Most are aware that US REITs are staring down the barrel of a steady process of re-rating as interest rate expectations move higher. This is a broad statement and the investor can certainly find examples of REITs and real estate companies that are growing revenue as a result of unique positioning and exposure to growth assets – but for the average investor, the prospects for US REITs are mediocre at best.
Let’s start with revenue:
The Top 10 US REITs with over $270 billion in market cap, are actually projected to see lower sales in 2017. Think about that for a second: real estate is fundamentally a vehicle to capture rent revenue. In a stable or declining interest rate environment, such as the one we’ve been in for six years, revenue growth doesn’t matter as much as cost of capital and prevailing yields. US REITs were major beneficiaries of lower interest rates. That is over. REITs now have to perform and that means growing rental revenue. The issue of course is the larger REITs are generally correlated with the US economy and with tepid GDP growth, they’re just not going to see the kind of growth to sustain current valuations.
We foresee a stairway down versus a broad fire sale each time the market prepares itself for another Fed hike. This process will take time but over the course of two or three years, asset values will be lower and yields will rise. Growth for US REITs, in our opinion, won’t really start to kick in until mid 2018. So what’s an investor to do? Look south…
Latin America REITs are attractively valued, are growing revenue and dividends are expected to increase. The Solactive Latin America Real Estate Index tracks all major listed REITs and real estate operating companies in the region and offers a uniquely diversified access to the growing asset class.
Mexico REITs, for example, are relatively new but are in expansion mode and expected to grow revenues by over 24% in 2017. Commensurately, with revenue growth, we expect dividends to grow as well. Given that the Mexican economy is closely tied to the US, impacts from higher interest rates in the US will be partially, if not entirely, offset by organic growth. Brazil REITs, on the other hand, offer attractive valuations and high dividend yields. Brazil, as many know, is expected to return to growth in 2017 and is at the front end of a multi-year process of cutting interest rates. In other words, the same conditions that existed for US REITs a few years ago exist in Brazil today. As interest rates come down in Brazil, economic recovery will strengthen and asset prices should appreciate.
Finally, a word on relative valuation. US REITs are at a historically high valuation by almost every metric – including price-to-earnings, price-to-sales, and price-to-book value. But what should really concern investors is price-to-FFO or Funds from Operations which stands at 16.6x or about a 6% FFO yield. That number is the one that tells you how tight yields are and the main reason why we’ve seen constant selling in US REITs since September when it became clear that the Fed intends to raise interest rates at least 25 bps. The combination of low FFO yields, muted or no revenue growth and higher interest rates means simply that asset prices will come down. It may take a while, but whatever dividend yield the investor is getting today will be more than offset with a capital loss later on.
Latin America REITs are not only reasonably valued from price-to-earnings standpoint but have FFO yields well north of 8%. The fact that they are growing revenue also suggests that dividends can increase. In the particular case of Brazil, it’s the trifecta: improving economic conditions, attractive yields and declining interest rates. Mexico, on the other hand, will boost dividends through organic growth and as revenue growth is expected to top 24% for 2017.