2023-03-28 12:28:09 ET
Summary
- The dip in the Schwab U.S. REIT ETF’s share price does not appear to be a buying opportunity because the real estate sector is expected to perform poorly in 2023.
- Risk factors such as the banking crisis, rising interest rates, and the impending recession have yet to fully impact the financial and share price performance of real estate companies.
- Another headwind that could impact share price and dividend growth in 2023 is declining earnings growth potential.
The real estate-focused Schwab U.S. REIT ETF ( SCHH ), which underperformed in 2022, is expected to perform poorly again in 2023, with little chance of recovery. For a variety of reasons, including slowing economic growth, rising interest rates, and dwindling earnings power, the sector's performance is questionable. The banking crisis has also complicated matters for the industry, as bank lending is essential to the growth of the real estate industry. Several events have already been factored into the real estate sector's performance over the last year, but the current state of the economy suggests that many risks have yet to impact performance in the coming quarters.
The Worst is Ahead
In spite of finishing third among the 11 S&P 500 sectors in terms of earnings growth in 2022, the real estate sector has underperformed, falling 25% versus a 20% drop in the S&P 500. The underperformance is blamed on concerns about weakening fundamentals. The most concerning aspect is the uncertainty about whether adverse events have already been factored in and the sector has bottomed out.
SCHH Vs S&P 500 (Seeking Alpha)
In my opinion, the worst is yet to come, as the market fundamentals have started to rapidly deteriorate and a number of unfavorable events have not yet had an impact on the financial and price performances. For instance, despite raising rates at the fastest rate in four decades, the Fed hasn't achieved the desired results. This has led to the Fed raising interest rates by 0.25% in March and indicating that it will do so again in the coming months in an effort to slow the economy, which is bad news for the real estate sector. A higher interest rate means higher borrowing costs on existing loans, which poses a serious risk to real estate companies' earnings growth because they rely heavily on loans to fund their investments in growth opportunities. Furthermore, they would be forced to cut back on their future borrowing plans due to high financing costs.
In addition to the possibility of a drop in residential and commercial construction spending due to rising interest rates and the impending recession, falling rental prices may have an impact on their financial numbers. According to a recent report from credit rating agency Moody's, the rise in work-from-home opportunities is causing office tower revenue to fall to the point of default. The growing popularity of remote working has also made it more difficult for them to repay their debt. In the last two quarters, apartment rental rates have fallen in all major American metropolitan areas. Rent price declines are primarily due to demand and supply dynamics rather than a decline in purchasing power. According to RealPage data , approximately 600,000 new units will enter markets across the country in 2023, representing the largest influx of brand-new houses in nearly 40 years. Overall, it seems that due to robust underlying end markets, only a small number of REITs, such as industrial and self-storage, will likely be resilient. The majority of real estate industries, including technology, retail, and healthcare, will be more negatively impacted by rising interest rates and slower economic growth.
Banking Crisis Adds to Headwinds
Real Estate Exposure to Small Banks (Axios Visuals)
The real estate sector's ability to obtain new loans is in doubt given the current banking crisis. Regional banks, who are among the biggest lenders for residential and commercial real estate, are particularly susceptible to failure because of liquidity problems and losses in bond portfolios. According to Axios data , regional banks account for 67% of commercial real estate loans and 37% of residential real estate loans. Signature and First Republic Bank ( FRC ), two recently failed regional banks, are major lenders to residential and commercial real estate developers. Morningstar has also assigned regional banks a high-risk rating when compared to diversified banks. Additionally, Luke Ellis of the $143 billion Man Group hedge fund predicts that a large number of regional banks will go out of business within the next 12 to 24 months, with the majority of them being acquired by bigger financial institutions. Moreover, market analysts predict that the banking crisis could have a similar impact on economic growth as the Fed's 1.5% rate hike. The banking crisis is covered in great detail in my article , "Vanguard Financials ETF: A Gamble For Dip Buyers."
A Look at Top Schwab U.S. REIT ETF Holdings
The Schwab U.S. REIT ETF provides broader real estate sector coverage because it invests in stocks of companies operating across the real estate sector. The fund is made up of approximately 128 stocks, with the top ten holdings accounting for approximately 46% of the overall portfolio.
SCHH Top 10 Holdings (Seeking Alpha)
Prologis, Inc. ( PLD ), an industrial REIT, is the largest stock holding in SCHH's portfolio, accounting for approximately 9.5% of the portfolio's weight. Although Prologis reported double-digit FFO growth in 2022, its stock has dropped around 26% in the last year due to concerns about deteriorating fundamentals. Its forecast for 2023 core FFO per share of $5.40 to $5.50 also missed the $5.56 consensus estimate. In 2023, Prologis anticipates its occupancy rate to decline between 96.5% and 97.5% compared to over 98% in 2022. I believe forecasts may be revised even further in the coming months because the banking crisis and the Fed's rate hike policy are expected to cause economic trends to worsen than many had anticipated.
The second-largest holding of SCHH, American Tower Corporation ( AMT ), also missed its FFO forecast for the fourth quarter and gave a less optimistic outlook for 2023. Compared to the $10.58 consensus, the company forecasts that AFFO per share will be between $9.49 and $9.72 in 2023. Similar to American Tower, Crown Castle ( CCI ) provided a less optimistic outlook for 2023. The company projects AFFO per share of $7.58 to $7.68 in 2023, compared to the consensus estimate of $7.75 billion. Retail REITs like Realty Income Corporation ( O ) and Simon Property Group ( SPG ) are likely to see flat to slightly negative growth. Meanwhile, double-digit FFO declines are expected in the office, healthcare, and a few other property categories in 2023. According to FactSet data, the real estate sector will likely see low single-digit earnings growth in 2023, as opposed to high double-digit growth in 2022.
Quant Ratings
The quant method is one of the best ways to remove emotions from the analysis because it only focuses on real data rather than fundamentals. Schwab U.S. REIT ETF received strong sell recommendations from the Seeking Alpha quant system, with a quant score of only 1.30, owing to poor performance on the risk, dividend, and momentum metrics. Stocks and ETFs with low momentum and high risk should be avoided by investors hoping to generate healthy returns in 2023. Furthermore, the dividend factor's D grade suggests that there is a low likelihood of a dividend increase in 2023 because real estate companies are having trouble producing FFO growth. Another worrying statistic is that the SA quant system gave hold ratings to eight of SCHH's top ten holdings.
In Conclusion
In light of an impending recession, a banking crisis, and rising interest rates, investing in the risky real estate sector might not be a good idea. In the upcoming quarters, sluggish earnings quality and dividend growth concerns would also hit investor sentiment. Overall, despite the recent price decline, there are still a number of unfavorable developments that will affect Schwab U.S. REIT ETF's performance in 2023.
For further details see:
SCHH: Tough Time Ahead