Coronavirus has sent disruptive shockwaves throughout U.S. REITs, well at least in terms of market pricing. In the days since the outbreak, there has been a substantial twist in market pricing that has left significant mispricing in its wake. This article will discuss the market distortion that has already occurred and specific opportunities it has created.
The first coronavirus cases were officially reported when China notified the WHO on 12/31/19. The virus was identified on 1/7/20 and its genome was sequenced and released on 1/9/20. Fatality was first observed on 1/11/20 and it officially spread to Thailand on 1/13/20. In the following days it spread to a few other countries, including the U.S. on 1/21/20. As the number of cases continued to rise, the WHO declared an international health emergency on 1/30/20. The latest numbers as of the time of this writing are 170 deaths and 7,711 confirmed cases in China. So far, the numbers are much smaller outside of China, but it gives a sense for where it could go globally if left unchecked.
I have no medical expertise, so the following statement is just based on the numbers. Compared to previous outbreaks such as SARS, this appears to be significantly more contagious in terms of rate of spread, but significantly less severe. Thus far, the death rate remains quite low relative to the number of instances.
This is a tragic event for those afflicted and their families, but I will try to remain objective in analyzing its financial impacts. There are 2 specific impacts that I would like to discuss: actual fundamental impact and market impact.
Within China, the fundamental impact appears to be moderate with analysts taking a couple percentage points off of their first quarter GDP estimates. The severity of impact was heightened by the timing of outbreak around the Chinese New Year which is a major economic spending period. While a couple percentage points off GDP for a country the size of China is substantial, remember that this is one time in nature. All else being equal, the virus will have minimal impact on next year’s GDP and there may be a rebound as early as the 2 nd quarter.
Outside of China, the overall fundamental impact is somewhat minimal assuming coronavirus is successfully quarantined or treated. Specific sectors may feel a bit more burden such as travel and leisure which will lose bookings due somewhat to quarantines, but mostly to apprehension from would-be travelers.
The fundamental impact on U.S. REITs, is almost negligible. There may be some first quarter drag to hotel REITs with properties in Miami, L.A. San Francisco, Seattle and NYC which are popular destinations of Chinese travelers. In contrast to fundamentals, the market pricing impact has been anything but mild.
Market price distortion
The primary market impact of coronavirus on market pricing has been a broad based flight to safety as evinced by mass purchasing of long dated treasuries.
In just a month, the ten year treasury yield dropped about 25 basis points to just over 1.5%. The shift was seen in roughly parallel fashion for all treasuries 3 years in duration of greater.
What were people selling to buy these treasuries?
Well there was a clear “risk off” trade in which anything perceived as risky got clobbered. Presently, in the REIT universe, risk is conflated with recent price performance, so the risk off trade behaved more like a momentum trade.
Anything that has been up went up further and anything that has been down sold off further. This means large caps became even more bloated while small caps suffered.
Source: SNL Financial
Similarly, property types that were already the darlings of the market soared while the downtrodden fell further.
Hotels dropping makes sense for reasons discussed above, but the rest of the move is counterintuitive. Small caps are overwhelmingly domestic while large caps have significantly more exposure to China. Further, the large caps were already overvalued and the coronavirus related move has exacerbated the distortion. REITs greater than $2B in market cap now trade at a 23.3X FFO multiple compared to REITs in each bracket below $2B which trade between 14.5X and 17.3X.
Source: SNL Financial
That is a 6 to 8 turn gap based solely on size. In the broader market, this pricing gap does not exist. In fact, small caps often trade at a premium to large caps. This price distortion is unique to REITs and amplified at this particular moment in time.
We see it as a great opportunity.
While we have no medical expertise, our base case is that coronavirus will turn out like all of the other recent outbreaks (ZIKA, SARS, and ebola among others) where the global health professionals will use their collective expertise to beat the virus whether through vaccination, isolation or other prevention or treatments. It is almost certainly not the end of the civilized world and the markets will eventually return to normalcy.
Given the magnitude of mispricing, we see a sizable rebound for small cap REITs when the normalization occurs. Over a 10 year period, the FFO multiple difference between small and large caps has been about 2 to 4 turns. Thus, a return to normalcy would represent a 4 turn outperformance for small caps which at current multiples would be about 20 percentage points of outperformance (a little more or a little less depending on which direction the gap narrows).
How to play it
We consistently advocate for individual security selection based on fundamental analysis rather than buying baskets of securities through ETFs. Our latest small cap REIT picks can be seen here.
I understand, however, that not everyone has the time to meticulously study all the small cap REITs to separate the wheat from the chaff. For some people the ETF approach may make a bit more sense. Invesco’s premium yield REIT ETF (KBWY) is a small cap REIT focused ETF that could be used to capture the rebound in small caps if/when it occurs.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.