BYLOF - There Might Not Be An Opportunity Like This In Years

Summary

• REITs crashed because the high inflation rate caused interest rates to rise.
• But now, the opposite is happening, and REITs present significant upside potential.
• We buy REITs hand over fist because there are the cheapest in years.

The big story of the last month is that inflationary pressures began to cool down.

The year-over-year CPI figure, which is commonly cited in the media, is still high, but the month-over-month CPI, which is a more "real-time" measurement of inflation, has been trending lower and is now back to where it was in early 2021:

As we argued in our recent " Macro Update ," the economy appears to be slowing, the labor shortage easing, and input cost pressures fading. This should allow the rate of inflation to continue its gradual downward slide.

Why does this matter?

If inflationary pressures continue to cool down, then interest rates will also likely stop increasing, and eventually, even return to lower levels. The Fed has tried to normalize interest rates for decades, but it has repetitively failed due to the 5 horsemen of disinflation (aging demographics, high debt loads, income inequality, tech innovation, and globalization) which act as gravity on long-term consumer prices.

Occasionally, we get a surge in interest rates like in 2022, but shortly after, this is followed by large rate cuts to stimulate the economy:

Today, the Fed is already hinting at a pivot...

The world's richest man is asking for substantial and immediate rate cuts...

And the 10-year treasury rate is already starting to price lower rates...

How did REITs react to this?

They rose significantly.

On average, real estate investment trusts ("REITs") ( VNQ ) rose by 13%, and some of our larger holdings like Global Medical REIT ( GMRE ) rose by as much as 36%. That's in just a month:

This is a great reminder that share prices can recover just as fast as they drop.

REITs dropped in 2022 because the high inflation caused interest rates to rise, and it scared off investors. But as inflationary pressures continue to cool down, interest rates will likely stop rising and eventually decline to lower levels... which should serve as a strong catalyst for REITs going forward.

It will remove the main concern of the market and could lead to a rapid recovery in valuations across the REIT sector:

But the REIT story gets even better.

While interest rates may revert back to lower levels, rents will remain high and won't return to pre-inflation levels.

In other words, the higher rents are sustainable, while the higher interest rates will likely prove to be only temporary.

Therefore, most REITs will actually have to rise quite a bit higher than their late 2021 levels since their rents have grown significantly in 2022.

Just to give you a few quick examples:

EastGroup Properties, Inc. ( EGP ), our favorite industrial REIT , has been hiking its rents on expiring leases by 20%+ this year, and yet, its share price is down by 33%. This essentially means that its valuation has been cut in half since the beginning of the year.

BSR REIT ( BSRTF ), our favorite apartment REIT , has been able to hike its rents by another ~10% on expiring leases, and yet, it is down 40% off its highs. This, again, essentially means that its valuation has been cut in half.

Finally, Big Yellow ( BYLOF ), our favorite self-storage REIT , has grown even faster with its funds from operations ("FFO") and dividend per share rising by 24% in 2022, and despite that, it is down by 33%. Once more, its valuation has been cut in half as a result of the strong growth and declining share price.

So, simply returning to the highs of 2021 won't be enough in many cases because the rent growth has been very substantial in 2022. The market has forgotten that real estate investments benefit from inflation, but eventually, it will have to come back to its attention because it is hard to ignore such significant growth.

Even if you think that interest rates will remain somewhat higher, and valuation multiples won't fully recover, then this rent growth should compensate for that, allowing REITs to return to around where they were in late 2021.

As this plays out, we think that our investments are particularly well-positioned to profit. Many of our largest holdings could rise by 50% and still remain reasonably priced. While we wait, we also earn high cash flow and the value of our holdings keeps on rising.

So all in all, I am very optimistic about the future as we head into 2023.

Of course, we cannot predict how REITs or any stock will perform in the short run, but since REITs dropped due to rising interest rates, and rates now appear to be leveling off, it would be only natural for REITs to recover, especially since rents have grown so much.

Therefore, we will keep accumulating larger positions in our favorite REIT names in the coming weeks. In addition to our current holdings, our watchlist of potential new investments is currently also the largest it has been in a long time.

For further details see: