Skip to main content
No. of Recommendations: 57
My wife and I went out to dinner with her sister and husband Friday night. Tom, my brother-in-law, owns a lot of REIT stocks, and is a typical worried investor. Naturally, he asked me about the performance of REIT stocks this year – not a particularly pleasant topic. But, obviously, it is also on the minds of many other investors.

REIT stocks are down something like 11% year to date. That is a shockingly poor performance, and is worse than most broader market averages. The S&P 500 is down 6.7% YTD. But I told Tom that it is very important to distinguish between how companies are performing and how their stocks are being treated – often there is a very substantial disconnect that cannot be explained merely by the market performing its frequent discounting function. The market is not always rational, at least for relatively short time periods.

So I told Tom that the commercial real estate space markets are doing quite well this year, actually a little better than most expectations. The only sector where we experienced a disappointment, and it was mild, was with respect to hotel REITs where the impact from a strong US dollar was a bit more than expected. Every other property sector is performing well, although you wouldn’t know it by the stocks’ performance. Rents are still rising, occupancy rates are near all-time highs and same-property NOI growth has been substantial. New supply is increasing but remains at manageable levels.

There is a lot of concern about the Fed raising interest rates this year, although it has been talked to death; that said, the prospect of higher borrowing costs does not seem to be having any impact on commercial property prices. Green Street Advisors’ Commercial Property Price Index rose another one percent in August, and it raised NAV estimates in early September for 22 REITs, reducing NAV for only one.

Tom, naturally, wanted to know, if the “fundamentals” were still healthy, why were REIT stocks being taken out and shot? I told him that no one is ever sure why stock prices decline in the face of strong fundamentals. We always need to consider that Mr. Market is telling us something that isn’t generally apparent. With respect to REITs, that message could be that property prices are on the cusp of a decline in the near future. We all need to consider this possibility, and certainly interest rates are a factor in cap rates and property prices.

However, there are many other factors as well, including property cash flow growth, replacement value, longer-term bond yields, risk perceptions and returns expected from other asset classes. And, at the present time, with the exception of Houston and a few other oil-dependent markets, we’ve seen no meaningful upward pressure on cap rates. It may very well be that the flow of capital looking for a home in commercial real estate, due to predictable and stable cash streams and a lack of exposure to China, falling commodities prices, and a strong US dollar, will continue to support today’s property values.

There’s another possible reason for REIT stocks falling. Are they discounting a recession? That’s not very likely; the US economy isn’t moving very fast, but it is growing and there are few imbalances among consumers or businesses. Low oil and gasoline prices are helping consumers, and businesses are adding to payrolls.

It may very well be, I told Tom, that commercial property prices will decline a bit if interest rates go up. However, that decline is not likely to be of major size, particularly as the Fed is going to be cautious in its tightening because of today’s market volatility and potentially destabilizing effects from a slowing Chinese economy. Furthermore, REIT stocks are already trading at a double-digit NAV discount, so that even if commercial property prices decline a bit, there is no logical reason why that would cause REIT stocks to decline further from current levels (although in the short term, traders and hedge funds can push them down further). And, of course, they may snap back if investors decide to seek shelter in higher dividend yields, more stable cash flows and almost no exposure to China or falling commodity prices.

It is certainly not easy to commit capital to REIT stocks at the present time; falling prices trigger the “fight or flight” mechanism, and thus most investors sell, rather than buy, after the market has declined significantly. And momentum investing seems to be alive and well. However, I told Tom that he really should consider deploying some of his cash into additional REIT investments for good longer-term performance. He looked at me funny, and asked the waiter for a coffee refill.

Print the post  


What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.