Full disclosure: I am not a weatherman but on a good day even I can tell which way the wind blows; looking broadly at the Real Estate market the trees are bending in the breeze. But is this just a squall or something bigger?
REITs are a great way of generating income in a portfolio because, by law, they must distribute at least 90% of their taxable income as a dividend to their investors every year. According to NAREIT (National Association of REITs), in 2022 the REIT sector paid out about $69 Billion in dividendsi, that is some lovely cash flow for investors wanting income from their portfolio.
But consider this, according to Morgan Stanley:
“More than 50% of the $2.9 trillion in commercial mortgages will need to be renegotiated in the next 24 months when new lending rates are likely to be up by 350 to 450 basis points,”ii
That increase of up to 4.5% above the current loan rates stands to add between $50 Billion to $65 Billion just in interest costs to the Commercial Real Estate sector, and about 10% of the sector is owned by REITsiii.
That is a serious headwind facing REITs; although it is difficult to quantify the effect of higher rates exactly, we’d estimate that could consume up to 8% of the 2022 levels of income.
By the way, pension funds and banks own the majority of Commercial Real Estate in the US so any adverse changes could affect those entities dramatically.
Another major headwind lies in office vacancy rates.
Axios reports that as of April 2023, the U.S. office vacancy rate is at an all-time high of 12.9%. They also mention that this is the sixth straight quarter that the rate has increased and up from a post-financial crisis low of 9.4% in Q2 2019.iv
https://www.axios.com/2023/04/13/office-vacancy-rate-remote-work-hybrid-work
Notice the ramp-up in vacancies during the Great Financial crisis from 2008-2010? Curiously we are not in a recession and yet vacancies are at a record. This does not bode well at all for office REITs.
On a brighter note, industrial property sales volumes are near-normal thanks to re-shoring and logistics expansion and hospitality pricing is increasing.i
The true danger here is that higher interest costs and lower occupancy (and the corresponding lower rental revenues) can seriously hinder a REITs ability to generate positive cash flows and consequently to provide dividend income to expectant investors.
Investors holding REITs currently expecting for property price appreciation borders upon foolish, current MSCI Quarterly pricing forecasts project lower property prices in the Office, Industrial, Multifamily, and Retail subsectors; only Hospitality looks positive.ii
But in the words of the great Jim Chanos, “Opinions about facts are what set prices”. And here’s Morgan Stanley’s opinion about the facts they see:
“(the bank’s analysts) forecast a peak-to-trough CRE price decline of as much as 40%, worse than in the Great Financial Crisis.”iii
Other banks have rosier opinions of the space but given the wide range of opinions here is what we are advising:
- If you are a business owner with any leaseholds expiring within 2 years investigate re-negotiating, the time is right to lock in a very attractive lease agreement.
- Also, if you have excess space for your operation, consult a leasing specialist to help you downsize (and reduce cash outflows); there are a lot of options to consider. I’d be happy to point you in the right direction for guidance.
- If you are an investor, please do not be tempted by the super-high yields currently available in the REIT space, yields are high (ie. prices are lower) for a reason. Better to wait for 6-9 months and re-evaluate. Rates can most definitely stay higher for longer and we feel that financial markets in general have not taken this into account. Sustained higher rates would be highly corrosive to cash flows for any REIT operation.
- At Haddam Road we are currently short of the general REIT sector, owning only farmland, farmland-mortgage cumulative preferred shares and a few select foreign real estate holding companies.
Our goal currently is preservation of client capital and pursue a conservative allocation to more robust parts of financial markets, specifically:
- US Treasuries
- The Healthcare / Pharmaceutical sector
- Energy sector
- Foreign Industrials
- Gold and Gold miners
Please reach out if you’d like to learn more about how we allocate capital and manage market risks.
Thank you for reading.
Brian Kearns, CPA/CFP®
Haddam Road Advisors
Registered Investment Advisor
brian@haddamroad.com
Ph: 312 636 3067
www.haddamroad.com
NOTE: This is being provided for informational purposes only and should not be construed as a recommendation to buy or sell any specific securities. Past performance is no guarantee of future results and all investing involves risk. Index returns shown are not reflective of actual performance nor reflect fees and expenses applicable to investing. One cannot invest directly in an index. The views expressed are those of Haddam Road Advisors and do not necessarily reflect the views of Mutual Advisors, LLC or any of its affiliates.
Investment advisory services offered through Mutual Advisors, LLC DBA Haddam Road Advisors, a SEC registered investment adviser.
[i] “Listed REITs (equity REITs and mREITs) paid out approximately $63.1 Billion and public non-listed REITs paid out approximately $6.1 Billion in dividends during 2022”. https://www.reit.com/data-research/reit-market-data/reit-industry-financial-snapshot#:~:text=Listed%20REITs%20(equity%20REITs%20and,billion%20in%20dividends%20during%202022.
[ii] Lisa Shalett - Morgan Stanley Wealth Management Chief Investment Officer, June 27, 2023. https://www.thewealthadvisor.com/article/morgan-stanley-says-commercial-real-estate-will-crash-harder-during-great-financial-crisis
[iii] https://www.reit.com/data-research/research/nareit-research/estimating-size-commercial-real-estate-market-us-2021
[iv] https://www.axios.com/2023/04/13/office-vacancy-rate-remote-work-hybrid-work
[v] Colliers US Market Snapshot: Q2 2023
[vi] Colliers US Market Snapshot: Q2 2023
[vii] https://www.thewealthadvisor.com/article/morgan-stanley-says-commercial-real-estate-will-crash-harder-during-great-financial-crisis