2023-08-30 07:00:00 ET
Summary
- Cap rates are expected to move back to higher historical levels, potentially higher than the current 6% or 7%.
- The risk-free interest rate, the 10-year U.S. Treasury Bond yield, is a key reference point for evaluating real estate investments.
- Realty Income and Mid-America Apartment Communities are two REITs that are expected to perform well.
A few years ago, I wrote a Seeking Alpha titled “ The Answer is 9 ” in which I explained that “cap rates will eventually move back to higher historical levels, perhaps not 9%, but higher than today's 6% or 7%."
That article was written in July 2017, six years ago.
Also, in that article I described an event that took place in the early 1970s in which a Harvard professor who taught his MBA students real estate capital markets. The professor, Bob Ellis, would always start his class by asking his students the question, “How many of you would like to make a lot of money selling properties you have been leasing?”
Of course that was the attention-grabbing question and when the room became silent Ellis replied,
“The answer to the final exam will be "nine ."
Here’s an excerpt from the article which describes what the Harvard class was learning more than 50 years ago:
Seeking Alpha
The Most Important Thing!
Warren Buffett was once asked the most important data point when trying to evaluate future investment performance and his response: " interest rates."
In a recent Seeking Alpha Epic REIT Rally 3.0 (The Most Important Thing) I discussed the concept of WACC (weighted average cost of capital) in which I explained,
“We’ve identified our favorite net lease REITs backed by empirical evidence that supports the notion that growth and ROIC are the key drivers of shareholder value.
Although accelerating interest rates have created a dynamic that slows growth (margins aren’t as wide), the net lease REITs are still able to generate sustainable organic growth.”
As I learned in business school (many moons ago), the ultimate reference point for relative valuation is what is referred to as the risk-free interest rate, the 10-year U.S. Treasury Bond yield .
Macrotrends | The Long Term Perspective on Markets
That’s because interest payments and return of principal are backed by the full faith and credit of the federal government .
It’s believed to be the safest investment in the world.
And it does make sense since all possible investments and returns are priced at a premium to it based on their risk profiles.
For example, when investors examine REIT prices, they look to P/FFO ratios, dividend yields, and other key valuation metrics relative to the risk-free rate of return.
Bond investors price corporate bonds as a premium to the risk-free rate with projected higher returns corresponding to higher risk.
Higher rate spreads entice investors into an asset class as their investment risk is rewarded with potentially much higher returns.
Enter the World of Cap Rates
Unique to real estate investing, a cap rate is the yield of an unleveraged real estate investment.
It’s the relationship of the net operating income (‘NOI’) of the property divided by the sales price or appraised value. So a property with $200K of NOI that sold for $2 Million, sold at a 10% cap rate ($200K divided by $2 Million).
So, as the Harvard Professor taught his students in 1971, cap rates were around 9% and guess where they are today?
Note: I already told you… just read the title to the article.
Holding income constant, cap rates indicate value and rising cap rates reflect value declines and falling cap rates reflect value increases .
How do investors evaluate cap rates according to risk and potential total returns?
Intelligent REIT investors undertake a similar analysis called a cap rate spread analysis.
Cap Rate Spread Analysis
A cap rate spread is simply the current average cap rate (the yield of an unleveraged real estate investment) vs. the risk-free rate of the 10-year U.S. Treasury Bond yield.
Spreads near or above the longer-term average imply that real estate pricing is not overheated, as cap rates are not low relative to the 10-year U.S. Treasury Bond yield.
The chart below reflects historical institutional real estate valuation cap rates and 10-year U.S. Treasury Bond yields from 2000 to 2023. The average from 2009 – 2019 is 3.0%.
iREIT®
As you can see above, I highlighted 2009 (spread of 250 bps) because this was the period in which there was unprecedented contractions of the credit markets sparked by lower investor demand (10-year was 4%) and softening property fundamentals (6.5% cap rates) that resulted in a climb of cap rates due to one of the most severe recessions on record.
Now, as you can see, in 2023 we have cap rates again in the 6.5% range moving closer to 7%, while the 10-year is currently 4.2%, which translates into a 230 basis points spread.
The phrase “cap rate compression” was born as cap rates fell from the 8%-9% range in the early 2000’s to around 6% by 2006.
Now, back to the Harvard professor.
In 1971, the 10-Year was around 6.25%.
Macrotrends | The Long Term Perspective on Markets
So, using the Harvard Professor’s 9.0% cap rate example (from 1971) and the 6.25% 10-year, we calculate the spread (risk premium) to be 3.75% or 375 basis points.
As the Fed continues to work to get inflation down to 2%, it seems that one more rate increase may be warranted, and our model suggests that the answer is now “7” not "9."
With our forecasted Q1-24 investment spreads returning back to 300 basis points or higher, we believe that REITs will become more attractive as investment spreads will widen.
Could cap rates go to 8%?
Or even 9% as the Harvard Professor suggested back in 1971?
Possibly, but not likely.
FRED
As seen above, inflation was just over 4% in 1971 and then it ran as high as 12% in 1975.
When you look back over the past twenty years, the 10-year has averaged 3% which we believe it will drop below 4% in Q1-24 and Bankrate agrees.
After surveying Bankrate expects the 10-year yield to be 3.7% at the end of Q1-24, down slightly from the 3.8% level they expected it to reach at the end of 2023.
Now, let’s take a look at 2 REITs that should see lift off in Q1:
Realty Income ( O )
Realty Income is a beast…
The largest net lease REIT with an enterprise value of $62 billion and a diversified portfolio of over 13,000 properties.
Make that 13,001.
The company recently announced it was investing $950 million in a new JV that owns 95% of the Bellagio in Las Vegas. O will invest ~$300 million of common equity in the JV to acquire a 21.9% indirect interest in the property and $650 million to acquire a yield-bearing preferred equity interest in the JV.
After the transaction, O’s JV partner, BREIT, will hold a 73.1% indirect interest, and MGM Resorts International ( MGM ) will keep a 5.0% stake in the property.
To break down the math: O’s 21.9% stake ($300 million) in the Bellagio is valued at a 5.2% cap rate and the $650 million preferred equity bears a yield of 8.1%. However, the existing debt on the property is just 3.67% which is much cheaper than the 5.7% rate O would be issuing at today. So the blended rate on the $300 million and $650 million is 7.7%
The preferred equity component is subject to a 3% redemption fee for the first three years, which decreases to 2% afterwards. However, given the elevated interest rate environment, we suspect the near-term redemption risk is low risk.
The Bellagio deal marks the second gaming acquisition by Realty Income (first was Encore in Boston) and another high-profile trophy financed with a creative capital stack.
As I referenced in a recent article, I would not be surprised to see O going after Spirit Realty ( SRC ) given the almost infinite appetite of the company to seek out large accretive deals.
Even in this environment O is transacting accretive deals and recently bumped 2023 guidance by $1 billion (from $6 billion to $7 billion). The company intends to pursue similar credit enhancing deals (similar to VICI) that should lead to elevated returns.
Realty Income
O has been successful in raising its dividend for 29 years in a row (as a public company) which include various cycles, including recessions, high inflation (80s and 90s), and a global pandemic. In addition, O is well positioned to benefit in the sale-leaseback arena where there are more opportunities today than ever.
Shares are now trading at $56.00 with a P/AFFO of 14.1x. The dividend yield is 5.5% and analyst forecast 4% growth (AFFO/sh) in 2024 and 2025. This is consistent with the company’s historical growth rate.
FAST Graphs
As shown below, we forecast shares to return 20% annually:
FAST Graphs
Mid-America Apartment Communities ( MAA )
MAA is yet another high conviction pick in the apartment sector.
The REIT is a sunbelt focused REIT that owns, acquires, develops, and manages apartment communities with a large presence in the Southeast, Southwest, and Mid-Atlantic regions of the U.S.
Their properties are well diversified by asset class with 40% of their portfolio rated class A or A+, 52% rated class B+ or A-, and 8% rated class B- or B. They own or have an ownership interest in 101,986 apartment units that are located across 16 states and Washington, D.C.
Similar to Realty Income, MAA is investment-grade with an A- credit rating and has excellent debt metrics including a net debt to adjusted EBITDAre ratio of 3.41x and an EBITDA to interest expense ratio of 8.23x.
Cap rates for apartment communities are lower than net lease properties. MAA has “seen an average buyer cap rates move up to 4.9% in the second quarter from 4.7% in the first quarter, with most cap rates ranging between 4.75% and 5.25%.”
MAA is patiently waiting for opportunities as its balance sheet is in great shape.
In Q2-23 MAA increased the midpoint of its effective rent growth guidance to 7.4%, a 25 bps increase and total revenue growth guidance for 2023 is unchanged at the midpoint of 6.3%.
MAA Investor Presentation
Of course, solid rent growth, along with expense management and a strong balance sheet, resulted in steady earnings (FFO per share) growth. As seen below, MAA’s outperformance compared with its peers during both the latest down cycle and recovery period positioned this REIT well for Q1-24.
MAA Investor Presentation
MAA is now trading at $144.73 with a P/AFFO multiple of 17.9x. The dividend yield is 3.9% and analysts forecast growth (AFFO/sh) of 3% in 2024 and 7% in 2025.
FAST Graphs
As shown below, we forecast shares to return 15% to 20% annually:
FAST Graphs
In Closing…
Much like Professor Ellis started his class… I’ll ask you…
How many of you want to make a lot of money owning REITs?
Okay then, the final answer on my exam will be 7.
Why has the number moved from 9 to 7?
I have a few ideas…
Most obvious is the fact that the 10-year today is around 4.2% not 6.2% like it was in 1971.
However, I believe two things are driving commercial real estate today that were not on anyone’s radar in 1971.
First, technology has made real estate transactions much more efficient, which means that buyers and sellers are able to source, close and manage deals much faster. Sites like CoStar have made it much easier, and the brokerage industry has evolved substantially, which has in turn generated much more investor demand.
Secondly, REITs have evolved, and they now own roughly 10% of all institutional quality commercial real estate in the US. This demand (for income) has fueled growth which has made REITs more dominant in their scale and cost of capital advantages.
iREIT® and Nareit
So, I suspect that if Professor Ellis were alive today, he very possibly may agree with me that the Answer is no longer 9, it’s 7.
Do I get an A+?
(OK, I look forward to you grading me below in comments.)
As always, thank you for reading and commenting.
PS: Did you read my REIT Rally 1.0 , REIT Rally 2.0 , or REIT Rally 3.0 articles?
Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
For further details see:
The Answer Is 7