REIT Total Return Portfolio Review Heading into 2Q2024

A shifting macro environment should benefit REITs

We continuously review the positions in the 2nd Market Capital REIT Total Return Portfolio (RTR) to make sure each thesis is up to date and throughout the month we trade out if a new position looks more opportunistic than an existing position.  In recent months we have been trading out of preferreds as they approach par value which limits the remaining capital gains potential.  They have been replaced primarily by REIT common stocks which remain substantially undervalued.

In this update, we want to discuss the forward outlook for REITs as Fed cuts draw nearer.

REITs in a declining cap rate environment

The Fed began raising rates in early 2022 with the last raise in mid-2023.  Over that period the Fed Funds rate went from nearly 0 to 5.33% with the current range being 5.25%-5.5%.

This had 2 major impacts on REITs

• Cost of capital is now higher
• Cap rates on properties are now higher

In the long run, these effects balance out such that spreads remain the same.  In other words, REITs used to buy properties at 4.5% cap rates with a 3% cost of capital and now they are buying at 8% cap rates with a 6.5% cost of capital.

Obviously, these are rough numbers and there is lumpiness in how cap rates respond to interest rates, but the idea is that over time things adjust such that interest rates do not have all that much impact to FFO/share.

The above cap rates are related to acquisitions, but a similar adjustment takes place in existing properties.  Properties already owned by the REITs also have 2 effects which are analogous to those above.

• Rents go up (when owning is more expensive, landlords can charge higher rent)
• Interest expense goes up as mortgages get refinanced.

With acquisition spreads and the NOI of existing properties largely adjusting, the net impact to FFO/share is rather minimal.  There has been lumpiness with some REITs benefitting due to rents rolling faster than debt that must be refinanced and some REITs getting hurt if they had debt terms shorter than their rental contracts.

Indeed, the FFO/share of REITs in general has been steady with most growing at a low single-digit pace.

If we assume the market consensus is right or that the Fed’s dot plots approximate reality there are going to be 1 to 3 Fed cuts this year (25 basis points each) and a handful more next year.  Recent inflation data has moved the estimated start date back from June to more likely September.

These are expected to take the Fed Funds rate back down to about 3% in the next couple of years.  The same adjustments that occurred on the way up should happen in reverse on the way down.

Cap rates are likely to maintain a similar spread over cost of capital and fall from roughly 8% to about 6%.  These cap rates impact both the value of the properties and the implied cap rates at which the REITs trade.

All else equal, when the cap rate on a given property goes from 8% to 6% the property value increases by 33%.  The math is fairly straightforward, just consider a building with $100,000 of annual NOI.

Similar math applies at the REIT stock level.  In the higher interest rate environment investors have demanded higher forward expected returns which means REITs have traded at lower multiples than historical norms.  The median REIT right now is trading at just over 12X FFO and historically it has been closer to 16X.

If interest rates move back to a more normal 3% Fed Funds rate, we would anticipate FFO multiples moving back up to more normal levels.  Going from 12X to 16X would be the same 33% as the delta in property values from an 8% cap rate to a 6% cap rate.

Thus, if the Fed moves as anticipated, we think REITs will now be trading with a tailwind rather than the headwind they have been battling for the last couple of years.

How does this differ from the S&P?

In theory interest rates should affect everything as all financial assets should be based on some premium to the risk-free rate.

The tepid performance of REITs in the rising rate environment strikes me as financially rational.  With the risk-free rate higher, stock prices should adjust to lower multiples such that the forward expected returns are higher thereby maintaining a similar risk premium.

The S&P seems to be the outlier here as its earnings multiple has actually expanded in the rising interest rate environment.

It doesn’t really make sense to be trading at abnormally high earnings multiples when the risk-free rate is abnormally high.  The risk premium has shrunk to almost nothing.  It goes against the basic principles of finance.

So while interest rates should impact REITs and the S&P in a similar fashion, we think an expected drop in interest rates over the coming periods will play out much better for REITs.  Quite simply, REITs already adjusted downward to accommodate higher rates and will now get to adjust upward to accommodate more normal rates.

The S&P never adjusted downward and with the multiple at which it is trading it does not have room to adjust upward if/when rates fall.

With that macro backdrop, let us now turn to the portfolio and the stocks within.

Portfolio Valuation

The REIT universe has a wide range of valuations, and the index consists mostly of the expensive names.  We sift through the REITs to try to find superior combinations of value and quality.  When looking for value, there are many stocks to choose from as the median REIT is trading at just over 12X FFO.  In fact, REIT Total Return’s FFO multiple is in line with that of the average REIT.    The anomaly here is that despite most REITs being very cheap, the index trades at 16.83X.

So while REITs are cheap, most REIT ETFs or other broad REIT exposure does not actually provide that value.

Hand-selecting the mispriced REITs affords a significantly higher FFO yield which fuels a larger dividend yield of 5.14% for the RTR portfolio.  Below is the sector weighting of RTR.

The big changes from last month are fewer preferreds (zero now) and more land.

Many of the land plays are presently being valued based on their cashflows rather than the combination of cashflows and land appreciation.

Wrapping it up

We look forward to a time when company fundamentals drive market prices, but for now, it remains a macro-driven market.  The good news, as discussed at the outset, is that the macro backdrop seems to be turning in favor of REITs.  We like the set of REITs in the portfolio and think they are positioned to excel in this environment but will remain watchful in case better opportunities come along.

Important Notes and Disclosure

Material Market and Economic Conditions.   March 2022-2023: Significant increases in the Federal Funds Rate by the Federal Reserve have caused REIT market prices to decline more than the broader markets. REITs rely on debt financing to acquire properties and fund their operations; expiring lower-cost debt is being refinanced at higher interest rates due to prevailing market conditions. March 2020: REIT Total Return’s value declined substantially as COVID shut down the economy.  It recovered in 2021 as the economy reopened.  January 2019: Tax-loss selling’s calendar expired and the government reopened on January 25, 2019. The combined effect caused our shares to rise more than the broader markets.  December 2018: Another Fed-Funds rate hike, unresolved US-Chinese trade, a partial government shutdown, and an exaggerated tax-loss selling season put extreme downward pressure on equity prices.  All of these factors contributed to diminished liquidity and more significant share price declines in small-cap/value issues; REIT Total Return is focused on small-cap/value issues, so our decline was significantly more precipitous.

Material Conditions, Objectives, and Investment Strategies.  REIT Total Return is an actively managed investment portfolio of real estate equities, primarily common and preferred shares of REITs, with an aim to generate high total returns from a mix of dividends and capital appreciation.

All REIT Total Return Portfolio performance information on this page is based on the performance of the Portfolio Manager’s account, using the manager’s own funds. Performance of the Portfolio Manager's account is calculated by Interactive Broker on a daily time-weighted basis, including cash, dividends and earnings distributions, and reflects the deduction of broker commissions (when commissions were charged). Actual client returns will differ. **2nd Market Capital’s advisory fees are simulated and applied retroactively to present the portfolio return “net-of-fees”.

None of the performance information displayed on this page is based on the actual performance of any 2MCAC client account investing in this portfolio. The performance in a 2MCAC client account investing in this portfolio may differ (i.e., be lower or higher) from the performance of the account managing this portfolio and portrayed on this page based on a variety of factors, such as trading restrictions imposed by the client (resulting in different account holdings), time of initial investment, amount of investment, frequency and size of cash flows in and out of the client account, applicable brokerage commissions (when commissions were charged), and different corporate actions. Clients investing in this portfolio may view the actual performance of their investment in this portfolio by logging into their Interactive Brokers account and reviewing their customized dashboard.

Clients may restrict any of the securities traded in their account but should note that any restrictions they place on their investments could affect the performance of their account leading it to perform differently, worse or better, than (a) the above-portrayed account or (b) other client accounts invested in the same portfolio.

Forward-looking statements. Commentary may contain forward-looking statements which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts, and findings in these documents.

Past performance does not guarantee future results.  Investing in publicly held securities is speculative and involves risk, including the possible loss of principal.  Historical returns should not be used as the primary basis for investment decisions.  Although the statements of fact and data in this commentary have been obtained from sources believed to be reliable, 2MCAC does not guarantee their accuracy and assumes no liability or responsibility for any omissions/errors.

Use of Leverage or Margin. REIT Total Return Portfolio will utilize margin only for trading purposes (the ability to use the proceeds from stock sales immediately for new purchases instead of waiting for the usual 2-day settlement period), but not for borrowing purposes.

Benchmark Comparison. Our REIT Total Return Portfolio is compared to the Dow Jones Equity REIT Index and the MSCI U.S. REIT index because they are common REIT Indices.   The Dow Jones Equity All REIT Index is designed to measure all publicly traded equity real estate investment trusts (REITs) in the Dow Jones U.S. stock universe. The MSCI US REIT Index is comprised of equity real estate investment trusts (REITs) eligible included within the eight Equity REIT Sub-Industries of the Equity Real Estate Investment Trust (REITs) Industry. It is not possible to invest directly in the Dow Jones Equity All REIT Index or MSCI US REIT index.  Index returns do not represent the results of actual trading of investible assets/securities. Index returns do not reflect payment of any sales charges or fees an investor may pay to purchase the securities underlying the index. The imposition of these fees and charges would cause the actual performance of the securities to be lower than the Index performance shown. The results portrayed include dividend income. Our REIT Total Return Portfolio may include REITs that are not eligible for inclusion in the Dow Jones Equity All REIT Index or MSCI US REIT Index.

There can be no assurance that a benchmark will remain appropriate over time and 2MCAC will periodically review the benchmark’s appropriateness and decide to use other benchmarks if appropriate.

Expenses.   Returns reflect the deduction of any transaction expenses. REIT Total Return's advisory fees are simulated and applied retroactively to present the portfolio return “net-of-fees”.

Calculation Methodology.   Returns are calculated by 2MC with data from Interactive Brokers LLC using the Modified Dietz method, a time-weighted measure of performance in which cash flows are weighted based on their timing.    Dividends in REIT Total Return are reinvested.

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