CA - How The U.S. Government Shutdown Could Impact REITs

2023-09-30 08:00:00 ET

Summary

• The U.S. government appears headed for a shutdown.
• I look at four ways that this could disrupt the REIT sector.
• I also share my approach to REITs right now and share my top picks.

The U.S. Government appears headed for a shutdown. In this article, I discuss four potential ramifications that it might have on the REIT sector ( VNQ ) and then share how I am working to mitigate this risk in my portfolio.

Impact #1: Interest Rates

Perhaps the impact that investors are most concerned about is how a government shutdown might impact interest rates. One of the biggest ways it could potentially do this is by disrupting the release of key U.S. economic data (i.e., employment and inflation reports), making it harder for markets to judge where monetary policy and interest rates in particular may be headed next. As a result, investors and policymakers alike may have to rely on non-government data, potentially affecting Federal Reserve rate decisions.

As a result, it is very possible that - should the Federal Reserve lack sufficient data to get a firm read on where the economy and inflation are headed - may decide to err on the side of caution and hike interest rates again before the end of the year in order to make sure that inflation is not running too hot. On the other hand, the Fed may decide that caution is warranted in the other direction as well, and therefore may decide to maintain the status quo on interest rates until the shutdown gets resolved.

Additionally, Moody's has warned a government shutdown could prove to be a credit-negative event, which would likely cause long-term interest rates to rise. Given that REITs are general interest rate sensitive - as evidenced by their steep decline since interest rates began rising in 2022 - any scenario that may push interest rates higher would definitely be a negative catalyst for them:

Impact #2: Transaction Delays

Another major potential impact on REITs from a government shutdown is a disruption of some transactions. For example, oftentimes federal agencies are needed for regulatory approvals on matters pertaining to real estate transactions. During a government shutdown, these agencies will likely be either understaffed or even closed entirely. As a result, major commercial real estate transactions could potentially be delayed.

Another disruption could be to development projects, as there are times when government approvals are needed for development projects to move forward. This is particularly true when the development involves major public infrastructure that in some way involves the federal government.

Finally, the financing required for some real estate transactions depends on federal loans, subsidies, and/or grants. A government shutdown could delay or even prevent the disbursement of these funds.

The net effect of this on REITs is that it could lead to a slowing of growth rates for some REITs if the government shutdown were to last for an extended period of time.

Impact #3: A Blow To Investor & Consumer Confidence

Another potential major impact of a government shutdown on the REIT sector is that it could shake investor and consumer confidence, thereby hurting REIT share prices, access to capital, leasing demand, and even potentially the economic strength of REIT tenants. If the government is unable to function at its normal pace, many businesses - especially those who do business with the government - may become more cautious with their spending and investment decisions. This can have a second-hand impact on REITs by reducing demand for commercial real estate, thereby leading to reduced leasing activity and property values.

Moreover, commercial real estate investors may perceive government shutdowns as a sign of political instability or economic uncertainty, thereby reducing their appetite for long-term real estate investments. This could then lead to less debt and equity capital being made available to REITs.

These effects of these concerns - along with rising long-term interest rates - are already being seen in the broader market, with major indexes like the S&P 500 ( SPY ) and especially capital intensive subsectors like utilities ( XLU ) pulling back sharply in recent weeks:

As BlackRock's ( BLK ) CEO recently said of the potential shutdown:

Can you imagine you go to your bank and say I’m not paying my mortgage, I mean that is what we’re doing.It’s irrational from my vantage point, it’s wrong from my vantage point. It’s political and as we know in politics today that creates the fear and it’s scary.

Impact #4: Potential Positive Long-Term Impact

That said, a government shutdown may not be all bad for REITs. For example, while several of the cons of a shutdown are discussed in this article, a long-term benefit of the shutdown is that it could force the Congress to meaningfully slash its runaway deficit spending in order to make a deal to re-open the government, thereby blunting the rapid rise of long-term interest rates.

This is because when the government engages in deficit spending, it essentially means that it is spending more money than it collects in revenue. To cover this shortfall, the government must borrow money by issuing Treasury bonds ( GOVT ). As the government's borrowing needs increase, it competes with other borrowers, such as businesses and individuals, for available funds in the bond market, thereby putting upward pressure on interest rates by increasing the supply of debt in the market. This is of course very bad for REITs given that they are dependent on bond markets to finance their business models, so the more the government spends - and by extension borrows - the higher their cost of capital.

Moreover, even if the government goes the route of printing money - most often via the Federal Reserve buying their treasury bills on the open market - to finance their deficit spending, the long-term impact is typically higher inflation rates, which in turn puts pressure on the Federal Reserve to eventually raise interest rates and engage in quantitative tightening such as it is today. This in turn negatively impacts REIT valuations.

Given that massive treasury issuance to fund the deficit spending is one of the major factors that is driving up long-term interest rates right now, the eventual outcome of this shutdown - should it result in lower spending - could actually be a tailwind for the REIT sector.

Investor Takeaway

Given these potential impacts, what is my approach to investing in REITs right now? First of all, I have personally maintained a rather small allocation to REITs over the past two years, given that it appeared that we were likely heading into a rate hiking cycle. This has paid off nicely.

However, I am now gradually beginning to increase my allocation to REITs as I believe we are now near peak interest rates because:

1. The Federal Reserve's own dot plot indicates that this is the case, with interest rates likely to begin falling in 2024

2. We expect the Federal Reserve to soon reverse its quantitative tightening and resume buying treasuries on the open market in order to bring interest rates under control and help stave off a debt crisis and severe recession next year.

3. The upcoming U.S. election will likely pressure the Fed into trying to maintain economic and market stability next year in an attempt to avoid swaying the election dramatically.

4. Deflationary impacts from technological innovation - particularly in artificial intelligence - should play an increasingly prevalent role in the economy moving forward.

As a result, I am buying REITs right now while pessimism is very high and opportunities abound. Some of my favorite personal investments at the moment include:

• Tricon Residential ( TCN ) - a chance to own single-family rentals in strong markets at a steep discount to their private market value, along with an attractive asset management business.
• W. P. Carey ( WPC ) - a REIT that just violated investor trust by cutting its dividend, but still has a solid long-term track record, a high-quality real estate portfolio, a BBB+ credit rating, and will still be paying out a pretty decent dividend after spinning off/selling its office assets and resetting its dividend in response. Meanwhile, the sell-off after the dividend cut and spin-off announcement is overblown in my view, leading to the chance to buy high-quality real estate at a rare discount to NAV.
• Crown Castle ( CCI ) - a telecommunications infrastructure REIT that has gotten absolutely pummeled due to concerns about interest rates and a short-term slowdown in dividend growth. With a solid investment-grade balance sheet and very high-quality assets, CCI looks like an attractive risk-adjusted long-term investment at these prices.

Of course, it is important to remember that diversification is important for any portfolio. It is very possible that a government shutdown will have a majorly negative impact on REITs in the short term and that higher interest rates will persist for years to come. In such a scenario, REITs will likely continue to underperform the broader market, as they have in the past few years. As a result, while I think it is prudent to gradually increase one's allocation to REITs right now, it is important to not go all-in on them to the detriment of at least some exposure to other sectors.

Moreover, keep in mind that the discussion around the merits and demerits of forcing the government into a potential shutdown is nuanced. As a result, this article is not intended to take a position one way or the other over the shutdown. Rather, it is simply an exploration of potential short to medium-term impacts on the REIT sector, so investors can better prepare their portfolios for such an outcome.

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