Real Estate Investment Trusts (REITs), which are mandated to distribute 90% of their free cash flow back to shareholders in the form of dividends, have been a favorite place for yield hungry investors to generate income in this low interest rate environment. Now, ironically enough, the continuation of low rates is what is causing fundamental problems for the industry.
The crux of the problem lies in the fact low rates lead to very low costs of capital, which help spur development in everything from high end housing, especially luxury apartments, commercial spaces such as offices and warehouses and probably most misguided was the addition of retail space. This increase in supply is starting to face a slowdown in demand. This mismatched equation will lead to a sharp decline in REITs’ share prices in coming months.
In 2015, REITs, as measured by the iShares Dow Jones Real Estate Fund (IYR), tumbled some 20% from January to September in anticipation of the “lift-off” of rate hikes. When Yellen and the Fed decided to punt, REITS enjoyed a sharp bounce. Then after the broad market sell-off earlier this year REITs have come roaring back towards all-time highs.
Unfortunately, what is driving share prices is a flood of capital rather than favorable fundamentals.
First and foremost has been the large increase in supply, especially in the high end residential and to a lesser extent, office space.
Multifamily housing units, mostly in the form of high end condos in urban centers, has increased by 28% and 32% in 2014 and 2015 respectively and is on pace for another 15% in 2016. A report from Fitch notes “Class A construction in the higher-rent neighborhoods in the top 12 metros is by far the most common type of multifamily development at the moment.” It goes on to note asking rents increased by 4.6% in 2015 and are forecast to increase by only 2.9% in 2016. “If the pace of rent increases continues to fall, this concentration could compound downward rent pressure on rents in those areas,” concludes Fitch.
Student housing, which had enjoyed a big boom from 2011 to 2015, is facing some headwinds. New supply of student housing has reached record levels in recent years—some 48,000 units were delivered in ’15 alone—here again Fitch sees pressures from “superior and newer properties that have entered their submarkets during the rise in construction.” The newer product impacts older properties in the form of “increased expenses, deferred maintenance and/or average rent declines. Along with competition from newer deliveries, some student housing product may be affected by declining enrollment at certain institutions, such as Community Colleges, which found that distance-education enrollments accounted for nearly all recent student growth at two-year institutions between the fall of 2013 and fall 2014. “Over the longer run, the trend toward off-campus learning options may lower overall demand for student housing,” according to Fitch.
Office space is coming under similar pressure. A recent report from PIMCO, aptly titled U.S. Real Estate: A Storm is Brewing, predicts commercial real estate prices may fall as much as 5 percent in the next 12 months. A number of factors are coming together to drive the market that way.
A report from the University of Central Florida predicts the US office market will absorb approximately 34.6 million square feet of space in 2016, down from 62.1 million square feet last year. The biggest drag on the forecast comes from lower GDP expectations going forward and falling rates of nonresidential private fixed investment, which measures the willingness of private businesses to expand their productive capacity. Coming in second is the decline in corporate profits, which have been falling since Q4 of ‘15, “a reversal of a trend that bears watching and is a cause for concern, especially for the office sector.”
The other concern is the fact the price of properties have been driven up by capital influx, with many price insensitive investors such as sovereign wealth funds, while the fundamentals and returns have not kept pace. “Consider this: Since the fourth quarter of 2009, overall office prices have doubled (as have general CRE prices), yet national office rents have risen only about 15 percent. The primary price driver for U.S. CRE assets instead has been capital flows.”
Now, due to diminishing returns, capital flows are growing unstable. A recent report from ratings agency Fitch noted, “Capital access is the linchpin of REIT liquidity, given the inherent regulatory cash-flow retention constraints.” This has numerous investors questioning the sustainability of the historically low cap rates underpinning direct property market values, citing persistent net asset value discounts for equity REIT shares.
The three names I’m targeting for bearish positions are:
AvalonBay (AVB), which focuses on multi-family apartment rental properties.
Boston Property (BXP), which as has a mix of office and residential and some exposure to retail.
Vornado (VNO), which is also a mix of office and residential and is currently considering the splitting the two units.
All have liquid options in which buying a long dated puts would provide a low cost, limited risk way to gain downside exposure.
— Steve Smith