Making the REIT call

Real-estate investment trusts (REITs) have traditionally been viewed as a ‘mid-risk’ asset that can diversify equity market risk by dint of the physical assets they own, the cashflows they are owed through tenancy agreements, and the obligation on them to pay out dividends to their shareholders.

But far from providing much-needed protection in the recent bear market, over the past few weeks REITs have traded more like economically sensitive stocks.

This weird behaviour is being caused by weird macro conditions. Nobody would argue that the property market is entirely insulated from difficulties in the rest of the economy. During the financial crisis of 2008-09, real-estate markets were obviously at the heart of the recession and also behaved like cyclical assets. But in a normal recession, tenants have typically prioritised their rent payments – they may be able to defer new capital expenditure, but without premises many businesses would be unable to operate.

In the present crisis, however, rents are much more at risk as a growing number of tenants are choosing not to pay or are simply unable to pay their landlords. Retail is the most extreme example: revenue is not down to 80% like in a normal recession; it is down to 0%. At the same time, many REITs have debts of their own, so they are caught between this shortfall in income and their commitments to their creditors. This combination means that REITs’ dividends are much more at risk than normal.

This suggests the unusual recent performance of REITs is not simply a technical issue, but something fundamental and that these characteristics will persist for the duration of this crisis. REITs also tend to be relatively small-cap and leveraged, with both attributes being more out of favour this time than in some previous recessions.

Secure foundations

The existential threats to REITs nevertheless still seem limited. For the vast majority of them, their legal status as REITs (which is vitally important as it confers tax advantages), bond covenants, and balance sheets do not – yet – seem to be big risks. REITs in fact went into this downturn with less leverage and fewer near-term maturities than in the past; globally, the sector’s credit lines were also largely undrawn at the start of the downturn.

REITs have some scope for self-help too. Their development pipelines have already been scaled back and will likely continue to come down as work is postponed. The industry has also proven itself adept at lobbying in the past, both to defer property tax payments and to increase the proportion of their mandated dividends that REITs can pay in stock (this was raised from 80% to 90% in the US in the financial crisis). And last but not least, REITs can work constructively with their tenants to adjust leases in the short term.

On balance, then, while we do not think REITs as an asset class are structurally challenged as a result of the recent developments, it seems likely they will continue to trade with unusually cyclical characteristics for the duration of the crisis. So for the time being, we are happy to re-balance REIT holdings, but are holding back from going tactically long.