2023-05-02 18:56:52 ET
Summary
- Interest rate hikes and the trillion and a half dollars of commercial real estate debt have both filled the sector with gloom.
- This pessimism is not justified when dissecting SPDR's XLRE holdings and looking at metrics like debt and revenue growth, while also not forgetting the tools the Fed has put in place to contain liquidity risks.
- Also, a comparison with Vanguard's VNQ helps to show its lower exposure to office properties, where demand is low.
- However, despite all this strength, expect volatility with the impending interest rate decision, which implies that investors should be cautious.
- The underlying theme of this thesis is not to generalize pessimism, but, instead, to dive into details to assess for strength.
According to Bloomberg, about $1.5 trillion in CRE (commercial real estate) debt will mature by the end of 2025. Now, this is an astronomically high amount considering that the Fed fund rate, one of the key determinants of commercial mortgage interest payments for property buyers and enterprises, was at near zero only last year compared to 4.83% currently.
Now commercial REITs (Real Estate Investment Trusts) are included in the index tracked by The Real Estate Select Sector SPDR Fund ETF ( XLRE ) as I will elaborate upon in this thesis whose objective is to show that it is important not to fall prey to the overall market gloom. Instead, my approach will be to highlight the ETF's strengths by diving into details and looking at specific metrics like debt.
I start by detailing the holdings from the CRE perspective.
XLRE's Holdings Skewed Towards Tech, Logistics, and Residences
Commercial REITs engage in income-producing activities involving owning and operating facilities like offices, warehouses, data centers hospitals, shopping malls, hotels, storage, and even rented apartment buildings. Noteworthily, owner-occupied residential homes or apartments are not classified as commercial properties.
In this respect, XLRE holds just thirty REITs, some with the highest market capitalization like Prologis ( PLD ) a logistics giant, and American Tower ( AMT ) which provides 5G tower infrastructure in 25 countries.
The underlying fund also includes residential property owners like Equity Residential ( EQR ), but, not troubled Applesway Investment Group which borrowed a lot of cheap money during the pandemic. This brings me to the banking turmoil which started to plague stock markets in March, largely due to liquidity issues, as U.S. banks were sitting on large unrealized losses made up of bond securities. The reason is that since the Fed started to raise rates rather aggressively (introductory chart), the yields on long-dated treasuries surged, in turn reducing bonds' market value.
However, another effect of higher interest rate risks is likely to impact CRE loans, as constituents of a large portion of banks' assets, which could be the next domino to fall.
CRE Loans and the ETF's Low Office REIT Exposure
For this matter, banks with less than $250 billion dollars in assets hold approximately 80% of CRE loans, according to Goldman Sachs ( GS ) and this is cause for worry as these are not the U.S. majors which are "too big to fail". Here, some will remember how First Republic Bank ( FRC ) whose stock collapsed by over 75% in the first week of March after fears of a bank run due to a substantial portion of its deposits being uninsured. Now, imagine what would happen in case there are defaults on mortgage payments as the higher interest rates engineered by the U.S. central bank become too strenuous to bear for some real estate developers. On top, they are already faced with lower demand, higher labor and material costs.
Furthermore, let us not forget that a troubled banking system increases the probability of credit conditions deteriorating as lenders become more stringent when allocating funds, in turn heightening the risks of a recession occurring in 2023. To this end, the loans are most often guaranteed on the properties themselves, such as buildings, warehouses, or commercial space and the value of these premises has fallen since the pandemic.
However, we can't just generalize as the sector which has been impacted the most is office REITs in large metropolitan as remote working has dampened demand, thereby creating an oversupply. For this matter, hedge fund titan Paul Marshall, while cautioning about the banking system and CRE loans in general, specifically emphasized " office property ". Checking XLRE's exposure, only 3.07% of its overall weight was dedicated to office REITs as of April 27, compared to nearly 47% and 13% for specialized and industrial REITs respectively. It also has nearly 14% of exposure to residential properties, signifying that it is heavily weighted in tech, logistics, and residences.
XLRE's sector exposure (www.ssga.com)
To show how this exposure has impacted the price performance, I compare it with the Vanguard Real Estate ETF ( VNQ ) which is more exposed to office REITs, at 4.5% of its overall weight.
As shown in the chart below, since the beginning of March, XLRE has delivered a 0.03% gain, which is not great, but, VNQ has lost 1.8%. The differential in performance comes to 1.83%, compared to a historical (one-year) difference of 0.63%. Consequently, VNQ recently underperforming XLRE to a larger degree indicates that the market has clearly been pricing in its higher exposure to office REITs, instead of indiscriminately punishing both ETFs in my opinion.
Now, the next question is whether you should buy shares of the State Street ETF which comes at an expense ratio of 0.10%, or lower than its peer by 0.02%. In this respect, with office REIT holdings like Alexandria ( ARE ) and Boston Properties ( BXP ) down by more than 20% since the beginning of this year with the pain likely to continue, some may even question the rationale of opting for an ETF in the first place.
XLRE's Strengths
However, to mitigate against volatility, XLRE does have exposure to healthcare REITs like Ventas ( VTR ) and Welltower ( WELL ) which have suffered much less downside . Thus, investing through a fund has its own advantages like providing for diversification in this highly uncertain world where few expected interest rate risks to impact the banking sector through a devaluation of long-duration treasury bonds.
Next, I specifically look at debt aware of the $1.5 trillion figure.
For this matter, the chart below shows the three-year evolution of the quarterly debt-to-equity ratios of the top ten holdings which form 62.63% of XLRE's portfolio. First, it can be observed that none have a ratio exceeding one, synonymous with high leverage. Second, most have been reducing debt or increasing the amount of capital raised through equity with the notable exception of Public Storage ( PSA ) but whose ratio is the lowest at 0.128. As for Welltower, its debt to equity went down by more than 30% from mid-2020 to 0.438 currently, while for Realty Income ( O ) with retail exposure, it is 0.435.
Another advantage of XLRE is that it lays emphasis on dividend growth. Thus, those merely looking at yields could be tempted to opt for VNQ which pays higher, but, with a 0.49% CAGR growth during the last three years, this is lower than XLRE's 4.63%.
Thinking aloud dividend growth is important at a time when rates, which are the Fed's main tool to combat inflation, remain high resulting in higher bond yields, both for treasuries or investment grade bonds. These have become more attractive for income seekers and come with fewer risks than REITs. However, both fixed income and real estate will suffer as the Fed may have to sustain its hawkish tone given that the PCE index, which is its measure of inflation remains above the 2% target, despite dropping to 4.1% in March.
This may be the reason why JPMorgan's ( JPM ) acquiring First Republic on May 1 failed to stir up any upward momentum in regional banks or REITs stocks as investors may be eyeing the next monetary policy-determining FOMC meeting on May 2-3.
Exercising Caution Amid Volatility
Pursuing with a cautionary tone, another factor that may impact the REIT sector is the true value of properties that will emerge with the sale of a bankrupt Signature Bank's ( SBNY ) sizable portfolio of CRE loans. For this purpose, the FDIC or Federal Deposit Insurance Corporation has planned to sell about $60 billion of the failed bank's loan portfolio to qualified buyers. The process should start in the summer and some would prefer to wait for the actual value of these loans especially given that they will be disposed of on an as-is basis which entails no warranties.
Looking at the bigger picture, whatever the concentrations of CRE loan portfolios held by regional banks, it will ultimately depend on the capability of the banking system to absorb default risks. Up to now, the weakest links have fallen, and given the pace at which monetary policy has been tightened, other failures cannot be excluded, but, to avoid contagion, and as I explained in a recent thesis , the Fed has the tools in place to ensure the availability of liquidity so that banks do not have to liquidate their treasuries at a loss.
Moreover, the recession is still not here and despite slowing down from 2.6% in the fourth quarter of 2022, GDP grew by an estimated 1.1% in the first three months of 2023. Hence, talking about growth, XLRE's top ten holdings which account for more than 60% of its total weight, incrementally grew their quarterly revenues during the last three years as shown below.
This growth has been achieved while exercising debt control and it has further room for progress given that it is mostly driven by secular trends like digital transformation, realignment of supply chains to support onshoring, and the American dream to own a house.
Along the same lines, seeing the recent gains in data centers, telecom towers, and healthcare REITs in the aftermath of earnings, there are reasons to be optimistic. On the other hand, retail property developers suffered, and, as expected, office REITs were crushed.
In these circumstances, trading at around $37.4 and being down 17.8% in the last year, some may be tempted to invest, but, it is better to wait for the Fed's Chairman's comments in order to assess whether he is willing to compromise on inflation in order to decrease the probability of further cracks appearing on the liquidity front. Finally, there should be plenty of volatility as the debt ceiling deadline looms and the share price could fall to the $35 support level , providing an opportunity for those wishing to position themselves for the long term.
In conclusion, there are challenges for commercial real estate as the economy decelerates and borrowing costs move higher, but, amid the gloom, there can be opportunities.
For further details see:
XLRE: Some Strength Amid Real Estate Gloom, But Wait