SCHH - Cap Rates Real Estate Prices And VNQ: What Investors Need To Know

2023-04-03 06:52:27 ET

Summary

• Skyrocketing inflation has led to sharply higher interest rates.
• Higher rates have important implications for investment markets and securities.
• A look as to how higher rates impact real estate, REITs, and VNQ follows.

Skyrocketing inflation has led the Fed to sharply raise rates, leading to higher interest rates and yields across investment markets and asset classes. Real estate has been something of an exception, with cap rates, an important industry-specific metric, increasing much less than average, and remaining below historical averages. Real estate does not look like a particularly compelling investment right now, at least not relative to other asset classes. As the Vanguard Real Estate ETF ( VNQ ) focuses on real estate, and owing to current industry weakness, I would not be investing in the fund at the present time.

Real Estate Prices and Cap Rates

Let's start with the basics.

Cap rates are a key real estate metric, measuring a property's expected profitability or yield. Specifically, cap rates are equal to a property's annual net operating income, or NOI, over its market value. For real estate properties and REITs, operating income mostly consists of rents, but assorted fees, development, and other assorted activities might play a smaller role too.

As an example, a property worth $10 million generating $0.3 million in NOI would have a cap rate of 3.0%. Property owners should expect around 3.0% in cash-flows from a property with these characteristics, equivalent to its cap rate.

Cap rates are important in the real estate industry, and are key to real estate investment, demand, and prices. Low cap rates mean low profits, which means low investor demand. Low prices should cause prices to go down, although real estate prices are somewhat sticky. Developers might forego development opportunities for projects with low cap rates too, for similar reasons. High cap rates have the opposite effect, with these leading to stronger investor and developer demand. Investors might bid up the price of properties or markets with particularly high cap rates, although much will depend on the peculiarities of each market, as well as broader economic conditions. Developers are much likelier to finance projects with high cap rates too, as high profits are always enticing.

Cap rates are similar, although not identical, to several other valuation and income metrics, including dividend yields, earnings yield, and cash-flow yields. Properties with 5.0% cap rates are not identical to bonds with 5.0% interest rates, but the metrics are similar enough for comparison purposes, within reason, and are sometimes used as such by industry participants. Real estate investors might forego properties with 5.0% cap rates if bonds yield 10.0%, probably not properties with 20.0% cap rates.

In most cases, property cap rates are significantly higher than the interest or yield offered by low-risk assets, as real estate is a comparatively risky industry. At the same time, cap rates tend to be moderately higher than non-investment grade bond yields, for the same reasons. Importantly, spreads are much narrower now than in the past, as interest rates on most bonds have significantly increased these past few months, while real estate cap rates have only moderately increased. Cap rates went tumbling down when rates were slashed in 2020, but have seen much more modest increases once rates started to trend upwards.

VNQ does not provide investors with a weighted average cap rate for the fund's holdings, but as a diversified REIT index fund, cap rates should (roughly) track those of the broader real estate industry. Looking at the fund's top holdings, cap rates seem broadly in-line with expectations, a bit higher than average due to several industrial REITs. By my calculations, Public Storage ( PSA ) has a particularly good cap rate of 13.3%, triple-checked to be sure.

The situation above is unlikely to last long: cap rates and bond rates are too far apart relative to their historical averages to be sustainable. Investors are loathe to buy properties with 6.1% cap rates when t-bills yield 4.2%, investment-grade bonds yield up to 5.9%, and high-yield bonds yield 8.4% . Spreads are likely to move to more sustainable levels, and most real estate investors seem to be expecting higher cap rates in the coming months.

Cap rates can increase in two ways. Before that, a reminder that cap rates are equal to a property's annual net operating income / property market value

Considering the above, higher cap rates can take the form of higher rents. Rents grew quite rapidly in 2022 , but have stalled, sometimes even decreased , these past few months.

Higher cap rates can also take the form of declining property prices. Prices have started to fall this year, with housing down around 3.0% , as are broader commercial real estate properties . The outlook for the rest of the year is negative , if not terribly bleak.

Declining real estate prices would be detrimental to most REIT balance sheets, financials, and investors, for obvious reasons. Importantly, we can already see some of the damage. As per Bloomberg, malls are seeing higher default rates , due to underlying industry weakness, higher financing rates, and lower property prices. Offices are starting to crack, for similar reasons, and as demand decreased due to work from home policies. Weak industries were hit first, for obvious reasons, but the broader real estate industry is not looking particularly healthy. Conditions could worsen, with many analysts expecting a wave of defaults in the coming months. REITs themselves are unlikely to be spared, with at least one, the Blackstone Real Estate Income Trust, suffering from liquidity and capital issues earlier in the year.

Low cap rates also have a negative impact on new real estate development, which somewhat hampers REIT growth prospects. Part of the impact is direct, as some REITs do development themselves, another part is more indirect, with reduced development leading to lower investment opportunities for REITs. Development is already trending downwards, with housing starts down since mid-2022.

VNQ invests in REITs, and so is strongly, negatively impacted by these trends.

VNQ's underlying holdings might see declining assets, from lower property prices. Revenues could decline too, if rents continue to trend downwards. Growth could stall, if development grounds to a halt.

In my opinion, economic and industry conditions could always change or improve, so the issues above might not necessarily be all that impactful. Nevertheless, the risks are definitely there, and there is a real possibility these lead to losses and underperformance moving forward.

Although higher rates do negatively impact most industries and companies, the effect is more pronounced in real estate. Google ( GOOG ) does not sell fewer ads because rates are higher, nor does Exxon ( XOM ) sell cheaper oil, but Prologis's ( PLD ) real estate assets might decline in price. Higher rates have a greater impact on real estate versus most other industries, which reduces the relative strength of said asset class. VNQ is a diversified REIT index fund, and so does not look like a compelling investment relative to its peers right now.

Conclusion

Spreads between real estate cap rates and bond yields have narrowed since late 2020. Narrow spreads could lead to lower rents and real estate prices moving forward, negatively impacting VNQ. As such, I would not be investing in the fund at the present time.

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