Real estate investment trusts (REITs) have seen a boom in demand since the financial crisis. These instruments have become bond proxies as investors look to their relatively secure real estate holdings to provide a level of income above that offered by investment-grade bonds.
There’s been a huge surge of money into REITs because of this trend. Indeed, since the financial crisis, the Dow Jones U.S. Residential REITs Index has risen by around 300%, a staggering return for property.
But the big question is, as interest rates start to go higher will investors flee REITs for other lower-risk opportunities?
Time to sell REITs?
Some concerns are starting to arise that this might indeed be the situation that is unfolding in front of us. REIT investors have become used to both a steady flow of income and capital gains in recent years. The capital gains have been driven by a rush of cash into the sector, and when capital gains start to slow, it could spark a domino effect causing investors to rush to withdraw their funds. Further declines would follow as a result.
There are many different sectors within the REIT industry, and some of these are better positioned to weather the storm than others although overall market sentiment cannot be avoided.
The self-storage REIT market could be one of the most dangerous. Perceived as being "recession-resistant" the number of companies operating within the self-storage industry has surged in recent years. Operators believe that during recessions people who lose their jobs and move into smaller apartments require self-storage facilities to store their possessions. At the same time, landlords can auction the possessions of nonpaying tenants off to recoup lost rent.
However, the self-storage market remains subject to all of the market forces just like any other market.
There has been a boom in self-storage unit construction in the U.S. from 240 units per annum in 2011 to more than 2,100 units at the end of 2016. Even though only 10% of U.S. households own a storage unit, rents started to decline across the U.S. last year. In Dallas, Boston and Denver they fell 4.6%, 2.6% and 4.3% in December. Horseman Global, the ultra-bearish hedge fund that spotted the financial crisis before it engulfed the world, believes that this is the one REIT sector that is more exposed to a downturn than any other. A combination of overcapacity and rising rates weigh on the sector.
Hedge funds bet against the sector
Horseman isn’t the only hedge fund betting against REITs. Old Kings Capital, run by two Columbia Business School alumni, is short REITs in certain sectors including a REIT with assets concentrated in retail malls and an office property REIT heavily concentrated in New York City. Both of these shorts are a play on cyclical and structural problems in the REIT industry.
The problem that the rally in REIT stocks since the financial crisis has caused is that many of these stocks are trading at extremely demanding valuations. Desperate for income, investors have bid the stocks up to record levels without considering the long-term fundamentals.
Two of the leading REIT tracker funds, the Vanguard REIT ETF (VNQ, Financial) and iShares U.S. Real Estate ETF (IYR, Financial) trade at price-book (P/B) ratios of 2.4 and 2.5, which indicates investors are willing to pay a premium of 150% to get their hands on the property contained within these financial instruments.
Overvalued
It’s difficult to argue that any REIT deserves to trade at such a premium. It’s even more surprising that these ETFs (neither of which are trading at a substantial premium to NAV) trade at such a high P/B ratio when some of the holdings are facing serious structural headwinds. For example, office rents in commercial centers like New York have been dramatically inflated by years of quantitative easing. Meanwhile, shopping malls are facing a bleak future as consumers continue to move online and as noted above, overcapacity in the self-storage market is weighing heavily on self-storage rents.
Overall then, REITs are facing numerous headwinds from several different directions but despite these negative fundamental factors, many REIT stocks still trade at a huge premium to asset value. This may not last for much longer.
Disclosure: The author owns no shares mentioned.
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