The REIT Paradox: Cheap REITs Stay Cheap (2024)

The REIT Paradox: A Factor Analysis

In this report, we take a deep dive to analyze the underlying factors that drove performance within the REIT sector over the past decade and extract the major lessons that can be learned. Even as REITs have permeated into the investing mainstream, many of the traditional "style factors" and stock-picking techniques that work in other equity sectors haven't worked in the REIT space, a conundrum that has puzzled analysts and investors.

(Hoya Capital, Co-Produced with Brad Thomas through iREIT on Alpha)

Last week, we analyzed the overall performance of the real estate sector during the 2010s in Recover And Rebuild: A Decade In Review. If the 1990s were the "Genesis" and the 2000s were the "Terrible Teens," the 2010s was the "coming of age" decade. REITs moved out of their parent's basem*nt and into their own place in 2018 as GICS carved out an 11^th equity sector for the equity REIT sector. As of last August, real estate represented roughly 3% of the S&P 500 and roughly 10% of the mid-cap S&P 400 index.

Despite entering the 2010s scarred and wounded from the devastation of the financial crisis, REITs and Homebuilders delivered generally strong and steady performance throughout the last decade following an intensely volatile 2000s. Despite being viewed as a more defensive and yield-oriented sector during a decade that saw the longest US economic expansion in history, REITs (VNQ) produced an impressive compound annual total return of roughly 12.6%, slightly shy of the 13.5% annual total return on the S&P 500 (SPY).

Despite the mild underperformance over the last decade, REITs have actually outperformed the S&P 500 by more than 100 basis points per year over the last 25 years according to NAREIT, with average annual returns of 11.18% compared to 10.15% on the S&P 500 and put up similarly impressive numbers compared the small-cap Russell 2000 (IWM) and the tech-heavy Nasdaq (QQQ).

The strong performance raises an important question: How are REITs - which are required by law to pay out 90% of their taxable income every year - able to keep pace or even outperform these other more growth-oriented equity indexes? In short, REITs are far more growth-oriented than they get credit for, a misperception which we believe is the core driver of the unique "style factors" that have perplexed generalist investors.

Among other advantages of the REIT structure (liquidity, scalability, reliable dividends, ability to diversify, and good corporate governance), access to the public equity markets to fuel accretive acquisitions has been the defining competitive advantage for REITs, explaining much of the consistent outperformance over the last 25 years.

Counterintuitively, REITs are fundamentally at their best when their equity valuations are slightly elevated, thus enabling these REITs to utilize the equity capital markets to fuel accretive external growth. For illustrative purposes, we diagram the theoretically expected sources of total returns under two valuations scenarios. While yield-focused investors tend to view more "expensive" (and lower-yielding) REITs less favorably, the total return potential of these REITs has been persistently higher over the last ten and twenty-five years.

What Is Factor Investing?

The popularity of "factor investing" has exploded over the last several years, driven by the rise of "Smart Beta" passive strategies that choose securities based on attributes that have historically been associated with higher returns, not too different from the strategies utilized by active "stock pickers." ETF.com lists no fewer than 290 "multifactor" ETFs with an aggregate AUM of more than $100 billion. Ideally, these factors are the result of a persistent market anomaly, behavioral bias, or risk premium, and can thus persist over a period of time, even after the factors are widely known and understood by market participants.

(Image Source: MSCI)

While there is a limitless quantity of potential factors, the most commonly studied and employed include those initially outlined in the academic research of Fama and French and include value, momentum, and size. Here's the kicker: not only has the evidence indicated that these factors do not work when applied to the REIT sector over the past two decades, the evidence suggests that they have actually worked in the opposite direction and this stubbornness has shown remarkable persistence.

The REIT Factors That Work

We studied REIT performance trends over the last decade and our analysis uncovered five "factors" which have exhibited the most notable outperformance. Headlined by the finding that lower dividend yielding REITs have consistently delivered stronger total return performance, we also uncovered a market cap "sweet spot" for outperformance and found that elevated share price valuations are actually associated with further outperformance, a finding that clashes with the traditional "value" factor.

These findings are consistent with our view that "growth" has been persistently undervalued within the REIT space and that the importance of "cost of capital" (reflected in higher relative FFO and NAV valuations) has been underappreciated by REIT investors over the past decade. Our findings are also broadly consistent with research from other REIT research firms, suggesting that even though these trends are generally understood by market participants, they still persist over time and thus qualify as true "factors." We outline these findings in the chart above and discuss each of these factors in further detail below.

1. Sector Selection First, Stock Selection Second

There's a reason that we dedicate so much time and resources to analyzing (and sharing) our property-level and macro-level sector fundamental analysis: property sector selection is the single most important determinant of performance in real estate investing. Over the last decade, the average year saw a 40% average spread between the best and worst-performing real estate sectors. Importantly, the evidence suggests that higher-growth sectors have been persistently undervalued within the REIT sector while lower-growth sectors have been overvalued, as measured by the trailing 3-Year FFO growth. To give oneself a shot at outperformance, we believe that security selection within the REIT sector must begin with property sector selection.

2. Don't Fall For the High Yield Trap

Like the sirens from Homer's Odyssey, the allure of high dividend yields has led many REIT investors astray over the past decade. For older investors that absolutely need the immediate income, the appeal of higher-yielding REITs is understandable, but other investors should "trust the process" and view REIT dividends as one part of total returns, which include internal growth (same-store NOI), and external growth (acquisitions and development). Splitting the REIT universe into thirds, our analysis indicates that the highest-yielding REITs have persistently underperformed while the lowest-yielding REITs have delivered outperformance by roughly 3.6% per year over the REIT average. 2019 took these trends to an extreme with the lowest-yielding REITs delivering total returns of nearly 39% compared to returns on the highest-yielding REITs of under 20%.

3) Cheap REITs Stay Cheap

In a business where "cost of capital" is the true competitive advantage and the driver of underlying dividend growth, cheap REITs tend to stay cheap while expensive REITs tend to stay expensive. We stress in all of our sector reports the importance of Net Asset Value and how cheap equity capital (as measured by NAV premiums or FFO per share premiums) can help to drive external growth which has historically explained more than half of REIT total returns. Again splitting the REIT universe into thirds, our analysis indicates that the "cheapest" REITs, as measured by FFO per share multiples, have persistently underperformed while the more expensive third of REITs have delivered outperformance by roughly 2.8% per year over the past decade. Similar to the dividend yield factor, 2019 took these trends to an extreme with the more expensive REITs delivering 38% total returns while the cheaper REITs lagged with 19.2% total returns.

4. There Are No Shortcuts: Slow And Steady Wins

In a decade that saw some of the most favorable macroeconomic conditions for companies sensitive to economic growth and an "easy" interest rate environment, one would expect that utilizing higher amounts of leverage would have been a winning strategy. That wasn't the case in the REIT sector in the 2010s, as REITs that used higher leverage - as measured by NAREIT's Debt Ratio - lagged over the past decade as balance sheet quality continues to be one of the more reliable outperforming factors. In 2019, REITs that fell into the lowest third in the debt ratio metric produced total returns of nearly 33% compared to the sub-20% total returns of the more highly-levered REITs. We found that over the past decade, investing REITs with better balance sheets produced outperformance of roughly 2.6% per year.

5) Find The Market Cap "Sweet Spot"

One of the more interesting factors was the discovery of a "sweet spot" of market capitalization that resulted in persistent outperformance. Similar to the valuation effects noted above, small REITs tended to stay small, but REITs that fell into the middle 50% of market capitalization saw the best performance over the past decade. This finding is consistent with the "access to capital" growth theory: REITs that are too small have more difficulty raising growth equity, but once they reach a certain threshold, the differences in access to capital between mega-cap REITs and larger mid-cap REITs is minimal. This 'Goldilocks' effect implies that investors in traditional market capitalization-weighted indexes like the broad-based Vanguard Real Estate ETF are underweight REITs in this "sweet spot" and are failing to capture the positive effects of this size factor.

Recap: Applying These Factors To Portfolio Strategy

While the allure of high yield REITs can be tempting, we stress that while there are no shortcuts in REIT investing, that one can indeed "tilt the playing field" in their favor by having the discipline to focus on high-quality names and long-term dividend growth rather than double-digit dividend yields that can be cut to zero at any moment. Looking at you, CBL & Associates (CBL).

Counterintuitively, in an industry generally associated with lofty dividends, the evidence suggests that "high dividend yield" and "low valuations" as factors led to persistent underperformance within the REIT space while "growth" has been persistently undervalued. Other factors that have exhibited persistent outperformance include balance sheet quality and property sector selection.

We also identified a "sweet spot" of market capitalization that is associated with outperformance, suggesting that exclusively utilizing market capitalization-weighted indexes like the Vanguard Real Estate ETF may systematically underperform due to the natural overweight on the largest capitalization names. While factor analysis is inherently backward-looking and clearly impacted by the macroeconomic regime over the past decade, we believe that several important lessons can be gleaned from these results.

Most importantly, we think that our readers and subscribers should consider the possibility that the REIT sector requires a unique analytical approach due to the critical importance of "cost of capital" on the underlying business operations. "Expensive" doesn't mean quite the same thing to REITs as it does to other equity sectors that are less reliant on equity capital raising, so understanding and forecasting property sector fundamentals become more critical and is the most important determinant to outperformance.

Further, we again stress that focusing primarily on ultra-high dividend yields rather than total return is likely negatively impacting investment performance to a significant degree. While higher-yielding "diamonds in the rough" certainly do exist in the REIT sector, the evidence suggests that systematically overweighting these high-yielding names while systematically avoiding higher-valued, growth-oriented REITs is a losing strategy over the long term.

If you enjoyed this report, be sure to "Follow" our page to stay up to date on the latest developments in the housing and commercial real estate sectors. For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Apartments, Homebuilders, Student Housing, Single-Family Rentals, Manufactured Housing, Cell Towers, Healthcare, Industrial, Data Center, Malls, Net Lease, Shopping Centers, Hotels, Office, Storage, Timber, and Real Estate Crowdfunding.

Announcement: Hoya Capital Teams Up With iREIT

Hoya Capital is excited to announce that we’ve teamed up with iREIT to cultivate the premier institutional-quality real estate research service on Seeking Alpha! Sign up for the 2-week free trial today!

Hoya Capital

Alex Pettee is President and Director of Research and ETFs at Hoya Capital. Hoya manages institutional and individual portfolios of publicly traded real estate securities.

Alex leads the investing group Hoya Capital Income Builder. The service features a team of analysts focusing on real income-producing asset classes that offer the opportunity for reliable income, diversification, and inflation hedging. Learn More.