The next recession is coming. We cannot predict its exact timing, but what we know is the occur:
- Generally every 5 to 10 years;
- when unemployment rates hit 4% to 5% figures;
- and when the yield curve becomes inverted.
These factors combined are a powerful signal that has accurately predicted recessions in the past. Today, we are 11 years into the expansion, unemployment is below 4% for the first time since 1969, and the yield curve recently inverted for the first time in a decade.
At the same time, investors are rightfully concerned because stocks, bonds, real estate, and all other major asset classes appear richly priced even as we get closer and closer to the edge of the cliff:
Recession-related articles are very popular during these times. Market pundits offer their recommendation for sectors to avoid, and others to favor to ride out the anticipated down cycle.
In today’s article, it is my turn to offer you my best recommendation for the preferred sector for capital allocation in 2019. My top pick remains Real Estate Investments Trusts or REITs.
A REIT is a company that invests in income-producing real estate. The intent of REITs is to provide investors the opportunity to own and participate in real estate investments and enjoy taxed-advantaged income and long-term appreciation that can lead to compelling total returns.
Here you might say: But wait, didn’t REITs get crushed during the last recession?
Yes, they did. 2008 and 2009 were very rough years for REITs. The housing market crashed, banks stopped working, and suddenly, refinancing debt became much more difficult or even impossible. REITs were forced to cut dividends not necessarily because of operational issues, but because they needed liquidity to deal with maturating debt and other uncertainty. Dividend cuts, combined with a housing crash and troubled banks, led to massive volatility across the REIT sector and a lot of investors panicked and sold off at large losses.
Why would I suggest REITs heading to a recession?
Well, here we must first understand that each recession is different. The Great Financial Crisis was a rather exceptional event in that banks stopped working. This caused a lot of stress to all leveraged vehicles, including REITs. However, since then, banking regulation was greatly expanded to assure that this does not repeat itself in the future.
A lot of investors avoid REITs today simply because they still have nightmares of the 2008-2009 carnage and fear a remake of it sometime in the near future. Recognizing that each recession is different, we believe that it is more rationale to look at the performance of different asset classes over many cycles to assess their resilience to recessions.
The conclusion is that REITs (VNQ) are exceptionally resilient to recessions. At the exception of the great financial crisis, they have provided meaningful downside protection in recessions and outperformed the S&P500 (SPY) by more than 7% per year in late cycle periods since 1991.
This result makes perfect sense when you consider that REITs generate highly consistent and predictable income from long term leases. These leases generally range from 5 to 10 years and so cash flow remains fairly stable through down cycles.
Even during the sharpest real estate crash of mankind, the same-store NOI of REITs dropped by just 2%. Most tenants kept paying their rent in full and on time:
On the other hand, a regular business will typically feel the impact of a recession long before the average REIT. Take the example of a manufacturing company that may see its order book cut in half from one year to the next and see its profit plummet along with it.
Moreover, real estate is the epitome of Benjamin Graham’s definition of a conservative investment. It is quite simply a piece of Planet Earth that combines land with a man-made structural improvement. As a result, it's a tangible asset that provides clear value to its occupier. Additionally, the nature of its value is limited, necessary, and flexible - giving it remarkable durability and stability in value.
Real estate is limited because the amount of land on Planet Earth is finite and only certain portions of earth are suitable for various types of real estate (i.e., the Sahara Desert is not ideal for most types of farming).
Real estate also is necessary because everyone in the world needs shelter in which to live, farmland for growing food, factories to produce goods, storehouses to keep surplus food and goods until needed, etc. Simply put: Real estate is absolutely needed for the survival and prosperity of the human race and cannot be replaced.
Finally, real estate is flexible in that many buildings can serve multiple purposes with only a little or even no changes needed to the land or the structure, and even when significant redevelopment is needed, it can still often be done in a profitable manner over the long run. As a result, even property that's currently allocated to a business enterprise that is no longer sufficiently profitable still possesses significant value due to its flexibility.
These qualities make it extremely unlikely for real estate to become worthless over time, unless it's grossly mismanaged and overleveraged. This is especially true in the case of REITs, because they own highly diversified portfolios of hundreds of properties that are professionally managed and only use limited leverage. It makes them highly resilient to recessions.
On the other hand, businesses come and go. Sears (OTCPK:SHLDQ) was replaced by Amazon (AMZN). Nokia (NOK) was replaced by Apple (AAPL) and Samsung (OTC:SSNLF). The list goes on and on. The reality is that a business is much less durable to changes than a property investment.
Bottom Line: REITs are Safer than Stocks in a Recession
- REITs have historically greatly outperformed during most recessions.
- They produce cash flow that is highly resilient to downturns.
- They are much more durable than the average business.
This is Especially True for the Next Recession
All these benefits are today compounded, and REITs are particularly well-positioned for the next recessions:
(1) Leverage is Low: REIT balance sheets are the strongest they have ever been. REITs learnt their lesson from the last recession and have ever since deleveraged to an average debt-to-assets of just ~35%. This is very conservative. To give you some perspective, most private equity real estate investors generally use up to 70% debt to finance deals.
(2) More Resilient Banking: REITs suffered greatly from 2008-2009 not so much because of operational issues at the property-level, but more so because the banking sector was under severe pressure. It lead to refinancing issues that forced REITs to cut dividends and raise capital at the worst time. This risk is greatly mitigated today because actions have since been taken to assure that the banking sector can better withstand economic shocks. We don’t have the widespread subprime lending issues anymore and the banking sector is much cleaner.
(3) Strong Fundamentals: Real estate fundamentals remain healthy with 2-3% NOI growth across most property sectors. NAREIT notes that the current operating performance of REITs is in the “sweet spot”. There is no overbuilding in most property sectors and NOI growth is set to continue.
(4) Favorable Macro Background Favors REITs: Interest rates are peaking; economic growth is slowing down; and trade war concerns are putting a lot of pressure on global companies. What better than REITs in this environment? REITs generate consistent and high income that becomes increasingly valuable in a low interest rate world; they are less reliant on growth to produce attractive total returns; and finally, they are mostly insulated from the trade war since they do not generate foreign income.
(5) Reasonable Valuations: The average FFO multiple of REITs is today in-line with its historic average at roughly 18x FFO. This is despite enjoying the strongest balance sheets ever. The yield spread over the 10-year treasury is historically high – suggesting that REITs are underpriced. In comparison, the S&P500 is currently priced at a 30% premium to its historic average. This suggests that most stocks have significantly more to fall than REITs in the next recession when you consider that they do not enjoy the same cash flow resilience, they are more reliant on growth, and finally, their valuations are more aggressive.
With this in mind, is it still surprising to you that we recommend REITs as a preferred sector in today’s late-cycle economy?
Most market pundits are affected by recency bias, which is the phenomenon of easily remembering something that has happened recently, compared to remembering something that may have occurred a while back. Investors remember 2008 and connect that to a real estate crash.
Today, REITs enjoy their strongest balance sheets ever in their history, healthy fundamentals, and trade at earnings multiple discounts to broader stocks. Therefore, we would expect REITs to outperform stocks in today's late cycle economy, and even more so as the cycle finally turns.
REIT Investors: Be Selective to Boost Income and Total Returns in a Recession
With that said, not all REITs will do. Most importantly, some are more exposed to the potential consequences of a recession. We are very selective -- we only pick one REIT for every 10 we cover.
We believe what will drive our outperformance in the next down-cycle is our heavy exposure to REIT investments in defensive sectors, with long remaining lease terms, and conservative balance sheets.
We are also very opportunistic. By targeting undervalued REITs, we can mitigate downside even further, because all else equal, a discounted company has better margin of safety.
As of right now, undervalued REITs are abundant in the small-cap segment, where index funds are still lacking. Most of the passive index money has flown straight to the large caps and pushed their FFO multiples to new highs of ~20x FFO, all while small caps were left behind and trade at just 12x FFO today.
The difference in small-cap vs. large-cap REIT valuations has rarely been this large and creates an opportunity for active REIT investors.
source
This is where we are investing today for income and resilience in a late-cycle economy. Our core portfolio has a dividend yield of 7.75% with a 69% payout ratio despite a yield that's almost double the REIT indexes. Beyond the dividends, the core holdings are trading substantially below intrinsic value at just 9.5x FFO, providing both margin of safety and capital appreciation potential:
Believe it or not, we are strongly convinced that this high-yielding portfolio has much more resilience in its cash flow generation potential than your average stock.
Do we know whether REIT prices will be higher 6 months from now? No. Will they likely drop in the next recession? Yes. However, the pain is expected to be more mitigated and short-lived.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
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