential Federal Reserve (Fed) rate hikes. Higher-yielding segments of the market, REITs included, have had a rough past week or so. The recent weakness also may have been caused by the realization that fundamentals have been softening over the past year— something we noted in our August 11, 2016 Global Real Assets Report titled “REITs: Still Overweight—But We Have Concerns”. In the publication, we highlighted three specific fundamental fears: 1) slowing real-estate price gains, 2) tougher lending standards from banks and capital markets, and 3) real-estate insiders becoming more cautious on real-estate conditions. We will use Charts 2, 3, 4, and 5 to review these three fundamental REIT concerns.
Chart 2 highlights three different commercial real-estate price indices. The top clip shows price gains for the three indices, since 2001. The bottom clip highlights the year-to-year price changes in each index. Notice that the year-to-year price gains are still positive for each index, but gains are beginning to slow. We would not classify this angle as a clear REIT negative today, but it is enough of a growing worry where keeping a tactical REIT overweight becomes questionable.
Chart 3 connects real-estate prices to REIT prices. You can see why negative year-to-year real estate prices, should they happen, would make us more cautious on REITs. The blue line in the top clip is the main REIT price index we cover, the FTSE NAREIT All Equity REITs Index. The green line is a real-estate price index, the Green Street CPPI. The bottom clip shows the year-to-year changes for each. Notice that the two times (2001 and 2007) that year-to-year real estate returns dipped below zero, REIT returns followed into negative territory. If real-estate prices go negative year-over-year, REIT prices may very well follow.
REIT Concern #2 (Chart 4)—Banks and Capital Markets Tougher On Real Estate Financing
Chart 4 shows domestic bank lending standards (top clip), and demand for commercial real-estate loans (bottom clip). Numbers above zero in the top clip mean that domestic banks are tightening lending standards. Notice that lending standards in 2016 have tightened ominously —and to levels not seen since the 2008-2009 financial crisis. And the tightening has happened across multiple types of commercial real-estate loans (construction and development, multifamily, and collateralized).
The tightening of lending standards over the past few years has led to slower loan-demand growth (not necessarily negative), as it typically does. This can be seen in the bottom clip of Chart 4. Notice how the top and bottom clips in Chart 4 mirror one another. When lending standards are tightening (rising lines in top clip), loan-demand growth typically slows (falling lines in bottom clip), like today. And the opposite is commonly true—when lending standards are easing, loan-demand growth typically increases.
The bottom line with Chart 4 is that tougher lending standards may be playing a part in recent REIT price weakness. Not shown here, but also of concern to us, is the shrinking availability of debt and equity capital for commercial real-estate financing.
REIT Concern #3 (Chart 5)—Real Estate Insiders Losing Confidence in Real-Estate Conditions
Chart 5 shows investor sentiment around real-estate conditions. Polls from The Real Estate Roundtable reveal that real-estate insiders have been losing confidence in current (2nd clip) and future (3rd clip) real-estate conditions. In fact, sentiment readings have dropped to levels last seen during the 2008-2009 financial crisis.
Alternative investments, such as hedge funds, are not suitable for all investors. Any offer to purchase or sell a specific alternative investment product will be made by the product’s official offering documents. Investors could lose all or a substantial amount investing in these products.
Hedge Funds are only available to persons who are “accredited investors” or “qualified purchasers” within the meaning of U.S. securities laws. Hedge funds are not required to provide investors with periodic pricing or valuation and are not subject to the same regulatory requirements as mutual funds. An investment in a hedge fund involves the risks inherent in an investment in securities, as well as specific risks associated with limited liquidity, the use of leverage, short sales, options, futures, derivative instruments, investments in non-U.S. securities, “junk” bonds and illiquid investments.
The use of alternative investment strategies, such as Relative Value and Structured Credit, are speculative and involve a high degree of risk. These strategies may expose investors to risks such as short selling, leverage risk, counterparty risk, liquidity risk, volatility risk, and other significant risks. In addition, they engage in derivative transactions. Short selling involves the risk of potentially unlimited increase in the market value of the security sold short, which could result in potentially unlimited loss to a portfolio. In addition, taking short positions in securities is a form of leverage which may cause a portfolio to be more volatile. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks which may hurt performance. Leverage can magnify gains and losses in a portfolio. Structured credit strategies aim to generate returns via positions in the credit sensitive area of the fixed income markets. The strategy generally involves the purchase of corporate bonds with hedging of interest rate exposure. Such strategies involve taking advantage of mispriced credit exposure at certain points in the term structure of single name credits relative to other points in the same term structure. Positions may use, but are not limited to, traditional fixed income and credit securities, as well as other structured credit products and credit derivatives. Investments in fixed-income securities are subject to market, interest rate, credit/default, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and/or principal. This risk is heightened in lower rated bonds. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.
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.
An index is unmanaged and not available for direct investment.
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.
COSTAR Investment Grade CPPI: Index is based on observed changes in individual property prices. Price data are gathered and confirmed by CoStar researchers for commercial property sale transactions across the country. For each transaction, the most recent sales price is compared with the price from the previous sale of the same property. Investment Grade properties as a group consist of larger-sized, reasonable-quality properties that match the type most often purchased by institutional investors.
Green Street Commercial Property Price Index: Green Street’s publicly available index that estimates monthly changes in U.S. property values. The index provides a time series of unleveraged U.S. commercial property values that captures the prices at which commercial real estate transactions are being negotiated and contracted.
Moody’s/RCA: The Moody's/RCA Commercial Property Price Index is a transaction based index that measures property prices at a national level. The Moody's/RCA CPPI is based on repeat-sales (RS) 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 Roundtable Sentiment Index is a quarterly survey conducted by FPL Advisory Group on behalf of The Roundtable, it measures the views of CEOs, presidents, and other commercial real estate industry executives regarding current conditions and the future outlook on three topics: (1) overall real estate conditions, (2) access to capital markets, and (3) real estate asset pricing.
S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.
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