Overlooked and undervalued REITs are positioned to outperform

From: Institutional Real Estate, Inc.
Date: January 19, 2018

Driven by investor demand for large-cap technology growth stocks, the S&P 500 delivered an exceptionally strong 21.83 percent total return in 2017, while the FTSE Nareit All REITs Index underperformed the broader market with its 9.72 percent total return. An analysis by Nareit Senior Vice President of Research and Industry Information Brad Case, however, argues that investors’ focus on large-cap tech stocks has left REITs overlooked and undervalued, and poised for outperformance in 2018.

Case’s analysis, included in a 2018 market outlook from Nareit, uses a valuation method based on comparing REIT dividend yields to the yields on other investments that, like REITs, provide strong and steady income streams, such as Baa-rated corporate bonds.

A surprisingly reliable predictor

“For nearly 30 years, there has been a remarkably consistent relationship—with a correlation of more than +90 percent—between equity REIT dividend yields and the market yields on Baa-rated corporate bonds,” Case said. “The spread between them has usually been between 80 and 180 basis points, and deviations from that normal spread have generally provided a reliable predictor for future performance.”

According to Case, when the yield spread has been in its normal range, REIT total returns over the next 12 months have averaged 13.44 percent and outpaced the broad stock market (measured by the Russell 3000) by an average of 2.53 percentage points.

When the yield spread was greater than 180 basis points—that is, when REIT dividend yields were extraordinarily low, reflecting REIT stock prices that were especially high relative to their current distributions—REIT performance over the next year tended to be weak, with total returns that averaged 6.98 percent and underperformed the broad stock market by 1.84 percentage points.

But when the yield spread was less than 80 basis points—when REIT dividend yields were extraordinarily high, reflecting REIT stock prices that were especially low relative to current distributions—REIT performance over the next year tended to be especially strong, with total returns that averaged 20.81 percent and outpaced the broad stock market by 5.67 percentage points.

“That’s exactly where we are today,” Case said. “At the beginning of the year, the REIT-Baa spread was extraordinarily small at just 29 basis points. If the historical relationship continues to hold, that points to REIT total returns of approximately 22 percent in 2018, outperforming the broad stock market by nearly seven percentage points.”

Economic and real estate market outlook are positive

Current macroeconomic and market conditions also point to the continued growth of the real estate economy in 2018, according to Nareit Senior Vice President of Research and Economic Analysis Calvin Schnure.

“My outlook on GDP is relatively optimistic, with more upside potential than downside risks,” Schnure said. “The typical issues that cause recessions—overbuilding, overheating, over-leveraging—are not present. Monetary and fiscal policy conditions are supportive of growth.”

In Nareit’s 2018 market outlook, Schnure provides his views on GDP and wage growth in the year ahead, as well as his outlook for inflation, the Federal Funds rate and long-term interest rates. He anticipates moderate upticks in all these metrics, which is representative of a period of continued economic expansion.

Regarding market fundamentals, Schnure noted, “Conditions in property markets are solid, with low vacancy rates, a rough balance between new supply and the demand for commercial space, continued rent growth and some acceleration in NOI growth.”