Monday, May 18, 2015

Real Return

After weeks of back-and-forth economic data, the overall trend broke to the side of weaker growth late last week and the outcome for the markets was obvious thanks to a trifecta of bad data on Friday…all new highs for the S&P 500 as investors wager rates will stay lower for longer resulting in the PowerShares DB US Dollar Bullish ETF (UUP) being pushed lower and the iShares 20+ Year Treasury Bond ETF (TLT) soaring up over 2% on the day to help the fund stay above its 50 week moving average.  And while Treasury funds were big winners thanks to the ten and thirty year bond yields plummeting over 4% on Friday, those lower yields offered serious succor to real estate investors who have been pummeled since the market turned against the interest rate sensitive sectors at the end of January.  With weaker growth and benign inflation forecasts, has the time come for a shift back to the real asset plays?

After a strong 2014 where the Vanguard REIT Index Fund (VNQ) dominated the S&P 500, delivering a 30.36% return to the S&P 500’s 13.69%, investors could almost be forgiven for hoping that such strong momentum would carry on in 2015 and why wouldn’t they?  Real estate had benefited from not just strong economic growth that reduced vacancy rates but an incredibly low interest rate environment where steadily declining Treasury yields made even relatively anemic cap rates seem attractive.  By mid-2014 top markets were seeing cap rates at or below 5% (close to the pre-Lehman lows) with Dallas standing out at a record low of 3.2%, a scant 70 bps higher than the ten year Treasury yield of 2.51% on June 30th.   With seemingly poor compensation for the amount of risk property investors were taking on, investors told themselves that the Fed would stay accommodative indefinitely and with higher dividends, the sky was the limit for REIT’s.  And while the asset allocators continued to pour money into the sector at year-end, January 2015’s strong return quickly faded as hopes that rates would stay low indefinitely faded and investors fled to less-rate sensitive sectors, sending VNQ on a downward spiral of underperformance with the fund down 11.29% from January 28th to May 6th compared to 2.49% for the S&P 500.

But for the observant investor there were glimmers of hope during the long period of underperformance earlier this year.  Every speech by a Dovish Fed Governor or weak economic data point gave REIT’s a shot in the arm although it was going to take more than a few individual data points to convince traders that the story was changing.  The increasing desperation in the sector drew the early bottom feeders to VNQ a week before the dollar topped out on March 16th after strong selling pressure on March 6th with a gap open down and a close just off the lows of the day.  And while REIT’s traded higher with the broader market over the following weeks, by late March the strong selling pressure had resumed as the economic data continued to point to a shallow rate hike later in 2015.  But with the increasingly negative economic becoming more apparent over the last two weeks, REIT’s and their defensive brethren utilities have finally begun to shine again.  VNQ has managed to put on 1.39% in the last two weeks compared to the S&P 500’s .68% gain with the largest REIT twice finding support along its 50 week moving average at $78.25.  Given the extensive technical damage, traders will need some convincing that REIT’s are worth another look, so it could take several weeks of consolidation before VNQ puts in a firm bottom.

However if you’re one of those investors looking to strike a balance between yield, capital gains and who can tolerate some volatility to boot you might want to focus on the much-despised subsector of mortgage REIT’s.  Once the darling of investors looking for a non-correlated asset class offering higher yields than traditional real estate products and without the systematic risk of traditional REITS or other equities, funds like the iShares Mortgage Real Estate Capped REM delivered solid performance while lagging the broader REIT category during the great real estate recovery of 2009 to 2013 when concerns over the policy outlook at the Fed began to weigh on the space.  With mortgage rates at record lows as we hover over the zero rate boundary, REM’s volatility was far higher than the broader sector or market and dragged on performance with REM up 6.11% over the last year versus 13.88% for VNQ and the subsequently lower alpha and Sharpe ratio’s sent investors scurrying away from the sector.  Currently sporting a category high yield of 12.84%, REM has begun to steadily attract new investors as confusion at the Fed has helped push the fund into the top quartile of REIT performers YTD although potential investors should take our warning about volatility seriously.

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