Market analysis by our public securities expert, Geoff Shaver
February 18, 2020
What Returns We Can Expect from REITs over the Next 12 Months
by Geoff Shaver
Director of Public Securities
Welcome to the first edition of the REIT Report! Every week, we’ll share our thoughts on what’s happening in the world of exchange-listed real estate investment trusts (“REITs”). Whether you’re new to investing in REITs or you’re a veteran, we hope you’ll find these reports helpful as you navigate investing in REITs. If you have a suggestion for a future topic, please shoot us a note at email@example.com. Thanks, Geoff
Forecasting market returns is often referred to as a fool’s game, but it’s also a popular one. With that in mind, let’s try to set a reasonable return expectation for exchange-listed REITs over the next year in a thoughtful and methodical way. We’ll attempt to bookend the total return for the FTSE Nareit All Equity Index (“FNER”) for the next twelve months.
Let’s define a few terms as we get started. “Total Return” includes, among other things, both a REIT’s dividends per share and changes in its value per share. For example, a share of a REIT that pays a 3% annual dividend and whose share value increases 6% from $10 to $10.60 over a twelve-month period, generates an annual Total Return of 9%.
A REIT is a company that owns and operates real estate properties, and we think the simplest way to understand the value of a REIT is by calculating its “Net Asset Value” (“NAV”), which is calculated as the value of the underlying properties and subtracting liabilities. This calculation is called “Net Asset Value,” or “NAV.” Generally, a REIT’s NAV takes into consideration variables including the REIT’s Capitalization Rate (“Cap Rate”) and Net Operating Income (“NOI”). The Cap Rate is a multiplier of the NOI and can be viewed as the inverse of the Price to Earnings Ratio (“P/E Ratio”), and it’s one of the most important things we should evaluate. However, a REIT’s share prices can trade well in excess of the value of the REIT’s underlying properties or far less than the value of the REIT’s underlying properties, and we should try to take this into consideration when making a forecast. Below, we put together what we think are the basic parts of a forecast and share with you our approach to calculate a 12-month forecast:
Calculating Share Price Changes
The Cap Rate Forecast
Cap Rates and interest rates tend to have some correlation. As interest rates rise, Cap Rates tend to as well, but not necessarily in a one to one fashion. If we use the U.S. 10-year treasury note as a proxy to gauge Cap Rate direction, it appears that the forecast for the U.S. 10-year treasury note is an increase of just 2 or 3 Basis Points (“BPs”), or 0.02-0.03%, over the next 12 months1. That’s pretty close to flat, and if we assume Cap Rates follow a similar path, we can probably assume Cap Rates at the end of 2020 are going to be similar to Cap Rates at the end of 2019.
Net Operating Income Growth Forecast
As of February 18, 2020, S&P Global Market Intelligence states that the consensus forecast for REIT NOI growth is going to be around 8.7% in 20202. This “consensus” is gathered by taking the average of estimates from various REIT analysts. For the sake of using round numbers let’s assume that the NOI growth over the next twelve months is going to be about 9.0%.
Net Asset Value Adjustment
REITs don’t always trade at Net Asset Value. They can trade above (at a “premium”) or below (at a “discount”) their actual NAV. Green Street Advisors have tracked NAV premiums and discounts of REITs for several years and claim that since the start of 1990—basically the past 30 years—REITs have traded at an average premium over NAV of +2.1%. Today’s premium is closer to 11.8% so we expect prices to come down to a more normalized level over the next twelve months. For the purpose of this forecast, we will use the long-term premium of +2.1% to be more in line with historical standards.
Let’s take a look at an example. If “REIT ABC” presently has a NAV of $100.00 and trades at an +11.8% premium, we would expect a market price of $111.80 today. If REIT ABC grows their NOI by 9% over the next year, and the Cap Rate stays the same, the REIT ABC’s NAV would be $109.00, and if the premium shrinks to +2.1% we would likely observe a market price of $111.29. A stock that moves from $111.80 to $111.29 has basically had a 0.5% decline in price.
Factoring in Dividends
REITs tend to be heavy dividend payers, and Total Return also takes into account the dividends an investor receives. As of Feb 18th, 2020, the yield of the FNER was 3.5%1. This is the yield based on what the REITs included in the FNER have most recently declared, but REITs can and do grow their dividends over time. Over the past year, the market cap weighted average dividend growth of the REITs that do pay dividends has been about 9.2%. If we assume REITs grow their dividends at a similar pace in the coming year as they have in the past year, that would give us a yield a year from now of almost 3.8% on today’s cost, but you probably won’t be receiving that full slate of dividends right away. A REIT could increase its dividends on the first day of the year, or on the last. As the truth often lies somewhere in the middle, we will assume a mid-year convention for dividend increases. This means that based on the foregoing, an investor could reasonably expect to receive a dividend yield of 3.6% in the coming year based on a REIT’s present cost.
Predicting the Next 12 Months
Putting this all together gives us -0.5% on NAV appreciation and +3.6% on dividend income for an expected total return of +3.1%. Of course, this is based on the assumptions I’ve outlined above, and this prediction could deviate from these assumptions. If we add +/- 5% to the midpoint to account for the unknowns, this could give us an expected Total Return ranging between -2% to +8% for the FNER in the forward year.
It should be noted that we ran this same exercise in December of 2019 when the average REIT premium was lower (+3.8%), and the dividend yield slightly higher (3.8%). This gave us an expected Total Return between +5% to +15%, based on a 6% premium and 4% dividend yield. Year to date through February 14th, 2020, the FNER has had a total return of +7.4%.
As REITs have risen in price this year, we have also seen the U.S. 10-year treasury note rate come down almost 40 basis points, or 0.4%, since the start of the year. This move in interest rates could mean that Cap Rates have moved or will move lower over the course of the year, which violates one of our initial assumptions, and if Cap Rates have or do move lower, it could also mean that REITs are probably trading at a premium lower than the 11.8% mentioned above. The magnitude of change in Cap Rates will likely drive REIT performance, but our base case expectation for the FNER’s Total Returns likely fall in a range between +2% to +12% for the coming twelve months.
Investing in Public REITs with Path
Given our discussion on overall REIT market predictions, one REIT Block that might be of interest to you is the Path Growth Block. This REIT Block seeks capital appreciation with a secondary objective of current income, and it invests primarily in exchange-listed REIT shares. The securities in the Growth Block are generally considered blue chip companies, make up some of the larger REITs by market capitalization, and are generally leaders in their respective property sectors. The Growth Block is also generally diversified by property type. For these reasons, the Growth Block seeks to provide the broadest exposure to the market, relative to our other REIT Blocks.
One final thing to note – we’re estimating our base case for the FNER is +2% to +12% for the coming twelve months, and if you own an index fund or an index ETF, you can expect to get index-like returns. Actively managed portfolios, like the Path Growth Block, may not correlate with any index, and returns may differ. By no means is outperformance in an actively managed portfolio guaranteed, and there is always the possibility of underperformance, but achieving Total Returns better than an index is the goal of almost every active manager, myself included.
2 From S&P Global Market Intelligence on 2/18/20
3 From S&P Capital IQ on 2/18/20
Director of Public Securities
Geoff leads the construction and monitoring of the public real estate securities portfolios available in our Path by Origin app. Prior to Origin, Geoff spent the last 12+ years researching and investing in public REIT securities at both Duff & Phelps Investment Management Co. and J.P Morgan Asset Management.
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