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Long/Short Investments in L/S Equity: Valuation and Ideas,

The Market’s Top REIT Fund – What’s In It?

Real estate investment trusts (“REITs”) are a common favorite among individual investors due to their high dividend yields. Many design portfolios with the goal of income in mind. However, I personally don’t believe in designing portfolios strictly with the intent of dividends or “income.”

I believe it’s too restrictive and can be difficult to properly diversify in order to hedge away risk if one becomes systematically biased toward a certain asset class, toward a certain type of security (“high dividend” or whatever), to trade only in a certain direction (“long only”), or to have a fixed holding period in mind (bias toward only holding for a short period of time, long period of time, etc.).

But it sounds reasonable in theory that, over enough time, continuous contribution to an “income” portfolio will accumulate to the point where the dividends/coupons will essentially replace the salary that could be obtained from a job. Accordingly, at one point, one could effectively retire and live off the income.

Given that REITs are legally obligated to pay out at least 90% of their earnings to shareholders – in exchange for corporate tax advantages – these entities commonly produce high dividends.

And dividend stocks tend to attract large crowds. There’s an inherent psychological bias in favor of high dividend stocks, given the thought process is that if you invest into these securities, the market can trade flat or even a little bit against you and you’ll still make money.

But the truth is that it really doesn’t matter either way whether you invest in a “high dividend” stock or one that offers a low (or no) dividend. In the end it boils down to earnings over the long-run.

If a stock offers a 10% dividend yield and earnings growth is estimated at 10% year-over-year, it would be expected that the stock would not appreciate in price terms, but still spit out the dividend.

If a stock had no dividend and earnings growth is estimated at 10% year-over-year, it would be expected that the stock would appreciate by 10% annually so long as the earnings growth matches these expectations. In the end, the result is the exact same.

Overall, the only advantage that “dividend stocks” may have over those that offer a low or no dividend is that the former will tend to be less volatile. If a company offers a dividend attached to its shares, it typically means that management expects a portion of its earnings to be effectively guaranteed. Thus it’s much more likely to regularly be a profitable, cash-flow positive business.

Largest Holdings

In the market’s most common REIT fund (ticker: VNQ), a total of six holdings have weightings greater than 3%, eleven with weightings of greater than 2%, and 25 with weightings of greater than 1%.

Simon Property Group (SPG), which is the largest REIT by market capitalization (around ~$50 billion) and largest mall operator in the US, takes up a little more than 6% of the fund. With its commercial mall, “brick-and-mortar” retail focus, the stock is off about 30% from its all-time high obtained in July 2016.

Self-storage service Public Storage (PSA) has nearly a 4% representation. The company has an easy to understand business model wherein it predominantly buys warehouse properties and rents out storage units for personal belongings. The company is off around 25% from its Q2 2016 highs.

Equinix (EQIX) (3.8% representation) operates internet business exchange centers where internet companies store equipment and other physical necessities related to network connectivity. Unlike many others in this fund, EQIX is around all-time highs, which has helped offset some of the losses associated in an environment where central banks are beginning to either take away liquidity and/or raise rates.

Prologis (PLD) (3.7%) is a multinational logistics REIT yielding around 3% and one of the few with a $30+ billion market cap. Like many in the sector, the company shed about 85% of its value in the financial crisis, and still remains 12% below its all-time high peak at the time of writing. Prologis is not a big name among the retail crowd given its fairly standard 3% yield, but is one of the most valuable REITs in the world due to its expansive reach. It takes in $2.5-$3.0 billion in revenue per year.

Welltower (HCN) (3.2%) invests in medical buildings, senior-citizen housing, and assisted care centers. As such, its price patterns tend to correlate fairly readily with the healthcare sector given the co-interdependence in business models. Since December 1998, HCN has had a +0.37 correlation with the healthcare sector. Like all asset correlations, it will hop around at times, sometimes dramatically.

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AvalonBay Communities (AVB) (3.1%) is one of my personal favorites given it focuses on the development and management of apartment complexes in markets that are difficult to penetrate among smaller competitors, providing some level of competitive insulation. AVB focuses on markets on both US coasts, in the Pacific Northwest, San Francisco Bay Area and southern California, and Northeast and Mid-Atlantic regions.  

Those are merely the top six. There are a total of 154 holdings and cover the range of the REIT universe, from single-family and multi-family housing, hospitals, mortgage REITs, storage units, shopping centers, warehouses, hotels, office spaces, and various other arrangements by which real estate is the operative income producer.

What About The Interest Rate Environment?

REITs as a whole tend to do better in a low rate setting, given real estate is fundamentally a “borrow and leverage” type of business. Although hurdle rates are idiosyncratic to different types of businesses, it is fundamentally easier to make accretive investments when rates are low.

Accordingly, many are concerned that REITs are falling out of favor as central banks pull away QE-related stimulus and raise interest rates.

However, like anything else, what the market expects in the future is already priced into the assets. If the market is expecting overnight rates in the US to rise to 3% by the end of 2019, then this discounting will already be reflected in the prices of not only REITs, but various asset classes affected by interest rates, which is more or less everything to a degree.

I believe for various reasons that central banks cannot raise interest rates substantially without excessively flattening the yield curve, which comes with issues related to lending profitability and the destruction of credit formation in an economy. When yield curves invert, recession usually occurs at some point in the next year or so.

I do believe central banks will become more dovish over the next twelve months, which could keep the equity and bond markets going. Overall, I’m not bearish about the economy or financial markets over the next 12-18 months. I think raising the overnight rate up past 2% in the US when inflation and real GDP are mediocre at sub-2% levels would be a policy mistake.

Unemployment is overstated by traditional metrics and ignores lowering labor force participation rates, productivity, and real wages, which are infinitely more important than a singular phony bureaucratically contrived figure.

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