C.J. Lawrence Weekly – REIT Underperformance Likely to Persist

“Bond proxy” equities struggled last week as the benchmark U.S. 10-Year Treasury Bond yield climbed to 2.42% (from 2.06% in early September) reinforcing fears among bond proxy holders that rising interest rates will compete more competently for income seekers. For the week, the Telecom, Real Estate, and Consumer Staples sector indices were down 3.2%, 1.6%, and 1.5% respectively, versus the broader S&P 500 Index, which was up slightly. Sub-par earnings reports may have contributed to the declines, versus positive surprises across most other sectors. Energy stocks, typically high dividend payors, were also off for the week (-0.5%), despite oil prices that climbed 4.4% (WTI). 46% of REITs have reported 3Q17 results to date and 60% have delivered funds-from-operations (FFO) below street expectations.

Real Estate Investment Trusts were carved out of the Financials Sector Index by S&P Global in August of 2016. Investors in securities that track the Financials Sector Index have been rewarded by the split. Since separation, the total return on the S&P Financials Sector Index is 43.0%. The total return on the new S&P REIT Sector is -3.0% during the same period. Year-to-date, the total return on the Financials Index is 16.6% and the total return on the REIT Index is 7.3%.

The good news for REITs is that as the economy improves so too do real estate fundamentals. Thus, in general, REITs’ ability to grow cash flow and increase pay-outs improves as the economy ramps. The off-set is that REITs tend to be serial issuers of new debt, using leverage to grow, and their cost of capital is now on the rise. According to data provided by FactSet, the REIT Sector Index cash flow per share is expected to grow 5.1% in 2018 versus 12.3% for the S&P 500. Increasing competition from fixed income instruments, sub-market cash flow generation, and a surging sector emphasis on early cyclicals may contribute to continued REIT underperformance. We remain underweight REITs in our model portfolio.

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