VNQ ETF: REITs In 2024 (Rating Downgrade)

Dear readers,

I was quite bullish on REITs for most of last year and invested a third of my total net worth in the sector through a diversified portfolio of about 10 REITs. Just as an example, below is a snap shot of what my portfolio looked like last fall (this was shared with members of High Yield Landlord at the time).

My bullishness towards REITs is well documented here on Seeking Alpha. I shared a number of my highest conviction ideas and also my thesis for investing in the sector.

In addition, in my most recent article on the most popular REIT ETF – Vanguard Real Estate Index Fund ETF Shares (NYSEARCA:VNQ), I discussed why fears of high interest rates are overblown.

In that article, I explained why I thought that further rate hikes beyond 5% would be unlikely due to a combination of declining inflation and a high level of national debt. I also gave a concrete example of how a quality REIT can easily offset any increase in interest expense by growing revenues, the key being the ability to increase rents in an inflationary environment and high interest rate hedging with low near-term maturities.

Having shown that quality REITs are likely to see their FFO grow even with high rates I issued a BUY rating for VNQ on October 30th, at a time when many were calling this foolish and looking for much lower prices. Since then, the REIT index has performed remarkably well, returning 19% in less than three months and outperforming the S&P 500 (SPX).

Going into 2024, REITs are clearly not as cheap as they were last year and while I remain invested, I have trimmed some of my positions.

In this article I present my outlook for the sector for 2024.

REITs will continue to be driven by rates in 2024

Over the medium-term, i.e. the next 12 months, I expect REIT prices to continue to be driven by interest rates. Looking at the past 12 months, it’s evident that there is a strong negative relationship between 10-year treasury yields and the price of VNQ.

In particular,

• As long-term yields increased from 4% to 5% last fall, the price of VNQ fell by 18%,
• then as yields fell to a low of 3.8%, the price of VNQ rallied by 25%,
• finally, the recent bounce in yields to 4.1% has resulted in a 5% sell-off in the VNQ.
• Put together, a 1 bps move in the 10-year treasury yields has, on average, resulted in a 0.19% move in the price of VNQ, in the opposite direction.

Company specific fundamentals, NAVs etc. matter, but it would be foolish to think that interest rates aren’t the single biggest driver of REIT prices. Consequently, any forecast for the sector has to, first and foremost, look at rate expectations.

I expect interest rates to fall, but so does the market

The market is pricing in substantial cuts by the Fed throughout 2024.

In particular, trading activity implies a 98% probability of at least three 25 bps cuts by the end of the year.

I agree with the market and think that it’s very likely that rates have peaked and the Fed will start cutting at some point this year.

What we don’t know, however, is whether the trigger for rate cuts will be a soft landing or a recession. Let’s examine these two options and their implications for REIT cash flows and prices.

Alternative #1 – soft landing

The market currently expects a soft landing and frankly, most data points are point in this direction.

Inflation has moderated significantly over the past year and a half and although December CPI was hotter than expected with month-over-month CPI of 0.3%, I expect it to trend much lower over the course of the year. The reason is that the current headline number of 3.4% YoY includes shelter CPI still at 6.2% YoY. Excluding shelter headline CPI would already be right around 2%. And since real time housing data, such as the National Rent Index has seen deflation over the past six months, it’s only a question of time before we work through the lag in reported shelter CPI.

Moreover, few people realize that in 2020 the Fed actually changed their mandate from targeting 2% inflation to targeting 2% inflation on average. This new policy is called Flexible Average Inflation Targeting (FAIT) and gives the Fed the ability to U-turn before inflation comes all the way to their target. I wouldn’t be surprised to see them mention FAIT in the coming FOMC meetings to prepare the ground for first rate cuts.

A soft landing would be good for the economy, the stock market and REITs.

But the problem is that this scenario is already priced in to a large extent, with 2-year yields now priced for 85 bps of rate cuts at 4.4%. And working through the lag in shelter CPI alone is unlike to push inflation meaningfully below the 2% target which is what it would likely take to see the 2-year yield decline further from its current level.

I don’t see clear catalysts to bring us to sub-2% inflation levels this year. As a result, I see lower upside potential in REITs than I did last year, but continue to HOLD because of high dividends and good valuations which, in my opinion, provide better risk-reward than that of the S&P 500 index.

Alternative #2 – recession

The risk scenario is that something breaks and the economy slips into a recession. There are currently few things suggesting that this is likely, except for (1) the yield curve which has been inverted for a year and a half and which, based on history, suggest a possible start of a recession this summer, and (2) the fact that optimism around a soft landing is usually poorly timed and tends to peak right before a recession.

If we get a recession, the Fed will very likely come to the rescue and lower rates, but unlike in the case of a soft landing, it’s unclear to me what the end outcome will be for REITs.

On the one hand, lower rates will ease the upward pressure on interest expense and cash flows will likely remain stable thanks to the insulated nature of being a landlord, but on the other hand sentiment will inevitably turn and push valuations of the whole market lower. It’s unclear to me whether the overall impact on REITs would be neutral or negative.

In either case, I would expect the S&P 500 to decline more than VNQ in this case, because:

1. REITs are more sensitive to rates and will therefore benefit from rate cuts, which should, at least partially, offset the deterioration in sentiment,
2. and REIT cash flows and earnings are likely be affected very little by a recession, unlike earnings of many of the company in the S&P 500 index

Bottom Line

REITs did really well in the second half of last year, but a lot of good news has been priced in. I expect the Fed to cut rates this year in line with market expectations, but don’t see clear catalysts that could result in sub-2% inflation and even more aggressive rate cuts than currently expected.

Therefore, I see the upside potential for 2024 as somewhat limited, but continue to prefer REITs, and more specifically VNQ, to the S&P 500 because of (1) a higher dividend yield of 4.1% vs 1.6%, and (2) better risk-reward under both a soft landing and a recession scenario.

I downgrade VNQ to a HOLD here.