Rates, Values & Quantitative REIT Investing
CBRE Predicts Further Rate-Driven Declines
Anyone in the real estate business has been glued to the volatile movements of the 10-year US Treasury this year. The benchmark rate briefly crested over 5% in October after falling to a low of 3.2% in April. The 10-year provides an important benchmark for commercial real estate lending which feeds into transaction volumes and in-turn, values. However, lower transactions volumes and distressed pricing creates a compelling opportunity for listed REIT investors.
10-year Treasury Yield at Highest Level in 16 Years
Source: U.S. Department of Treasury, CBRE Research, October 2023.
CBRE Research suggests investment volumes could fall by another 5% next year, driven primarily by tighter lending standards and higher cost of capital. Should the 10-year treasury stay elevated above 5%, CBRE is predicting peak-to-trough value declines of as much as 40% for Office, 10% for Industrial and as much as 25% for Multifamily. The long view is more positive though,
"Although the 10-year Treasury yield has briefly reached 5%, we expect it will end the year at 4.6% and decline to around 3% in 2025. We predict it will remain at approximately 3% over the next 10 years, well above the 1.9% average between 2009 and 2019 but low enough to drive recovery in real estate values."
Current & Forecast Change in Capital Values by Property Type
Source: CBRE Econometric Advisors, CBRE Research, Q3 2023.
The REIT Opportunity
CBRE's report is focused on commercial real estate prices broadly but listed REITs have already fallen by equivalent or greater values. REITs are also liquid, available daily in the market, whereas in private markets you can only buy what is for sale. In many ways, public markets are offering the private market values of tomorrow, today.
A Quantitative Approach to Residential REITs
The Big Ideas
Market Capitalization-driven REIT strategies do not create optimal portfolios
A large portion of REIT returns come from dividends
Residential REITs are fundamentally more suited to mean-reversion
One of Armada's core beliefs is that market capitalization-weighted REIT exposure does not create the best listed real estate strategy for investors. Because of the payout requirement, REITs are more like asset-heavy pass-through entities than traditional companies that can grow equity value through re-investing internally generated cash flows.
As a result, much of the return in REIT ownership comes from dividends. Further, how a REIT is capitalized is crucially important to its return, none of which is adequately reflected in a pure capitalization weighted portfolio. Going back 10 years, over 50% of total return in residential REITs has come from dividends not price appreciation.
When we began looking at ways to improve REIT investment strategies, we knew that alternative weighting methods and REIT-specific factors would be important considerations. It is a fair generalization to say that the equity of REITs is more volatile than the underlying assets. This may be exceptionally true for residential REITs where the consistent demand for housing supports generally rising rental rates. These fundamental characteristics make residential REIT equity more likely to experience mean reversion characteristics. As an example, in the preceding 10 years, Mid-America Apartment Communities' valuation multiple (Price / Funds from Operation) has been far more volatile than the underlying cash flows.
As we back tested weighting residential REITs by various factors (FFO Yield, Dividend Growth, even Total Asset Value), we noticed that REITs with smaller market capitalization were contributing more to the overall return. There are a variety of explanations for this, some quantitatively driven like leverage ratios and others that were more macro-based like exposure to faster growing rental markets.
Ultimately however, it became clear that the best solution was simplest: Discretionarily equally weighting residential REITs generates a portfolio of listed real estate with a slightly higher dividend, more leverage and greater geographic diversity than a market capitalization weighted portfolio. Moreover, an equal weighted strategy is definitionally one that benefits from the mean reversion inherent to Residential REITs, as you sell large caps and buy small caps on quarterly rebalances.
For investors who believe in the long-term strength of the domestic rental housing market, we believe a proximally equally weighted basket off high-quality residential and residential-adjacent REITs is a more optimal strategy.