December 10, 2018: How Defensive Are REITs? | Better Financial Future -- MyPlanIQ

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How Defensive Are REITs?

We have long argued that REITs (Real Estate Investment Trusts) should be considered as a core asset class in asset allocation (see, for example, October 16, 2017: REITs As An Asset Class). In this newsletter, we revisit its current state.

First, let’s look at the current asset trends.

REITs and defensive sectors are still holding

US stocks quickly reverted back to downtrend last week. However, REITs are still in a positive trend:

As of 2/07/2018

Description	Symbol	1 Week	4 Weeks	52 Weeks	Trend Score
US Equity REITs	VNQ	0.17%	1.89%	2.57%	1.99%
Intermediate Treasuries	IEF	1.23%	2.86%	-0.72%	1.44%
Municipal Bonds	MUB	0.74%	1.82%	0.67%	1.07%
Gold	GLD	2.21%	3.15%	-0.33%	1.06%
Treasury Bills	SHV	0.05%	0.19%	1.61%	0.67%
Total US Bonds	BND	0.78%	1.38%	-0.99%	0.5%
US High Yield Bonds	JNK	-0.34%	-1.5%	-0.98%	-1.19%
International REITs	RWX	0.11%	0.22%	-3.88%	-2.66%
US Stocks	VTI	-4.56%	-5.11%	0.64%	-4.65%
Commodities	DBC	2.68%	-4.27%	-1.63%	-4.74%
Emerging Market Stks	VWO	-2.7%	0.44%	-10.34%	-5.77%
International Developed Stks	VEA	-3.19%	-4.21%	-10.69%	-7.74%

It’s the only major risk asset (aside from Gold) that’s still in an up trend.

Fortunately, US bonds (Treasuries especially) are now positive, indicating the current stock weakness is mostly induced by a ‘normal’ fear of weakened economy that has little inflation pressure. In fact, investors are now expecting the Federal Reserve will most likely raise interest rate one more time from now to the end of next year. Thus, bonds rose while stocks tanked.

Among US stock sectors, the usual defensive sectors, consumer staples, health care and utilities, are the only ones that are still in an up trend:

As of 12/07/2018

Description	Symbol	1 Week	4 Weeks	52 Weeks	Trend Score
Utilities	XLU	1.57%	2.9%	4.49%	6.06%
Healthcare	XLV	-5.54%	-2.57%	10.71%	1.47%
Consumer Staples	XLP	-2.74%	-3.7%	-0.74%	0.39%
Telecom	IYZ	-3.41%	-3.82%	-2.81%	-2.93%
Consumer Discretionary	XLY	-4.28%	-6.04%	7.56%	-3.81%
Technology	XLK	-4.92%	-7.5%	2.95%	-6.25%
Industries	XLI	-6.22%	-6.06%	-7.32%	-8.51%
Energy	XLE	-3.09%	-6.47%	-4.93%	-8.52%
Financial	XLF	-6.9%	-7.41%	-9.22%	-9.02%
Materials	XLB	-4.94%	-5.58%	-11.14%	-9.58%

However, both Healthcare and Consumer Staples have incurred very meaningful loss last week and now are on the verge of slipping to a downtrend.

Current REITs situation

It thus begs the question that why REITs are still doing well. In our previous newsletter, we stated that

REITs usually show weakness at the start of an interest rate hike cycle. This is because investors become more concerned about their income when interest rates are high — in such a period, REITs will have tighter financing condition and cost that in turns can hurt their income. However, once the rate hike cycle is near its end, REITs usually show strength as they have done their inflation/interest rate hike adjustment in terms of their rental income (by raising rental prices, for example) to fully compensate for the higher rates. So in a longer term, REITs can deliver above inflation excessive returns similar to stocks.

The behavior of REITs in the past two years seems to confirm the above description: it had a weak 2017 and now it started to stabilize. Maybe REITs investors sensed that the interest rate raising cycle was near its end earlier this year and had ‘correctly’ positioned/stabilized REITs. Nevertheless, it does look like REIT investors now believe we are at the end of interest rate raising cycle, at least for a while.

In the newsletter, we further pointed out that during the bear market in 2000-2003:

During that bear market, REITs became an excellent diversifier: producing double digit annual return while stocks lost over 40%. On the other hand, we also showed the returns of two additional years (1998 and 1999) that preceded 2000. In those two years, compared with S&P 500′s double digit returns, it had very meaningful loss.

Or put it another way, REITs can sometimes be negatively correlated or uncorrelated with stocks. This is especially useful in a market downturn in an asset allocation portfolio to mitigate loss.

The current behavior is similar to what happened up to 2000 so far. The question here is whether the REITs will indeed withhold the next bear market and produce some positive or at minimum very little loss.

Let’s look at the current valuation of REITs. In general, for rental income properties like equity REITs, the best way to value them is to look at their modified cash flow, or so called Funds From Operation (FFO) that essentially is the net income with adjustment in depreciation and sales of properties. Roughly, just think of FFO as rental income minus normal expenses.

The following chart shows the price/FFO ratio of all public US equity REIT companies (capitalization weighted), based on NAREIT:

Because of the weakness last year, the price/FFO ratio has been relatively stable during this bull market cycle. Currently it’s slightly lower than its average. At the current price/FFO level, the ‘income’ yield (the inverse, i.e. FFO/price) is more than 6%, much higher than the 30 year Treasury yield (currently at 3.1%). However, it’s certainly higher than the average from 2003 to 2007.

In the meantime, the debt/total asset ratio (or so called leverage) is at the lowest level since 2003:

So REITs are in a reasonable shape.

What the above tells us is that for the current and the ‘next’ bear market that’s not caused by severe recession, i.e. a bear market or a deep correction caused by higher rates, higher labor cost and uncertainty in economy, REITs will probably fare well.

However, if the next bear market or correction is induced by a severe economy recession, given the current relatively high valuation, REITs will not be immune to loss – think about the loss of rental income as well as property value depreciation.

Market overview

Well, we were too fast to point out in the last week’s newsletter that the impact of the two of the three major factors that can seriously affect financial market were somewhat alleviated. At least for international trade war, investors are now skeptical about whether the US and China can really work out a deal. In the meantime, several indicators are now flashing a slowing economy. US (and global) stocks are again declining. S&P 500 index lost again more than 10% one time and now, its total return in 2018 is almost 0. To make matter worse, many international stocks such as Europe stocks, Australia stocks and China stocks are now in a bear market.

On the other hand, as we pointed out many times, a significant correction or a bear market will take time to develop. What we need is to manage our risk properly while in the meantime, stay the course based on a sound plan.

For more detailed asset trend scores, please refer to 360° Market Overview.

In terms of investments, U.S. stock valuation is still at a historically high level and it might still have a bigger correction. It is thus not a good time to take excessive risk. However, we remain optimistic about U.S. economy in the long term and believe much better investment opportunities will arise in the future.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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