Why active may be the right path forward for REITs

Despite an impressive 10-year record and a comeback for the space overall, it may be time to separate the wheat from the chaff

Why active may be the right path forward for REITs

Active management may have fallen out of favour among cost-conscious fund investors, but the top-down and bottom-up research that comes with the approach may still prove useful in one specific sector of the stock market.

According to WealthManagement.com, US-listed REIT ETFs have done well over the past decade, partly due to a strong comeback story that’s been developing this year. In particular, it noted the US$37-billion Vanguard Real Estate ETF (VNQ), far and away the largest product in the category, which according to Morningstar went from a dismal -6.02% return last year to 28.05% so far this year up to September 4.

“The fund produced an impressive annualized return of 14.12% over the past 10 years, as the real estate market has rebounded strongly from the Great Recession,” the report said.

But according to Barry Vinocur, editor of REIT Zone Publications, REITs should not be expected to deliver consecutive years of such eye-popping returns. They’re more likely to provide mid- to high-single digit performance over the long term, particularly as U.S. economic growth has slowed from 3.1% annualized in the first quarter to 2% in the second.

Two segments of the REIT market in particular are besieged by a continuing move to a digital economy: hotels and retail, specifically malls. Drilling into the FTSE Nareit REIT index reveals that Retail REITs have eked out just 0.87% over the past year, as mall REITs plunged 18.78%. Hotel/resort REITs in the index, meanwhile, have returned -16.59%.

That poses a structural problem for REIT ETFs that are tethered to their indexes. Mark Freeman, chief investment officer of Dallas-based Socorro Asset Management, noted that many such ETFs are highly concentrated in their top 10 holdings, with exposure to real-estate subsectors that face technological disruption.

Read also: REITs: The active vs. passive debate

With that in mind, US REIT fund investors may be better off seeking active strategies. In a recent blog post, Invesco reported that further deterioration in lower-quality REITs has spurred “a widening gap in the corporate performance of US REITs” it covers. It also cited the lateness of both the U.S. economic expansion and the commercial real-estate cycle.

“[T]he Invesco Real Estate team continues to believe that active management is critical to finding opportunities in higher quality REITs while potentially avoiding companies which we believe will continue to face fundamental deceleration,” the firm said.

For its part, Invesco said its real-estate securities team evaluates all 171 members of the FTSE NAREIT All Equity REITs Index every quarter based on fundamental criteria such as geographic footprint strength, real-estate asset quality, and management track record. It then divides the U.S. REIT universe into two groups of securities, with those in the bottom third based on performance being deemed as failures.

“Earnings growth for companies which have passed our qualitative screens (higher-quality REITs) has remained respectable at 4.3%,” the firm said. “On the flip side, for the one-third of names that fail our fundamental analysis (lower-quality REITs), earnings growth has fallen to -5.1%.”

Invesco also cited a disparity in balance-sheet quality between the two groups. From 2015 to 2019, those that passed its fundamental screens generally continued to de-lever from an average of 32% to 30%, as opposed to failing companies where leverage levels have increased from 40% to 50% on average.

“While falling interest rates have recently given a reprieve to highly leveraged companies, our REIT investment team believes that the increase in leverage for many names in the failing universe will continue to be a signal of long-term corporate weakness,” it said.


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