DRV - My Bullish REIT Thesis And Catalysts That Could Take Us To New ATHs

2023-08-14 23:12:35 ET

Summary

• I hold a significant allocation towards quality REITs.
• In this article, I share my bullish thesis for investing in the sector.
• I also highlight catalysts that could take quality REITs to new all-time highs in as little as 12 months.

Dear readers/followers,

Over the past couple of months, I've published over 100 articles, mainly focusing on REITs. I've shared many insights into the sector in those articles, but frankly, unless you've read all of them, you might be missing some pieces to understand what my overall thesis for investing in REITs actually is.

Today, I want to go over my bullish thesis in one place and highlight some key catalysts that I expect to play out over the next couple of months and quarters. My REIT Thesis

To understand my thesis, it's first important to understand why REIT (Vanguard Real Estate Index Fund ETF Shares ( VNQ )) prices have declined over the past year by almost 30% and what the bears' arguments are.

The bears argue that high interest rates are inherently bad for REITs, because they increase the cost of debt and pressure valuations.

But this thinking is short-sided.

Sure, the interest expense will increase, but only gradually as debt maturities come due and since quality REITs today have some of lowest leverage ever and their maturities are well spread out, the increase will be slow.

Moreover, we have to keep in mind why interest rates are high today. It's because of high inflation which tends to translate into higher rents for quality REITs.

In many cases, higher rents (whether thanks to build in escalators or significant spreads on new leases) will more than offset the higher cost of debt. And this is exactly what we've been seeking across the sector, as many REITs have increased their cash flows by double-digits, while their valuations have got cut in half.

And the thing is that numerous studies show that REITs out-perform once rates stabilize, regardless of the level they stabilize at. So while further rate increases would likely lead to more downside, staying at higher interest rates for longer wouldn't.

To put things in perspective, over the 12 months following a significant increase in interest rates, REITs have historically returned 21%, more than double the broader market return of 10%.

I have a reason to believe that we are now near the very end of the Fed's hiking cycle, which means that it may be the best time to go shopping for REITs.

Here's my thinking.

Inflation has already come down significantly with July CPI at 3.2% and that's despite shelter CPI, which accounts for about a third of the overall basket, still at 7.7%. If you do the math, you'll see that, on paper, shelter inflation contributed 90% of total inflation last months.

The problem with the shelter component of CPI is that it's backward looking and tends to lag what's actually happening quite a lot. There's no real time data that would indicate that the real estate market is hot and there's rampant inflation so it's only a question of time before shelter inflation trends lower and when it does, the CPI will inevitably decline with it.

The bond market knows this, which is why the 2-year expected inflation, which is calculated by analyzing the spread on TIPS (inflation protected treasuries) is already barely above the Fed's 2% target.

With inflation coming down, the best way to anticipate what will happen is to look at the bond market which has a great track-record of predicting what will happen.

Right now, the bond market is telling us that the U.S. is likely to fall into a recession as the yield curve is the most inverted since 1981. It's worth noting that an inverted yield curve has correctly predicted every single one of the last four recessions.

Once a recession starts, the Fed will cut rates to stimulate the economy. It has done so in 1991, 2001, 2008 and 2020. Of course, this time could be different, but I doubt it and I'm certainly not willing to bet on it.

Once the Fed cut rates, the REIT bonanza can take off. REIT valuations very quickly adjust, multiples expand and since quality REITs have increased their cash flows in the meantime and will be able to refinance at cheaper rates once again, I expect REIT valuations to reach all-time highs.

Of course, timing this perfectly is impossible, as the inverted yield curve is a poor timing indicator. The curve has been inverted for a year and we still haven't had a recession. This is why I think it's best to average into REITs slowly as I have over the past 6 months or so.

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