Market Commentary | September 20, 2024
Normalization
The ad nauseam discussion of when the Federal Reserve would cut interest rates finally concluded on September 18th when Jay Powell announced a 50-basis point reduction in the Fed Funds rate. While speculation has immediately shifted to predictions about how fast and how far yields will fall, we should take a moment to examine how our investment selections might be affected by this rate change and a return to normalized monetary policy.
Fixed Income with Growth Potential
As investors, we are often simultaneously both borrowers and lenders. When we own shares in an equity REIT, that company’s management may elect to borrow against its real estate assets in efforts to enhance investment returns. When we own shares in a mortgage REIT, we provide capital for management to lend to property owners. The rapid increase in interest rates beginning in March 2022 created significant disruption on both sides of the lender/borrower relationship and an even more exaggerated dislocation in the market pricing of preferred stocks. We saw this dislocation as an opportunity and have positioned accordingly.
The recent run up in interest rates spiked money market yields and swelled their coffers to $6 trillion, nearly double their historical norm. The reversal of interest rates will reduce money market yields and funds will flow back out in pursuit of higher yields. To capitalize on this funds flow, we have purchased a selection of discounted equity and mortgage REIT preferreds. At discounted purchase prices, we have secured higher dividend yields going forward. In a lower yield environment, the discounts to par could shrink as yield demand pushes prices toward par value. The result would be high yield with capital appreciation and, with the rate cut now official, the price ascension has already begun.
Equity Growth Potential
Equity REITs grow externally through the acquisition of new properties. To varying degrees, they employ debt financing to fund this growth, and the level of debt can have a meaningful impact on how they are perceived in the investment markets—a couple of examples:
Kite Realty Group (KRG) owns grocery-anchored shopping centers, with a concentration in rapidly growing sunbelt locations. Over the years, KRG has been very acquisitive in growing its retail real estate portfolio and uses some debt financing, but the real growth has come through acquisitions using its stock as currency, like its late 2021 merger with Retail Properties of America. Through stock issuance, Kite has taken on relatively little debt and has built a very strong balance sheet. That strong balance sheet has earned them multiple credit rating upgrades which allows them to issue debt at progressively lower costs. Lower-cost debt improves their operating margins and has allowed KRG to raise its dividend 3 times over the last 2 years. Credit ratings go up, the stock goes up. Dividends go up, the stock goes up.
BSR REIT (BSRTF) owns luxury apartments in fast-growing Texas markets. To grow its portfolio, BSR took on a significant amount of variable-rate mortgage debt. The debt level seemed to frighten the markets and BSR’s share price declined. In response, management bought back and retired 15% of shares outstanding. In August, BSRTF raised its dividend by 7.6%. In the last 12 months, BSR’s share price is up 35% and is still trading at a discount to peers.
Declining interest rates are good for real estate investment. Opportunities abound.
Notes and Disclosure
Articles are provided for informational purposes only. They are not recommendations to buy or sell any security and are strictly the opinion of the writer. The information contained in these articles is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person.
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