In 2013 financial markets have shown a significant breakdown in correlations.  The post-crisis familiar “risk on – risk off” effect of all assets moving in synchrony due to coordinated and massive global monetary policy significantly slowed down.  Some asset classes such as US equities did very well while some exhibited more volatility. One such area that was clearly affected by a change of wind in market’s behavior was the REIT sector. 

Real Estate Investment Trusts are usually quite correlated to interest rates since they benefit from low rates for their large and recurrent financing needs. They also compete with bonds for investment dollars as they reach out to similar income oriented investors. For this reason, a rise in rates may hurt the sector; of course the degree of correlation also depends on the economic conditions present in the background. A rise produced by strong economic growth may be absorbed much more easily than a rise in rates occurring during lackluster economic growth. 

REITs started the year extremely well as rates on the benchmark 10 year US Treasury were hitting all times lows; REITS distributions made the sector extremely attractive.  However, valuations quickly soared and in mid-year the Federal Reserve started to convey a different message about monetary policy which resulted in rates rising approximately 100 basis points.  REITs were affected quickly as the combination of lofty valuations, interest rates rising and question marks over the sustainability of economic growth started to weigh.

The correction in REITS was substantial, taking the sector down by approximately 15%.  Valuations seem overall fair at the moment and spreads are in line with historical averages. Based on numbers provided by the National Association of Real Estate Investment Trusts, the average equity REIT yielded 3.55% as of 10/31/13 which results in a spread of 101 basis points over 10 year Treasuries, just 4 basis points below the average since 1990. The key for future performance remains linked to economic prospects for 2014.  Most economists are expecting GDP to grow at 3% in the next 12 months while rates are expected to stay relatively muted even though Quantitative Easing is widely assumed to be tapered and eventually ended by the end of 2014. If such economic growth indeed will materialize, we think it could easily offset any headwind from rising rates.

In the short term, REITs may continue to be more volatile than usual as the market assesses future moves by the Federal Reserve; however, the longer term view remains one of cautious optimism.  

A recent industry survey produced by Standard and Poor’s Capital IQ[1] sheds some light on subsectors trends and conditions.  Commercial real estate remains active in spite of higher rates; S&P notes significant investments from foreign buyers, especially South Korea which is now believed to be the largest foreign investor in real estate in the world.

As far as residential REITs, we note full valuations in the multi-family sector yet conditions continue to be relatively benign.  A new trend we highlighted months ago in a previous analysis regards the emerging sub-sector of single family homes.  Private Equity giant Blackstone has reached critical mass by acquiring for the purpose to lease out over 32000 homes in different markets across the US.  Blackstone is expected to spin off this unit in an IPO later next year. Colony American Homes is also expected to IPO a similar subdivision.

S&P maintains a positive view also for retail REITS while we are a little more pessimistic given structural headwinds such as increase of on-line shopping, high cost of fuel and environmental concerns.  These are all long term issues which make us uneasy for the sub-sector.  Conversely, the rise of e-commerce should favor industrial real estate and drive demand for distribution facilities. To put thing into context, we can mention Amazon’s growth in its distribution centers and the importance of the recent opening of its fourth fulfillment center in California – a 1.2 million square foot center in Moreno Valley.

In line with our “Energy Renaissance” theme, we think that energy related real estate should also do well in the next few years. 

Given the current and projected demographics in the US, we continue to see long term opportunities in the health care sector.  This is in spite of short term volatility for some of the names due to the roll out of Obamacare and general fiscal restraint which puts pressure on reimbursements from Medicaid and Medicare.

S&P holds a positive outlook for self-storage especially in a rising rate environment due to short term leases, high sector fragmentation which breeds opportunities for consolidation and limited recent supply.

In conclusion, we think that as the sector stabilizes and clarity increases on future Fed policy, selective opportunities will arise.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory services by THALASSA CAPITAL LLC, in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction.  The information contained in this writing should not be construed as financial or investment advice on any subject matter.  THALASSA CAPITAL LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.