I received this great question from a Patron recently:
Hi FH, REITS have dropped about 10% in the past weeks and it looks like a good time to nibble. You mentioned previously that REITS are a long term hold for you – would you say the same if high inflation rates are a norm moving forward?
For the record, this was the answer I provided:
Yes, I think real estate can do decently in a period of high inflation, it just depends on the price you buy them at.
If inflation stays sticky, that means interest rates stay high, real estate cap rates go up – which is not positive for real estate. But at the same time real estate as a hard asset can hedge against depreciation of fiat currency, especially if they are in good locations (eg. Singapore).
But if you think about it – terminal rates this cycle is around 4% if we get a dovish soft landing. A blue chip REIT at 5% yield doesn’t look very attractive in that light.
TLDR – Yes I like REITs, and I will buy and hold them this decade. I just don’t think we’re at the price I would be backing up the truck just yet. And if they never get to those prices that I am keen on, I am happy to just load up on other asset classes instead.
Just to add I am taking this position because I already have a decent size exposure to REITs. So if I miss this boat it’s not the end of the world. For investors who have no exposure, it probably doesn’t hurt to nibble at these prices.
But the question stuck with me.
So I wanted to write this article to share some deeper views, and flesh out the answer – At what price would I start buying REITs again?
How do REITs do in high interest rates, high inflation?
Okay first off some basics.
REITs are basically levered investments in real estate.
So rising interest rates are a double whammy – you get hit with (a) higher financing costs, and (b) falling real estate prices (real estate capitalization rates go up with rising rates).
To make things worse, REITs are generally viewed as fixed income instruments. As interest rates go up, investors demand a higher yield from the REIT, putting further pressure on prices.
Now I get that in a period of high inflation real estate can hold their own. Mainly because REITs can (a) raise rent, and (b) real estate prices will go up in inflation.
But I do think you need to differentiate between the short term, and the mid term here.
Raising rents, and real estate prices going up, is more of a mid term thing. When you sign a 2-3 year lease, it takes a couple of years before you benefit from higher rentals. It also takes time for inflation to feed into higher commercial real estate prices.
Whereas higher interest rates hits you almost immediately – in the form of investors demanding higher yields, higher refinancing costs, and falling real estate prices (buyers get squeezed by higher financing cost).
Remember commercial real estate is different from Singapore residential real estate. The latter has a very unique demand curve because of ABSD and TDSR ratios. With commercial real estate, it’s a bit more free market.
Long story short – REITs can do well in high inflation, but in the immediate term with rapidly rising interest rates, they are probably going to underperform.
And you want to be very careful with geography as well because in the coming year or two I’m expecting major movements in the FX market. If you’re buying something like Japanese real estate, or European real estate, Yen and Euro movements are very real things you would need to worry about.
I would just stick primarily with Singapore real estate until things clear (or if you know what you’re doing in which case there could be big opportunity).
At what price will I buy REITs in 2022/2023?
To answer this question, let’s use a case study on Ascendas REIT.
I picked Ascendas REIT because it’s a large, blue-chip REIT that is fairly stable.
And unlike some other REITs like MCT or CICT, Ascendas REIT hasn’t had a major M&A in recent years that could distort the yield numbers.
Where did Ascendas REIT bottom in 2018?
Let’s go back to the last rate hike cycle in 2018.
Ascendas REIT’s 2018 low was about $2.5.
2018’s distribution was SGD 0.158, working out to a 6.3% yield.
Fed Funds Rate peaked at 2.5% in 2018, and the US 10 year treasury peaked at 3.2%.
This works out to a 3.8% yield spread (against the US Fed Funds Rate), and a 3.1% yield spread (against the US 10 year).
Or to put it simply, Ascendas REIT bottomed at a 3.8% or 3.1% yield spread in 2018 (depending on which risk free you use), the last time the Feds were hiking interest rates.
What is a fair price for Ascendas REIT this cycle?
This time around, if we get a dovish, soft landing approach, Fed Funds Rate will probably peak at 4.0%.
If we don’t and inflation stays sticky, we may see 4.5% peak fund rate.
Assuming 4.0% peak Fed Funds Rate
Let’s just be generous and assume 4.0% peak Fed Funds rate.
Applying a 3.8% yield spread gives us a 7.8% yield, which means Ascendas at $2.
Ascendas REIT trades at 5.4% yield today – implying a whopping 30% drop.
Assuming 3.5% peak 10 year
Where the US 10 year treasury will peak this cycle is really not an easy call, because this is ultimately determined by the market.
The high back in June 2022 was 3.43%.
So let’s say we overshoot that slightly, and settle on a peak US 10 Year Treasury of about 3.5% – 3.75%.
That works out to a yield of 6.6 – 6.85% on Ascendas REIT.
Which is about $2.2 – $2.35, which is a 20% drop from here.
These are rough numbers – but the message is clear
Now for obvious reasons, these are rough, back of the napkin style numbers.
Valuations are useful mainly as a guideline, and should not be taken as the ultimate truth.
What this exercise has shown though, is clear.
At current prices, REITs are looking very expensive, as they have not adjusted to factor in the rapid rise in the risk-free interest rates.
Ascendas REIT at 5.4% yield was fantastic when your Singapore Savings Bond paid 1.5% p.a. over 10 years. With the Singapore Savings Bond rapidly approaching 3% and beyond, REITs will need to reprice accordingly.
Here’s another chart to put things in perspective.
Looking at the yield spread – REITs are the most expensive they’ve been in 5 years.
Will we get a 20% drop in REIT prices?
Now let’s be conservative and use the second calculation above (based on the US 10 year).
This implies Ascendas REIT needs to drop about 20% from here, to reach “fair value”.
Is that realistic?
Will we get such a large drop in REIT prices?
Will we get a liquidity event?
I think much will depend on whether we get a liquidity event this cycle.
Something like March 2020, or 2008.
That kind of correlation goes to 1, margin calls across the board kind of situation where investors are in pure panic.
If we do, that means indiscriminate selling, and we’ll probably get a chance to pick up these REITs at the prices I set out above (perhaps even better).
If we don’t then it’s a bit more tricky.
What if REITs never drop this low?
I suppose the question then is why do REITs remain so resilient, despite a rapid rise in the risk-free rate?
Why are investors happy to buy REITs at a low 5% yield, when you can make 4% risk free from a government bond?
The most plausible answer is that (a) we don’t see a March 2020 style liquidity event, and (b) the market transitions rapidly into higher inflation for longer.
To give one possible example – let’s say the Democrats will an overwhelming victory in November’s elections. This allows Biden to pass huge new fiscal stimulus, which he does in early 2023.
In this scenario, despite interest rates staying elevated, inflation stays elevated too because of the huge fiscal stimulus offsetting tight monetary policy.
Okay, in scenario like that I can see REITs bottoming out at current prices, and going higher from here.
Investors are happy with the 5% yield, because they expect even higher capital gains due to inflation.
How to guard against this scenario?
For what it’s worth, there’s a non-zero chance of something like that happening.
Unfortunately there’s no easy way to call this in advance – you just need to look at the macro events as they play out, and respond accordingly.
So if you see the Feds/Govts starting to accept higher inflation for longer, you buy then.
You buy at the point when the Feds switch from trying to combat inflation, to accepting that inflation is here to stay.
Sidenote: Although just to qualify that if the above event plays out, REITs will probably still underperform other asset classes like commodities (mainly because of the higher interest rates). So if this event plays out there may still be better ways to play the trade via commodities.
What price would I buy REITs in 2022/2023?
But enough chatter.
Let’s address the issue head on.
Previously I said I would buy REITs if they trade at a 6.0% yield, which is about a 10% drop from here.
I think I’ll still stand by that.
Barring a big change in the macro, if we see names like Ascendas REIT or Mapletree Industrial Trust or CICT etc go to 6.0% yields (~10% drop from here), I think I would start buying.
Sometimes it’s impossible to time your buys perfectly.
So as long as they get into your fair value range, it makes sense to start buying.
But like I said, I think the true “fair” valuation might be in the 6.5% range (~15-20% drop from here), simply because the risk free rate has gone up by so much.
So while I’ll buy at 6.0% yield, I would probably still set aside dry powder, in the event that we get a liquidity event and REITs go into the 6.5% and beyond range.
I’m lucky in the sense that I already have decent exposure to REITs, so I don’t feel pressured to rush into the market at these prices.
If REITs don’t go there, then I will need to monitor the macro before deploying the cash, and I will update macro views on here as always.
Love to hear what you think!
With the massive drop in REIT prices this week. Do you A. Think it’s time to start buying them, B. Will you be adding to your REIT positions and C. Do you think they have more to drop?
Have an article coming out on this tomorrow, to share my latest macro view. 🙂