Zero Hedge

Zero Hedge has voiced its thoughts on the matter repeatedly (to the point where a broken record sounds outright creative) so I will present those of BCA Research instead, as the latter has some notable conclusions on the rationality of equity investments into the REIT sector.

REITs have historically been at the top of the yield-generating heap, but look to be in jeopardy of losing their appeal as reliable cash flow growth vehicles.

At first blush the attractiveness of REITs looks good. The dividend yield on the S&P REITs group is almost as high as at the end of the relative performance bear market in 2000 (Chart 15). Piling into REITs back then would have generated substantial capital gains as well as an attractive running yield in the subsequent years. But the differences between now and then are enormous.

Many REIT operators took advantage of what looked to be a permanent increase in demand and undertook a rapid facility build out. Our construction composite for the primary REIT sectors has been growing far above-trend for several years. If the residential market is any guide, a prolonged building retrenchment will be needed before underlying property prices will stabilize, especially in view of the plunge in occupancy rates.

Chart 16 highlights a number of indicators of demand. BCA’s REIT demand indicator continues to sink, consistent with a drying up in demand for commercial real estate loans (top panel, Chart 16). Vacancy rates have exploded higher in some categories. Our overall vacancy rate indicator, a composite of our REIT demand and supply indicators, shows that the vacancy rate composite is headed much higher (second panel, Chart 16). Property owners will have a very difficult time raising rents to existing tenants given a glut of unfilled space, and the ability to attract new tenants will be limited until overall economic activity improves significantly. The implication is that generating cash flow growth will become increasingly challenging, and some payouts are at risk of getting slashed.

Adding it up, the REIT sector does not offer an attractive opportunity to gain exposure to income. In fact, excess capacity argues for moving up in the corporate capital structure towards bonds. [very critical to note for investors who just threw a ton of money down the follow-on equity offering chutes in several names]. Deflation risks will hurt earnings before balance sheets. Deleveraging also favors credit over stocks. Perhaps investors are already moving in the direction of corporate bonds. Net sales of corporate bond funds have soared. In contrast, net sales of equity funds continue to sag. Retail investors appear to be looking to take advantage of juicy corporate bond yields that are already pricing in a grim financial outcome in most sectors, including REITs and utilities. The same cannot be said for the REIT sector in the equity market (in relative terms).

In a nutshell - if you really want, nay need, REIT exposure, buy bonds, stay away from equity. If recent stock actions by REITs such as KIMCO and ProLogis benefit anyone, it is the bondholders, since they will see benefits long before any incremental cash flows through to equity holders. Yet bonds have not had nearly comparable moves to what these companies' equity prices have demonstrated (30-60% upside moves in 2 weeks): in short, REIT stock are far ahead of the recovery curve, especially since even bondholders don't believe in significant upside value. Then again, if the whole thesis of marginal upside purchasing on declining volume has been true for the broader market in general and the REIT space in particular, once the real money (quants) becomes a participant in the next market move leg, watch out below. As ML pointed out, the quants have missed the upmove, but one can bet they will not do so with the move lower (not if but when it occurs). The only conclusion - once the flip occurs, and the quants jump on board for the reversion, the carnage will be unprecedented.

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