REIT - Sell The S&P 500 And Buy The REIT Sector

2023-10-16 10:50:13 ET

Summary

• REITs may be a better investment than the S&P 500.
• In this article, I analyse two scenarios - a recession and a high interest rate environment - and compare the index with REITs.
• My analysis leads me to believe that REITs come out better than the index in both, making it a better investment at this time.

If you’ve been following my articles, you know that I like investing in REITs. And there’s a good reason behind it. In this article, I want to guide you through my thinking which leads me to believe that REITs make a better investment right now than the S&P 500 ( SPY ) index.

The story over the past 24 months has revolved mainly around inflation and the Fed. Going forward it will likely be no different as the market will continue to be driven by interest rate expectations.

Predicting interest rates is an impossible feat and I will not attempt to do that. Rather, I will look at two possible routes that interest rates may take. Scenario number 1 will assume that we either get a soft landing or a recession which results in interest rate cuts. Scenario number 2 will assume that inflation is sticky and therefore interest rates stay higher for longer.

Let’s start with scenario number 1

Personally, I give this scenario a higher probability for two reasons. Firstly, inflation has already come down significantly from the highs and if we exclude shelter inflation which is notoriously reported with a significant lag, the headline CPI is already near the Fed’s 2% target. Moreover, the yield curve is deeply inverted, which suggests that a recession may come and could eventually lead to rate cuts.

Either way, I think it’s quite intuitive that REIT valuations would benefit a lot from a decline in rates. This is not hard to see. REITs are leveraged assets with long duration and are therefore quite sensitive to changes in interest rates.

Generally, a rate cut is bullish for most stocks and indices. But the problem with the S&P 500 right now, is that despite high interest rates, it trades at a very high P/E multiple of about 19x.

This is primarily a result of technology, which is the highest-weighted segment, and which has significantly outperformed other sectors. The outperformance was quite surprising because normally high interest rates should impact technology stocks even more than REITs. This is because technology stocks often have cash flows years down the line which makes them very high duration. But since tech already trades so high, my worry is that a rate cut won’t be nearly as strong a catalyst for the S&P 500 as it will be for REITs. Moreover, historically, a P/E of 19x has resulted in low total returns over the next 5 years of <5%.

So, in my mind, the index is not particularly well positioned to deliver high returns, while many REITs that I’ve covered recently are likely to enjoy substantial upside in this scenario and could earn investors double-digit returns over the next two to three years.

Unfortunately for S&P 500 holders, things get worse in scenario 2

The thing is that because the index trades at such a high multiple, which has essentially priced in interest rate cuts way too soon (at least compared to this scenario), if all of the sudden the market has to price in higher interest rates for longer, this is likely to result in significant downside.

It’s impossible to know how much downside, but we can look to the FOMC meeting for context. On September 20 ^th , the Fed increased their next year interest rate expectations from 4.6% to 5.1% and over the next couple of trading days, the S&P 500 has sold off by about 5% from 4,450 to 4,250. It’s not hard to imagine further downside if the market is to price in high rates for years to come.

So now, let’s look at REITs. Intuitively, one would think that REITs should perform badly for as long as interest rates are high. But here’s the thing, historically, REITs have actually outperformed in a high inflation and high interest rate environment. And the outperformance was quite big (21.4% vs 9.8% for the index). It turns out, that it’s not high interest rates that hurt REITs, but increasing interest rates. As long as interest rates stop increasing and stabilize, REITs tend to do well.

If you think about it, it actually makes sense. Sure, rising rates pressure valuations, but once they stabilize, valuations bottom while cash flows start rising as REITs are able to increase their rents significantly in a high inflation environment. Of course, it all comes down to rent escalation clauses, CPI-linked indexation, lease turnover, rent spreads, etc. But the point is that there are REITs, which are likely to do well even under scenario 2.

In fact, according to another study , REITs are one of the best sectors for a high inflation environment, second to only energy.

Bottom line

To be clear, I’m not advocating you go all in on REITs. All I’m trying to show is that the sector, which is currently experiencing an all-time low sentiment, is not nearly as badly positioned as many would have you believe. And actually, going forward, it might even outperform the S&P 500.

For further details see: