SRVR - Why REITs Will Likely Pummel The S&P 500

2023-11-16 08:05:00 ET

Summary

• The S&P 500 has massively outperformed REITs in recent years.
• But we expect this outperformance to soon reverse.
• I explain why I expect REITs to easily beat the S&P 500 going forward.

Co-produced by David Ksir

The S&P 500 ( SPX ) has become the holy grail of indexing over the past two decades. It has returned nearly 300% since 2005 and has outperformed the broader REIT index ( VNQ ) by a very large margin.

Does that mean that we should blindly invest into the index and hope for the best?

I think investors can actually do better than that. Today, I'll share why I think that REITs are actually much better positioned to deliver the 8-10% annual returns we've grown accustomed to.

Why not the S&P 500?

Let's start by exploring perhaps the biggest risk that index investors face, which is that of a dead decade. A dead decade is a period of many years (10-15 years on average) when the index fails to reach new all-time highs. In other words, it trades flat.

This scenario can be especially painful for retirees relying on their portfolio for income, because the S&P 500 dividend yield is low and selling your stocks at a loss to cover living costs is no fun.

Dead decades are somewhat rare, but they do happen. Over the past 100 years or so, we've had three major ones. In 1930-1950, 1969-1985 and most recently in 2000-2012.

Chart: S&P 500 price (log scale)

Forecasting dead decades is nearly impossible, but their start tends to coincide with either a period of raging inflation or very high valuations. Right now we're fighting both of these to a degree.

We may not have double-digit inflation right now as we had in the 1970s, but most would agree that inflation remains a problem as it stands above the Fed's target.

On valuations, once again, we may not be in extreme territory similar to that of the year 2000, but valuations are clearly above average. Currently, the S&P 500 forward P/E stands at 18.3x which is above the 20-year average of 15.5x.

This is especially worrying because interest rates are now the highest they've been in 20 years and the index has not re-priced to a lower multiple to reflect this new reality. If anything, in the current environment, I would expect valuations to be below average.

From a PEG ratio perspective things don't look quite as bad, but that's only because of recent AI-driven sharp upward growth revisions in the technology sector. In short, analysts have increased their 5-year growth forecast from 11% per year to 18.5%, based on not much more than AI hype.

I don't claim to be an expert on AI-driven growth, but remain skeptical that technology firms will be able to grow so rapidly in a high interest rate environment. And even if they do deliver on the growth forecast, I still expect the long-duration cash flows of the tech sector to eventually price-in the new reality of high interest rates.

It turns out that there is in fact a relatively close relationship between valuations and forward returns. JPMorgan ( JPM ) has done a study on this and concluded that the current forward P/E of 18.3x is likely to result in total annual returns of under 5% over the next five years.

Note that the correlation is not perfect and there have been instances where such forward P/E resulted in double-digit as well as negative returns, but it gives us ballpark expectations.

So where does all of this leave us?

I think that the best places to look for investments right now are those that have overreacted to the rapid increase in interest rates, despite the business doing well.

Value is now historically cheap (compared to growth) with a relative forward P/E of just 0.56x which makes investing in the technology-heavy S&P 500 relatively unattractive.

Why REITs?

I think REITs are particularly well positioned to outperform.

Here are 5 reasons why.

#1 - low valuations

Unlike technology stocks which haven't re-priced for higher interest rates at all, REITs overreacted and are today priced at the lowest valuations since the Great Financial Crisis.

This is reflected by a historically low spread to U.S. Equities, large discounts to NAV, and implied cap rates in the public market that are significantly above those seen in the private market. In short, there are many bargains out there today trading at 50-70 cents on the dollar.

Investors who jumped in at these valuations in 2009 and during Covid have doubled their money in the following years and I expect the same going forward.

#2 - lowest leverage ever

One of the main reasons why I think the high interest rate fears are overblown is the fact that most REITs today have very conservative balance sheets. The average LTV has come down from 50-60% in 2009 to a very reasonable 35-40%.

Not only that, but interest rate risk in much better managed today with substantially longer debt maturities and a higher average share of fixed rate debt (85% today vs 70% in 2005).

As a result, net interest expense increases are very gradual for most REITs and tend to be easily offset by rent increases.

#3 - growing rents

REITs actually have quite a bit of inflation protection built into their business model thanks to regular rent increases in the form of rent escalation clauses (sometimes CPI-linked) on existing leases and the ability to raise rents on new or renegotiated leases.

This enables most REITs to significantly increase their rents in inflationary times, which is exactly what we've seen since the start of 2022. Some REITs have growth their same-store rents by double-digits, more than off-setting the increased interest expense and consequently growing their cash flows and dividends.

#4 - well suited for high inflation

Because REITs can increase their rents, they tend to be some of the best performers during periods of high inflation. In fact, Equity REITs have the second best track-record (second only to Energy ( XLE )) of beating inflation when it's above 3%. Hartford Funds found that Equity REITs beat inflation 65% of the time with average annual real returns of about 5%.

#5 - well suited for high rates

Finally, despite an all-time low sentiment (or maybe thanks to it), now could be the best time to load up on quality REITs, especially if you think that the Fed is close to the end of their hiking cycle. I certainly do.

REIT valuations suffer when interest rates increase. We know that very well, because we've seen it over the past two years. Less intuitively though, once interest rates peak, REITs tend to take-off. Regardless of whether rates stay high or decrease, REITs tend to outperform U.S. equities by a factor of two over 12 months following peak rates.

Bottom Line

For me the decision is simple.

The index is relatively expensive today, because technology stocks have failed to re-price for high interest rates, despite their very long-duration which should make them very sensitive to rate changes. Consequently, expected total returns are low.

REITs, on the other hand, have seen their valuations plummet as interest rates increased and are now priced very favorably, despite having strong balance sheets and growing cash flows. Moreover, REITs should outperform in both a high inflation and a high interest rate environment, which makes them a great investment candidate today.

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