To The Moon

The US REITs sector, which is a major component of US real estate, underperformed the S&P 500 Index and most of the major REIT markets we track in 2022. Using the MSCI US REIT Index as the benchmark, total returns in 2022 came in at -24.5%, versus -18.1% for the S&P 500 Index. The sector started 2023 on a positive note; as of 12 Jan 2023, total returns of 6.7% year-to-date (YTD) was registered, while the S&P 500 Index has seen total returns of 3.8% during the same period. We entered 2023 with an ‘underweight’ rating on the global real estate sector, with the US contributing a total weight of 65.1% to the MSCI ACWI Real Estate Index (as at 30 Dec 2022). Although operating metrics appear healthy for most of US REITs, there are still concerns over the high interest rate environment given prior aggressive Federal Reserve (Fed) rate hikes. This not only pressures dividends growth given the drag from higher borrowing costs, but also stymies inorganic growth opportunities such as acquisitions and development projects. Furthermore, the spike in US Treasury yields have also compressed dividend yield spreads to historically tight levels.

Although the US physical private commercial real estate sector continued to exhibit positive total returns overall in 3Q22, a sequential moderation was clearly seen, with the office sector showing clearer signs of cracks. Given that the Fed is likely not done with its rate hike cycle (although the peak is in sight) and there has not been sufficient price discovery in the real estate markets given challenges in the capital markets, we believe cap rates have further room to expand, which implies downward pressure on real estate valuation.

Based on data from the National Association of Real Estate Investment Trusts (Nareit), the quarterly funds from operations (FFO) (a commonly used metric to measure a REIT’s earnings) of all US equity REITs stood at USD19.9b in 3Q22. This was not only 14.9% year-on-year (YoY) higher as compared to 3Q21, but was well above pre-pandemic levels (+30.1% versus 3Q19 FFO of USD15.3b). Same-store net operating income (NOI) grew 7.1% YoY, which suggests that the operational performances of US REITs were keeping pace with inflation. Inorganic growth has slowed down, but not completely fallen off. Given rising recessionary risks on the horizon, we believe this would dampen the growth outlook of US REITs further, although there are some defensive elements to REITs’ cashflows. Notwithstanding the challenging macroeconomic outlook, we note that US real estate players have continued to step up their focus on ESG matters. An increasing number of US REITs are setting and disclosing their carbon targets and sustainability goals on the environmental aspect, and are also increasing disclosure around key social issues, according to data from Nareit.

The dividend yield spread between the MSCI US REIT Index and the US 10-year Treasury yield has narrowed to 57 basis points (bps), which is at relatively tight levels considering that this is 1.7 and 1.3 standard deviations below the 10-year and 5-year averages of 182bps (both the 10-year and 5-year average yield spreads happens to be 182bps). Current forward price-to-book (P/B) multiple of 2.07x is in-line with the 10-year mean of 2.04x, but there are risks of asset devaluation which would adversely impact the net asset values of US REITs.

Within the US real estate sector, we would position with the more defensive names given our house view that the US is expected to slip into a recession in 2H23, and we also do not expect the Fed to cut its benchmark rates in 2023 as core inflation is still likely to be well above its 2% target. In our screening of Morningstar’s coverage universe, we would give additional points to real estate players which are able to deliver stable FFO (for REITs), earnings (for real estate services companies and homebuilders) and dividends growth. The above stocks are decent buys to consider at the moment!

@TigerStars 

DYODD