VNNVF - Urgent Warning For REIT Investors

2023-07-15 09:00:00 ET

Summary

• REITs are heavily discounted because interest rates are high.
• But as inflation now returns lower, interest rates will also likely follow.
• We think that this will lead to significant upside. We explain why.

Real estate investment trusts, or REITs ( VNQ ), crashed in 2022 because the high inflation led to a surge in interest rates.

On average, they dropped by 30%, with many individual REITs like ( NXRT , SLG , ARE , SAFE ) dropping by as much as 40-60%:

Investors were quick to extrapolate recent trends far into the future and that caused a panic chain reaction.

Inflation is persistently high > Interest rates will head higher > REITs are stuck with long leases and hit with rising interest expense > Cap rates expand > REIT NAVs collapse > REITs struggle to refinance debt > Leading to an even worse property crash... and so on.

But this whole narrative is now being challenged, and REITs have already begun to recover.

The market is slowly recognizing that perhaps it was a mistake to extrapolate recent inflation and interest rate trends so far into the future.

And so here is my warning to you:

I think that this is still just the beginning of the recovery and we could soon see another chain reaction, but this time a very positive one:

Inflation returns to exceptionally low levels > Interest rates are cut to stimulate the economy > REIT multi-year leases gradually expire with significant rent bumps because they have fallen deeply below market following the high inflation > Cap rates compress as investors chase for yield and want a piece of the rapid rent growth in an otherwise slowing economy > REIT NAVs surge to new all-time highs > REITs refinance recent debt issuances at much lower rates, proving that the pain of 2022 was only temporary > Leading to a recovery to new all-time highs.

In case you missed it, the latest inflation data just came out and the CPI is down to 3%, which is the lowest level since March 2021.

And here's the kicker: this 3% inflation rate is despite shelter inflation still being reported at 7.8% with a 1/3 weight in CPI.

Therefore, ex-shelter, the inflation is now less than 1%. In fact, it is near 0%.

By now, it has been widely publicized that the shelter component of the CPI is backward looking and the real inflation in shelter is actually close to 0%.

Therefore, the real-time inflation has now essentially returned to near zero.

In other words, it seems that inflation was actually transitory. It lasted longer than initially expected, largely because of Russia's invasion of Ukraine, which led to higher energy and food prices, disrupted supply chains, and forced governments to overspend.

Now inflation is returning to near 0 and so this whole narrative that we are headed into a high inflation spiral that justifies high interest rates is starting to fall apart.

Here you need to ask yourself:

How long before inflation concerns turn into deflation concerns?

How long before the high interest rates weigh down on the economy and we head into a recession?

How long before the Fed turns to stimulate a rapidly weakening economy now that inflation concerns are over?

How much longer can our highly indebted governments anyway deal with such high interest rates?

I don't have a precise answer for any of these questions, but I believe that it is just a question of time before interest rates return to lower levels.

As a reminder, the yield curve is still very deeply inverted, and this has historically been a near-perfect indicator of a recession to come:

And if you look back at the last 40 years, the Fed has always been quick to aggressively slash rates as soon as the economy began to struggle following periods of rising interest rates:

Each and every time, people claimed that this was "the end of low rates," but they were always proven wrong a few years later.

Will this time be different?

I strongly doubt it.

The long-term trend has been clearly lower, and this is because there are strong deflationary forces in our economy.

The interesting thing is that these deflationary forces are today stronger than ever in many cases and they are now slowly regaining people's focus after a few years of high inflation. These are:

• The aging demographics
• The high debt loads
• Income inequality
• Technological innovation
• Among other things...

Just try to imagine how big of an impact AI could have on various things for example.

Tesla, Inc. ( TSLA ) CEO Elon Musk recently said that AI "is probably the most disruptive technology ever" and it will bring "an age of abundance," allowing us to make a lot more goods and services very inexpensively when compared to today. He also said in a prior interview that everything will get very cheap.

That's the definition of extreme deflation or hyper-deflation.

Whether you believe that or not, it is clear that deflation remains a risk, and this risk will now likely regain more and more attention.

I remain in the camp that the high inflation was caused by the temporary impact of the pandemic and Russia's invasion of Ukraine, and as this inflation subsides, I believe that we will return to a period of low inflation and low-interest rates in the coming years.

This, in turn, will lead to a rapid recovery in REIT share prices as the market realizes that it was wrong to reprice REITs for a period of persistently high interest rates.

Even better: As interest rates return lower, rents will still remain persistently high, and rent growth will likely remain above average for years to come because lots of leases are yet to expire. I believe that this will justify new all-time highs and result in significant upside for investors who invest today.

Just to give you a few examples:

• Alexandria Real Estate ( ARE ) could rise by over 50% as it returns to its net asset value estimate or NAV in short.
• Vonovia (VNA / VONOY ) could rise by 200% as it returns to NAV.
• BSR REIT (HOM.U / BSRTF ) could rise by 70% as it returns to its NAV.

Life science building owned by Alexandria:

Apartment community owned by Vonovia:

Apartment community owned by BSR REIT:

This explains why we have been aggressively accumulating REITs at High Yield Landlord in anticipation of large returns in the coming years.

For further details see: