PFE - Very Good News For REIT Investors

2023-03-20 08:05:00 ET

Summary

• We just had two major bank failures, but deposits should be safe.
• Future interest rate expectations are now lower and this is very good news for REITs.
• We highlight a few REITs that we are accumulating.

We just had the 2nd and 3rd largest bank failures in US history and it all happened in just a few days.

First, it was Silicon Valley Bank ( SIVB ). Then came Signature Bank ( SBNY ) as the next casualty.

For a short moment, this caused great uncertainty and the market began to fear that we could face a banking crisis similar to that of 2008-2009.

This obviously would have been terrible news for REITs since it would have made it a lot harder to refinance debt maturities. This is what forced a number of REITs to cut their dividend and raise dilutive equity during the great financial crisis.

But here comes the very good news that we were all hoping for:

The US government stepped in and said that it will protect the funds deposited at these banks. Here is the announcement:

"After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary [Janet] Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank, Santa Clara, California, in a manner that fully protects all depositors. Depositors will have access to all of their money starting Monday, March 13. No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer."

President Biden also issued the following statement:

"I am pleased that they reached a prompt solution that protects American workers and small businesses, and keeps our financial system safe. The solution also ensures that taxpayer dollars are not put at risk.

The American people and American businesses can have confidence that their bank deposits will be there when they need them."

This is great news for everyone as it should prevent a severe banking crisis from occurring.

But there is another unintended consequence that should be particularly beneficial to REITs.

This showed the world that further interest rate hikes may not be sustainable and the bond market has already begun to price lower interest rate expectations.

The two-year US Treasury yield just recorded its biggest one-day drop since 1987 . The market is essentially betting that the Fed won't hike interest rates at the next meeting later this month.

Goldman Sachs ( GS ) made the following prediction:

"In light of recent stress in the banking system, we no longer expect the FOMC to deliver a rate hike at its March 22 meeting with considerable uncertainty about the path beyond March."

Also, if you look at Fed swaps, they now indicate that rate cuts are likely by the end of the year. Some people are already predicting up to a 100 basis point cut later this year!

"In essence, it is the Fed that's causing a bank run... Within the next couple of months, as the contagion brews up this channel — up to high yield, leveraged loans, across the entire ecosystem — that's when the Feds gonna have to bring out the other firehose and cut rates, probably within six to nine months," Larry McDonald said.

What he and others are saying is that our system simply cannot handle such large and rapid rate hikes and we are now seeing the first cracks.

These major bank failures should be a clear telltale sign to the fed that things are starting to break apart and a pivot is needed to avoid further contagion.

How does this benefit REITs?

REITs are real estate investment vehicles. They sold off very drastically in 2022 as the Fed began to hike interest rates and investors run for the exit:

Since REITs crashed due to rising interest rates... it would be logical for them to also recover as interest rates eventually stabilize, or even better, return to lower levels.

As I noted earlier, we just had the biggest one-day drop in the two-year Treasury yields since 1987, and this could be just the beginning. Yet, REITs are yet to respond to this because the uncertainty remains high.

But the story gets even better:

We have previously explained that REITs shouldn't have dropped by nearly as much in the first place.

REIT share prices collapsed in 2022 because of fears of rising interest rates but the market appears to have overlooked two important things:

• 1) REIT balance sheets are today the strongest they have ever been with just 35% debt and long debt maturities at 8 years on average. Nearly all of that is fixed rate and so the impact of rising interest rates isn't material in most cases.

• 2) REIT cash flows have risen a lot as a result of the high inflation. Rents grew some of the fastest in years and even today, rents keep growing at ~5% in many property sectors. The high inflation and interest rates made renting a lot cheaper than owning, increasing the demand even as most new construction projects were put on pause.

This explains why REIT cash flows hit new all-time highs in 2022...

... and also why most REITs hiked their dividends in 2022 even as their share prices collapsed.

Put simply, the positive impact of high inflation was greater than the negative impact of rising interest rates and therefore, I would argue that the sell-off was overdone.

Now, the sell-off makes even less sense since the interest rate expectations are coming back down and this is why I will continue to accumulate REITs while they remain heavily discounted.

I have highlighted many REITs that I have been buying over the past few weeks, but here are a few examples:

• BSR REIT ( OTCPK:BSRTF ) is an apartment REIT just like AvalonBay Communities ( AVB ), but it is much more focused and invests mainly in rapidly growing Texan markets like Dallas, Houston, and Austin. Its rents are growing at a good pace, it has a strong balance sheet and a great management team with lots of skin in the game. Despite that, it is today priced at a 35% discount to its net asset value, which is quite exceptional for assets of this quality. Just to return to its NAV, the shares would need to appreciate by around 50% and you earn a near 4% dividend yield while you wait.

• Alexandria Real Estate ( ARE ) is a REIT that focuses on life science buildings. It dropped heavily when the news came out that Silicon Valley Bank could fail because it leases to a lot of biotech companies. Most of its revenue comes from large and well-established companies like Pfizer ( PFE ) and Moderna ( MRNA ) but it also has small biotech tenants that could be exposed to the collapse of Silicon Valley Bank. It caused some investors to worry about their ability to pay their rent... but this concern has now been mitigated and the lower interest rate expectations only make ARE more attractive to us. The shares are currently priced at a near 40% discount to their net asset value, and the dividend yield is at its highest level in over 5 years. Therefore, we think that ARE is particularly attractive following its recent dip.

Bottom Line

I think that now is a great time to accumulate REITs because valuations remain historically low, balance sheets are strong, and cash flows are rising. I expect an epic rally in the coming years as interest rates return to lower levels. You don't need to be a rocket scientist to understand that buying real estate at a steep discount to its fair value will likely pay off handsomely in the long run.

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