Abu Hanifah
By Matthew Wolpert, CFA
High-quality REITs with steady cash flows can be a bulwark against volatility—better yet, they’re trading at attractive discounts relative to stocks.
Stocks managed a rally in October, but more volatility appears on the horizon. While the market expects the Fed’s terminal rate to be over 5.0% in the first quarter of 2023, many datapoints already show the economy dramatically slowing, including corporate earnings forecasts, Pending Home Sales, Business Conditions Surveys, and Composite PMIs. A currently rapidly slowing economy combined with tighter monetary policy sets the stage for further weakening in growth in 2023.
In this challenging environment, we believe public REITs can provide welcome shelter at relatively attractive valuations. Thus far in 2022, the MSCI US REIT index is down 25%, versus a loss of 18% for the S&P 500. And despite REITs’ strong performance in 2021, the sector has still lagged the S&P 500 by 26 percentage points since the end of 2019.1
REITs own hard assets that can produce steadier cash flows during cyclical downturns and provide additional inflation protection compared to the broader basket of companies in the S&P 500 that are more vulnerable to rising costs. In our view, REITs also have strong potential for their earnings multiples to re-rate more positively than other sectors in a recession, thanks to long-duration cash flows (akin to bonds) that would be worth more if sovereign debt yields decline (as they normally do in such downturns).
Relative valuation also favors the REIT sector. The REIT index’s recent dividend yield of 4.4% well exceeded S&P 500’s 1.7% yield,2 while its forward earnings multiple was nearly equal to that of the S&P’s, versus historically trading at a substantial premium.3 REITs can also generate more durable cash flows in a recession than other defensive sectors that currently trade at large relative premiums to REITs, such as Staples (4x above REITs) and Utilities (2x above REITs).4
While the direction of the broad stock market is difficult to forecast given today’s macro uncertainties, we believe investing in REITs appears to be a relatively attractive opportunity.
Notes: (1) REIT total return represents the MSCI US REIT Index (“RMS G Index”) calculated on a total return basis per Bloomberg as of 10/31/22; (2) REIT dividend yield is the Vanguard Real Estate ETF (“VNQ”) and S&P 500 is the SPDR S&P 500 ETF (“SPY”) per Bloomberg as of 10/31/22; (3) Citi as of 10/28/22; (4) Credit Suisse as of 10/31/22.
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