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Key takeaways:

  • The outlook for the domestic Real Estate Investment Trust (REIT) market is mixed. While low interest rates and contained levels of debt are positives, the negative impact of the Covid-19 outbreak on the labor market, retail sector and consumer demand are hurting REITs companies.
  • In an ultra-low rate environment, REITs have the potential to be an attractive source of income in a low yield environment.

Overview:

Though often perceived as a defensive sector, REITs were among the hardest hit segments and underperformed the broader market in the recent market selloffs. The impact of social distancing measures on the retail sector, a potential rise in unemployment and slowing wage growth are factors likely weighing on real estate fundamentals, despite ultra-low borrowing rates.

Figure 1: REITs relative performance to the S&P 500

Figure 1: REITs relative performance to the S&P 500

Source: Bloomberg, as of 3/23/2020.
Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

The REITs outlook:

Going forward, despite the recent volatility, several factors may continue to support strength in the real estate market:

  • Relatively stable levels of debt: Higher debt to income ratios can increase the default risk of a real estate investment (and the market as a whole). Currently, leverage is relatively contained with respective to GDP. The U.S. household debt-to-GDP ratio and debt servicing costs to personal income are well below levels struck during the global financial crisis (figure 2). Similarly, the amount of debt servicing relative to personal income is also still far below the housing bubble levels prior to the crisis.

Figure 2: Household debt to GDP is well below pre-recession levels

Figure 2: Household debt to GDP is well below pre-recession levels

Source: Bloomberg, as of 3/26/2020.
Notes: The household debt service ratio is the ratio of total required household debt payments to total disposable income.

  • Persistence of lower rates: With the Federal Reserve (Fed) cutting rates to support the economy, a prolonged period of lower interest rates should be a tailwind for the market. The 10 year U.S. Treasury yield has dropped to 0.77% since the beginning of this year. 1
  • Attractive yields: REITs have the potential to be an attractive source of income in a low yield environment given they are required to distribute at least 90% of their taxable income to shareholders annually in the form of dividends.

However, there are several noteworthy risks to the REIT market that investors should monitor. These include:

  • Weak labor market conditions: With much of the country sheltering in place, the unemployment rate is set to surge in the next few weeks. The weakness in the job market and wage growth could pass through to consumption/spending on real estate, hurting home sales.
  • Sensitivity to economic activities: Though REITs are often used as an income source in a lower rate environment, they are a cyclical sector given demand for real estate is highly sensitive to economic conditions. With hard economic data, such as global PMIs, plunging with the spread of the coronavirus around the world, cyclical exposures are likely to underperform.

Figure 3: Market pricing of cyclical assets and global manufacturing PMI

Figure 3: Market pricing of cyclical assets and global manufacturing PMI

Source: MSCI, JP Morgan, BlackRock, as of 3/23/2019.
Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
Notes: Cyclicals vs. defensives is represented by the ratio between the MSCI USA Cyclical Sectors vs. MSCI USA Defensive Sectors Indexes. The Global Manufacturing PMI is produced by JP Morgan.

Mortgage REITs in 2020:

Mortgage REITs in particular have suffered in the past month, plunging nearly 60%.2

Unlike traditional REITs, which own or operate underlying properties like residential (apartments etc.), commercial (offices), retail (shopping malls), and specialized REITs (cell towers, infrastructure, gaming etc.), mortgage REITs’ primary business is to provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities (MBS) and earning income from the interest on these investments.

As a result, mortgage REITs are sensitive to interest rates and the shape of the Treasury yield curve. While mortgage rates are falling, funding costs have risen; that combination is hurting the mortgage companies. It is important to note that they are currently included within financials from a GICS sector breakout perspective due to the unique nature of their business models.

Figure 4: 3-month Libor rate

Figure 4: Gap between market pricing of cyclical assets and global manufacturing PMI

Source: Bloomberg, as of 3/23/2019

ETF flows:

Investor positioning in REIT ETFs is high relative to other cyclical assets. Over the last twelve months, REIT-focused U.S. listed ETFs gathered $6.3 billion flows (figure 5). This positioning decelerated in recent months, but remains quite bullish compared to other sectors.

Figure 5: U.S. listed sector flows in the past 12 months

Cummulative ETF flows

Source: Markit, BlackRock, as of 3/23/2020.

Conclusion:

From an investment standpoint, the domestic focus of U.S. residential REITs may provide investors with some insulation from challenging international market conditions such as weak growth in both emerging and developed markets outside the U.S. Coupled with REITs interest rate sensitivity, a regime of low interest rates could provide a tailwind for REITs. However, deterioration in consumer sentiment, shift in consumer sentiment, and a credit crunch all are potential risks that bear watching.

Grant Dechert and Jasmine Fan contributed to this article.

Christopher Dhanraj
Director
Head of iShares Investment Strategy
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