The stunning Brexit vote was the final nail in the coffin for any further intervention by the FOMC for the rest of 2016. In fact, many in the investment community believe that the FOMC tightening cycle is over, having effectively started with the exit from Quantitative Easing (remember the “Taper Tantrum?”); the current implied probabilities for a future rate hike does not cross 50% until November 1, 2017. With inflation figures stubbornly low, only a policy blunder by the hawkish members of the FOMC would upset the apple cart and that possibility seems remote with what is likely to be a volatile election in the US looming. If Donald Trump can call Pope Francis “disgraceful,” the Washington Post “phony and dishonest” and claim that Chief Justice Ginsburg’s mind is “shot,” is there an estate of the realm that is safe from criticism?
With the denominator battened down for the foreseeable future, the numerator and expectations thereof are largely shaping investment returns. Domestic cash flows are better than global, longer lease terms are better than shorter and secular growth is gold. In the land of the blind, the one-eyed man is king and REITs have reigned over investment alternatives since the end of the Great Financial Crisis, which outperformance seems sustainable. Operating fundamentals for REITs are still solid. Occupancy levels are almost 200 bps above the historical average of 93.2%, allowing landlords to push rents and improve margins. Same-store NOI is also well above the historical average of 2.9% for the group. Given the fact that REITs are required to pay out 90% of their taxable income, their earnings growth is not manufactured through wholesale share buybacks like some of the S&P 500 companies. It may be an indictment on the rest of the US companies, but, for better or worse, REITs are starting to populate the growth segments of the various indices.
Obviously, REITs have had a great run and the multiples that investors are assigning REIT cash flows are historically high so the margin of safety is not great. Supply continues to be the Achilles heel for the group. Almost every pocket of recent underperformance can be attributed to supply: New York City (Hotel, Office and Apartment), San Francisco (Office and Apartment) and Houston (Office). While the overall level of new supply remains well below historical averages, there are areas of concern and investors should remain vigilant.