First off – my apologies.
I know that I’ve been doing a lot of posts on Singapore Savings Bonds and T-Bills recently.
I’ve just been getting a ton of questions – Investors can’t get enough of SSB/T-Bills it seems.
And given elevated macro risk, I think for a long only retail investor, that’s just the safest place to be for now.
But I know many long-time readers are here for macro views.
Much of it has moved over into the premium Patreon service, but I do want to keep general readers appraised of my thinking as well.
So today, let’s talk about an asset class most of you love – REITs.
Why I think REIT prices will struggle in 2023 (as a Singapore Investor)
The short version, is that I think REIT prices will struggle in 2023.
The slightly longer version, is that there are 3 key points to discuss:
- Interest rates may stay high for a while
- This has not been fully priced in
- Forced selling just starting to play out (liquidity mismatch)
Interest rates may stay high for a while
Okay, I know we are all sick of discussing interest rates.
But no discussion on REITs will be complete without touching on the interest rate outlook.
Higher interest rates mean higher refinancing costs for REITs, and higher cap rates for real estate.
Bad, and bad.
What is the latest Interest Rate outlook?
Serious investors should read the full transcript of Powell’s speech last week.
I did a detailed summary for Patrons, but to sum up.
The Feds will slow the pace of rate hikes going forward.
Powell doesn’t want to overtighten and be forced to cut rates too soon.
And given that higher interest rates take some time to work their way into the economy, he wants to slow down the pace of hikes as we approach terminal rate.
… my colleagues and I do not want to over tighten because, you know, I think that cutting rates is not something we want to do soon. So that’s why we’re slowing down and, you know, going to try to find our way to what that right level is.
BUT – bringing inflation down to 2% remains the official target.
So while the pace of hikes will slow, how high interest rates go, and how long they stay high – will depend on what is required to bring inflation down to 2%.
The key to breaking inflation, lies with the labour market
I’ve been saying this for a while.
If Powell is serious about bringing inflation down to 2%.
He needs to break the US labour market.
“Finally, we come to core services other than housing, and this spending category covers a wide range of services from health care and education to haircuts and hospitality.
This is the largest of our three categories, constituting more than half the core PCE index. Thus, this may be the most important category for understanding the future evolution of core inflation.
Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category.
In the labor market, demand for workers far exceeds the supply of available workers, and nominal wages have been growing at a pace well above what would be consistent with 2% inflation over time. Thus, another condition we’re looking for is the restoration of balance between supply and demand in the labor force, in the labor market.”
Last week’s Labour Report was a disaster
Which is exactly why last week’s labour report was so crucial.
Basically, the Feds won’t pivot until inflation comes down.
For inflation to come down, you need unemployment to go up (to weaken a tight labour market).
Before unemployment can begin to go up, you need to see wage growth start to come down.
And November’s wage grew 0.6% month on month – the highest growth in 2022.
After the fastest rate hiking cycle in 30 years.
Taking us from 0% to 3.75% in less than 9 month.
The labour market is still roaring along, and barely even showing signs of slowing down.
What does this mean for investors?
Many of you have asked how long will interest rates stay at ~5%.
Nobody knows the answer to that, not even Jerome Powell himself.
But what I do know – is that talks of interest rate cuts are still too early.
Before you can start thinking about interest rate cuts, you need to see the labour market softening up, and unemployment going up.
Typically speaking, you want to see 3 consecutive months of flattish / negative wage growth, before you can start to think about unemployment going up.
With November hitting the highest wage growth all year – we’re not there yet.
Think of it this way – We need to go from A (wage growth flat/negative) to B (unemployment going up) to C (inflation going down), before we can start cutting.
And for now, A has not even happened yet.
As Powell put it:
“Currently, the unemployment rate is at 3.7%, near 50-year lows, and job openings exceed available workers by about 4 million. That is about 1.7 job openings for every person looking for work. So far, we’ve seen only tentative signs of a moderation in labor demand.”
But gun to my head?
If Powell is really serious about bringing inflation down to 2%?
He may need to keep rates high perhaps 12 months or more, which takes us into end 2023 / early 2024.
Can the economy / markets hold up?
BUT – can the economy take another 12 months of higher interest rates?
Especially when you consider how much leverage is in the system today?
Frankly I don’t know the answer.
But I do think there is a good chance something will break before Powell succeeds in his quest to bring inflation down to 2%.
My base case – is that at some point in the next 12 – 24 months, Powell will be forced to give up on the inflation fight, and be forced to accept a higher level of inflation going forward.
This has not been priced in (for Singapore REITs)
But we’re getting ahead of ourselves.
Markets are forward looking, but they seldom look forward more than 12 months.
If you’re an active investor doing market timing, you should only be thinking about the next 3 – 6 months (possibly 12).
Based on the discussion above – interest rate cuts are not coming yet.
And if interest rate cuts are not coming yet – many REITs are looking very pricey.
Let’s use CICT as an example – CapitaLand Integrated Commercial trust (Singapore REIT)
Now of course this is ultimately a REIT by REIT level analysis.
Some Singapore REITs are cheap, some are not.
But for discussion’s sake – let’s just use a crowd favourite – CapitaLand Integrated Commercial Trust.
I plotted the dividend yield (yellow) against the 10 year SGS yield (white) below.
You can see how the 10 year SGS yield is well above 1 standard deviation.
But CICT’s dividend yield is still well below 1 standard deviation.
CICT’s long term yield spread against the 10 year SGS is about 3%.
Let’s say conservatively we assume a peak 3.5% on the 10 year SGS this cycle.
You’re looking at 6.5% yield on CICT at fair value.
That’s about a 20 – 30% drop from current prices.
That’s even before higher financing costs (for Singapore REITs)
CICT’s weighted cost of debt is 2.3%.
If interest rates stay up, and we assume they refinance at 3.5% (which is still very low).
You’re looking at a 45% increase in financing costs.
The $104 million interest expense will balloon to $151 million.
Working out to an 11% drop in DPU.
Which means a 5% dividend yield, is now 4.45% (assuming no change in rent etc).
For the record – I get that CICT’s debt is well spaced out.
But the longer the interest rates stay up, the more this will be a problem.
Which is exactly my point.
Most REIT investors are expecting the Feds to cut us back to zero interest rates in 2023.
But think about our discussion above.
What if interest rates stay up longer than people expect?
That’s even before higher cap rates (for Singapore REITs)
And I haven’t even started talking about higher cap rates.
I extracted the cap rates for CICT below.
On average, you’re looking at 3 – 5% cap rates.
Cap rates basically tell you how expensive a property is.
If you get 30,000 a year in rental income, and the property is worth $1 million, that’s a 3% cap rate.
The lower the cap rate, the more expensive the property.
A cap rate of 3 – 5% makes sense when interest rates average 1%.
But when interest rates soar to 4 – 5% in 2023, you tell me if it these cap rates still make sense.
Who will buy commercial real estate at a 4% cap rate, when they can get the same yield from a T-Bill, risk free?
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Forced selling just starting to play out (liquidity mismatch)
For the record, I am not singling out CICT here.
Nor am I singling out Singapore real estate.
The points I raise above, apply to global real estate.
And in my view, the pain for commercial real estate globally – it’s only just beginning.
Blackstone gates redemption on private REIT
There’s a good article from the FT recently.
It talks about the troubles facing Blackstone’s REIT, a $69 billion US REIT.
Extract below (emphasis mine):
In July, Blackstone chief executive Stephen Schwarzman recounted a surprise meeting with an investor in the firm’s $69bn-in-assets private real estate vehicle designed for wealthy individual investors.
The person had approached Schwarzman to tell him the fund, called Blackstone Real Estate Income Trust, or BREIT, was his largest position. “I love you people. This is so amazing. All of my friends are losing a fortune in the market and I’m still making money,” recounted Schwarzman of the meeting on a quarterly earnings call.
In fact, investors were pulling money from BREIT at the time, alarming close watchers of Blackstone. Investors withdrew more than 2 per cent of its net assets that month, according to sources familiar with the matter and securities filings, exceeding a threshold at which Blackstone can limit investor withdrawals.
Asian investors had been pulling cash from the fund during the spring and summer as property markets in the region plunged. Some carried high personal leverage and were hit with margin calls, said two people familiar with the matter. BREIT, the value of which has risen this year, could be sold at high prices to meet the cash calls.
As the selling intensified and moved beyond Asia, Schwarzman and Blackstone’s president Jonathan Gray each added more than $100mn to their investments in BREIT this summer, said a source with knowledge of the matter. Blackstone declined to comment on the purchases.
Blackstone chose to not place any limits on investors hoping to withdraw money from BREIT in July. Though it has always told its investors the product is only semi-liquid, such a move could have sparked fears among investors that they could not easily get their money out. But a growing tide of redemption requests forced BREIT to announce on Thursday it would finally raise “gates” — allowing the fund manager to limit the volume of assets redeemed — through to the end of the year.
The move has sent shockwaves inside Blackstone, tarnishing what has become the biggest engine of asset and fee growth inside the world’s largest alternative asset manager. On Thursday, Blackstone’s shares fell more than 7 per cent and a host of analysts downgraded their outlook on the company over fears that the decision could cause its growth to stall.
Forced selling just starting to play out (liquidity mismatch)
This is the point I’m trying to make.
Real estate is an illiquid asset class.
REITs turn real estate into a liquid asset class, where you can buy/sell positions easily.
But there is no true liquidity.
The liquidity is an illusion.
If a significant % of the investor base wants their money back at the some time, that illusion of liquidity will be shattered.
Think about Luna and UST, once investors started selling.
Market is undervaluing liquidity
And my view – is that this market is underpricing the importance of liquidity.
Singapore REITs are a slightly different product, because they can be traded on the open market. And even then, if too many investors want their cash back at the same time, you will have problems.
But a bulk of real estate globally is held via private funds.
The longer interest rates stay up, the more important cash becomes.
And the longer this plays out, the more real estate investors will want their cash back.
At some point, the redemption requests will come in, and all these private funds will need to find a way to give investors their money back.
We are nearing the tipping point, where many of these funds are turning from net buyers to net sellers.
Over the next 12 – 24 months you’re going to see a lot of real estate come to market.
And my suspicion – with higher financing costs, the market will struggle to absorb this real estate, especially if you’re a seller looking for 2021 prices.
Will we see a crash in REIT prices?
Many of you want to know if REIT prices will collapse in 2023, just like March 2020.
Frankly, I don’t know.
It depends on whether we get a liquidity event, and the jury is still out on that one.
It’s also possible there is no crash, and REIT prices just trade sideways for a while.
Many of the secular tailwinds for REITs are gone.
Low interest rates powered REIT returns the past decade – due to cheap borrowing costs, and cap rate compression.
If I am right – both will reverse this decade.
How I will invest in a REIT market like that?
I hate to say this, but a market like that would be brutal.
It would be a PvP (player vs player) kind of market.
Unlike the past 10 years, where the returns came from just buying and holding on, as the rising tide of fed liquidity lifts all boats.
In a market like that, the money you make comes from taking it from another investor.
You make money from another investor selling / buying at the wrong price.
In other words – it calls for more active positioning, both in terms of what REITs you buy, and what price you buy (or sell).
So just to be very clear – I’m not saying Singapore REITs are a bad investment. I’m just saying you need to be much more selective, and active in your approach.
At the right price, anything could be a good buy.
This applies to tech as well
Now a lot of the points I discussed above apply to tech as well.
In a higher inflation, higher interest rate climate, tech is also a lot less sexy.
Because firstly the cost of capital goes up, so the strategy of borrowing cheap capital to grow market share at all costs goes out the window.
And secondly, in a higher inflation world, growth is everywhere.
The past decade companies struggled to grow, so investors loved tech for their growth potential.
But today – Pepsi can raise the price of Doritoes 10% and consumers have no choice but to accept.
So growth from tech companies is a lot less sexy, because in an inflationary world – everyone is a growth company.
Just like REITs – individual names can do well of course, but the secular tailwind for the asset class is gone (for now).
Which is why I see investors with a long tech long REIT portfolio, and it just screams to me investing for the past decade.
That portfolio would have done well had you bought it in 2012.
But this is 2022.
Which sectors have the secular tailwinds this decade?
This article is getting long, and I want to wrap up.
But a quick note on what might be the winners for this decade.
Interestingly – the market may be providing clues.
Look at the 3 month performance of the different sectors.
The best performers?
Energy, Materials (Metals), Banks, Industrials.
The boring, Ah Gong stocks that fell out of favour the past 15 years.
In a higher inflation higher interest rate world – these might be the guys that would benefit.
They can raise prices (pricing power), and they generate a ton of cash flow.
And they are less vulnerable to higher interest rates.
Of course – there is recession risk.
So I’m not saying go out and put 100% of your portfolio into energy because there is a good chance the Feds tighten us into a recession in 2023.
But look past the short term, and I can kind of see the mid term secular tailwinds from a higher inflation world – powered by insufficient supply, and higher demand due to US-China cold war, and green energy transition.
The exact names to look at is beyond the scope of this article, but you can check out my stock watch on Patreon if you are keen.
Now, can I be wrong on the above?
Yes, absolutely, 100%.
People think of investing like chess.
But it’s not.
Investing is like poker.
It’s all about probabilities.
The future is never cast in stone.
It’s always about (1) the probability of a win, and (2) how much you make when you win.
And in investing – never be afraid to change your mind.
Just like in Poker, once each card is revealed – the probabilities change.
Change your mind accordingly.
I see many investors stubbornly sticking to their views, because they said it publicly in the past and fear looking stupid.
If the facts change, change your mind.
That’s just how investing works.
Closing Thoughts: What would make me change my mind?
Perhaps the most important question in this article – what would need to happen, for me to change my mind on the above?
I thought about it for a bit.
And my answer – If the Feds succeed in controlling inflation, bringing it down to 2% long term.
If that happens, then I think you take everything I wrote about above and throw it out the window.
Because if the Feds succeed in bringing inflation down to 2% without triggering a deep recession, then it means the whole narrative of structural inflation this decade needs to be relooked.
And this could allow a return to a disinflationary world, with lower inflation, and lower interest rates – basically how the past decade looked like.
And if that happens, then yes absolutely you want to build a long duration portfolio – long tech, long REITs, long bonds.
Personally I don’t think that will happen.
I think this problem is bigger than something interest rates can solve.
It’s a story about US-China cold war forcing new supply chains to be built.
It’s a story of green energy requiring massive infrastructure investment.
It’s a story of underinvestment into commodities / energy coming back to haunt us, and the shifting away from US supremacy into a more multipolar world.
But like I said, I’m not afraid to change my mind.
If something happens to disprove my views, I’m happy to do a 180 and change my mind completely. As I will my portfolio positioning.
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