Fed Loses Control | Seeking Alpha
This is an abridged version of the full report published on Hoya Capital Income Builder Marketplace on June 17th.
Real Estate Weekly Outlook
The sell-off deepened across U.S. equity markets this week after the Fed announced aggressive measures to combat persistent inflation – sending equities plunging to their lowest levels since the initial vaccine approvals in November 2020. Having already contracted by 1.4% in the first quarter, the GDPNow model estimate for real GDP growth in the second quarter of 2022 is now exactly zero. With a range of high-frequency data indicating a further cooling of economic momentum since mid-May amid a continued surge in energy prices and higher borrowing rates, the correct question appears to be not “if” but rather “how long” this recession will last – and how much pain is already priced-in to market valuations.
Now having declined in ten of the past eleven weeks, the S&P 500 dipped 6.1% on the week – its worst decline since the depths of the pandemic in March 2020. There were few places to hide as the Mid-Cap 400 and Small-Cap 600 each dipped nearly 8% while the historically large drawdown in fixed income securities across the credit and maturity curve further deepened. Real estate equities were unable to avoid the pain despite a wave of dividend hikes and M&A news. The Equity REIT Index declined 5.3% on the week with all 19 property sectors in negative territory. The selling pressure was deeper across the more economically-sensitive property sectors as the Mortgage REIT Index dipped more than 14% while the Homebuilder Index plunged by more than 16% as mortgage rates have now doubled since August.
The punishing declines deepened this week after the Federal Reserve approved a “triple” 75 basis point rate hike – the largest increase in short-term lending rates since 1994 – while questions mounted over whether the central bank has “lost control” over its ability to engineer a soft landing. After initial surging to 3.50% prior to the Fed announcement, the 10-Year Treasury Yield dipped back down to 3.24% by the end of the week as calls for a recession grew louder following weak economic data across the retail, employment, and housing markets. There was nowhere to hide this week even the previously high-flying Energy (XLE) sector plunged by more than 17%. The pain was particularly acute in the highly-speculative crypto space amid mounting liquidity concerns after several crypto platforms suspended withdrawals.
Real Estate Economic Data
Below, we recap the most important macroeconomic data points over this past week affecting the residential and commercial real estate marketplace.
New home construction in the U.S. cooled to the lowest level in more than a year in May as soaring mortgage rates and ongoing supply chain challenges have prompted builders to pump the brakes on new development. Underscoring the lack of efficiency of Fed rate hikes as a means to control price pressures – particularly in the critical U.S. housing market which accounts for roughly a third of the CPI Index – tighter monetary policy has contributed to a near-doubling in monthly mortgage payments on new purchases over the past year while also curbing supply growth. Lack of supply – not an overly speculative demand environment – has been the dominant factor behind rising home values and rents over the past several years.
Speaking of shortages, the BLS reported this week that Producer Prices soared at a 10.8% annual rate in May – slightly cooler than consensus estimates – but still notching the third-highest annual inflation rate on record. Goods prices drove nearly two-thirds of the increase and within the goods category, 70% of the increase can be attributed to an 8.4% month-over-month advance in the index for gasoline. On the services side, costs for truck transportation drove the cost increases. Among the relevant PPI metrics for the real estate industry, the PPI Self-Storage Index – which closely tracks rent growth in the storage REIT sector – posted another brisk month-over-month gain of 1.8%, pushing the year-over-year advance to 17.2% – just below the prior month’s record-high rate of 17.9%.
Equity REIT Week In Review
A wave of REIT dividend hikes was a bright spot amid the carnage this week as four equity REITs and four mortgage REITs hiked their dividends, bringing the full-year total across the sector to over 70. Net Lease REITs were able to avoid much of the selling pressure after W. P. Carey (WPC) and Realty Income (O) – the two largest net lease REITs – each hiked their dividend for the second time this year. Ground leases operator Safehold (SAFE) – which we hold in the new Landowner Portfolio – also hiked its quarterly dividend by 4.1%. In Net Lease REITs: Surviving Inflation, For Now, we discussed why net lease REITs have surprisingly been among the best-performing property sectors this year despite the challenging macroeconomic environment.
Cannabis: A trio of cannabis REITs hiked their dividends this week. Chicago Atlantic Real Estate (REFI) – which went public last year – hiked its quarterly dividend by 17.5% while AFC Gamma (AFCG) hiked its quarterly dividend by 2% and NewLake Capital (OTCQX:NLCP) hiked its quarterly dividend by 6.1%. This weekend, we’ll publish an updated report on the Cannabis REIT sector to the Income Builder marketplace which will analyze the reasons behind the sharp declines across the sector this year and our updated outlook. Concerns over tenant credit quality has been the concern this year as tightening monetary policy and stalled legislative progress on federal marijuana legalization have sent valuations of cannabis cultivators plunging. Innovative Industrial (IIPR) – which has ranked among the strongest REITs for dividend and FFO growth over the past five years – pushed back on scrutiny from short-sellers in its recent earnings call, highlighting the protections offered by its lease structure and state licensing framework.
Industrial: Together at last? Duke Realty (DRE) was the best-performing REIT this week after agreeing to be acquired by logistics giant Prologis (PLD) in a $26B all-stock deal expected to close in the fourth quarter. Following months of pursuit and several rejected offers, the deal adds another 160 million square feet of space to Prologis’ portfolio of over a billion square feet of logistics and industrial space. Duke shareholders will receive 0.475x of a Prologis share for each Duke share, which is roughly 2% above the exchange ratio offered in May, but 10% below the implied per-share value, reflecting the roughly 20% decline in industrial REIT valuations since the May offer despite another quarter of historically strong earnings results. Expected to generate immediate accretion through significant synergies, the transaction is expected to be accretive to Core FFO by roughly 5% in year one.
Hotel: Every hotel REIT with the exception of Apple Hospitality (APLE) posted double-digit declines this week as high-frequency data – including TSA Checkpoint data – has shown some signs of softening demand with June on pace to record the softest demand relative to pre-pandemic levels since the end of the Omicron outbreak back in early March. Pebblebrook (PEB) plunged 15% on the week after providing a business update in which it noted that its operating metrics softened a bit in May compared to April, but attributed the weakening to seasonal patterns rather than recent economic concerns. Its Revenue Per Available Room (“RevPAR”) was 9% below comparable pre-pandemic levels in May, giving back some ground from April when its REVPar was within 5% of pre-pandemic levels.
Single-Family Rental: This week, we published Single-Family Rental REITs: Shelter From Stagflation. Amid mounting recession worries and a return of heart-stopping market volatility, residential REITs – particularly the traditionally countercyclical single-family rentals – should prove to be a source of relative shelter. SFR REITs were born from the last economic crisis when a cascade of foreclosures enabled a new class of institutional rental operators to emerge by buying distressed properties en-masse. Similar distress in the U.S. housing market is highly unlikely given the underlying supply constraints resulting from a decade of underbuilding, and ironically, due to the presence of well-capitalized institutional investors. SFR REITs enter this uncertain period on solid footing, benefiting from historically favorable Buy vs. Rent economics
Farmland: Gladstone Land (LAND) provided a business update in which it commented that it’s close to finalizing an agreement to add up to 60 wind turbines, 1,600 acres of solar panels, and additional infrastructure as part of a renewable energy agreement on 16,500 areas of land. Elsewhere, Farmland Partners (FPI) announced that it purchased 280 acres of farmland in Illinois for $3.4 million, commenting that it remains in “growth mode.” Publicly-traded landowners – specifically timber and farmland REITs – have been among the better-performing real estate sectors this year amid concerns over persistent inflation and soaring commodities prices, but have given back some of this outperformance in recent weeks amid mounting recession concerns.
Mortgage REIT Week In Review
Mortgage REITs were sharply lower this week amid a surge in interest rate volatility, reflected in the jump in the MOVE Index to the highest level since March 2020 – a period when violent swings in rates led to significant distress across much of the sector. As discussed in our Mortgage REIT report last week, while a rising interest rate environment can be a net positive for mREITs, sharp changes in rates in either direction can wreak havoc on mREITs that are caught over-levered or improperly hedged. Reflecting this concern, seven mREITs declined by more than 15% on the week, dragged on the downside by Invesco Mortgage (IVR), AG Mortgage (MITT), and Redwood Trust (RWT) – three of the most highly-leveraged mortgage REITs.
While interest rate volatility is a risk with unknown effects, the underlying fundamentals within the sector were far less grim as the iShares MBS ETF (MBB) and the iShares CMBS ETF (CMBS) – the benchmarks tracking the unlevered performance of residential and commercial mortgage-backed bonds – posted fairly muted weekly declines of about 1%. Ellington Financial (EFC) reported that its estimated book value per share (“BVPS”) was $16.94 as of May 31, roughly flat since the end of April. The mREIT sector also saw a handful of dividend increases this week – including a 10% hike from Ladder Capital (LADR) and a 5% raise from BrightSpire (BRSP) – bringing the full-year total to over a dozen hikes compared to just four dividend decreases.
REIT Capital Raising And REIT Preferreds
The Hoya Capital REIT Preferred Index declined by 3.1% this week, consistent with the significant pressure on the broader iShares Preferred and Income Securities ETF (PFF) which dipped by nearly 4%. REIT preferreds are now lower by roughly 13% on a total return basis for the year after ending 2021 with price returns of roughly 8.0% and total returns of roughly 14%. This week, UMH Properties (UMH) announced that it will redeem all outstanding shares of its 6.75% Series C Preferred (UMH.PC) on July 26th – the first potential call date. Based on recent company commentary, UMH is also expected to redeem its other outstanding preferred issue – its 6.375% Series D Preferred (UMH.PD) at its first potential call date in January 2023 as it sees opportunities to reduce its cost of capital.
2022 Performance Check-Up
Through twenty-four weeks of 2022, Equity REITs are now lower by 24.4% on a price return basis while Mortgage REITs have slipped 28.8%. This compares with the 23.0% decline on the S&P 500 and the 21.8% decline on the S&P Mid-Cap 400. With the exception of the student housing sector, every REIT sector is now in negative territory this year while thirteen property sectors are lower by 20% or more and three have dipped over 30%. At 3.24%, the 10-Year Treasury Yield has climbed 173 basis points since the start of the year, breaking through the prior post-GFC-high rate of 3.25% reached in 2018. The 2-Year Treasury Yield has climbed from 0.73% to 3.07%.
Economic Calendar In The Week Ahead
Markets will be closed next Monday for the Juneteenth federal holiday. The state of the housing market will be in focus once again next week as we’ll see Existing Home Sales data on Tuesday which is expected to show a cooldown in May to the slowest rate since June 2020 while New Home Sales data on Friday is expected to show a contraction to the lowest-level since late 2018. The weekly Initial Jobless Claims data on Thursday has once again become a closely-watched report following two straight weeks of notable increases in unemployment filings. The Michigan Consumer Sentiment report has also suddenly been thrust back into focus after Fed Chair Powell specifically cited the hotter-than-expected consumer inflation expectations survey as a primary rationale for the FOMC’s decision to hike rates by 75 basis points rather than 50 basis points this month.
For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Apartments, Homebuilders, Manufactured Housing, Student Housing, Single-Family Rentals, Cell Towers, Casinos, Industrial, Data Center, Malls, Healthcare, Net Lease, Shopping Centers, Hotels, Billboards, Office, Farmland, Storage, Timber, Mortgage, and Cannabis.
Disclosure: Hoya Capital Real Estate advises two Exchange-Traded Funds listed on the NYSE. In addition to any long positions listed below, Hoya Capital is long all components in the Hoya Capital Housing 100 Index and in the Hoya Capital High Dividend Yield Index. Index definitions and a complete list of holdings are available on our website.