4Q17 Comments:
REIT (Real Estate Investment Trusts)

Categories Investing, OSAM Research, U.S.

Thinking about investing in commercial real estate portfolios? Here’s a look back at how REITs1 fared during the tail end of 2017. (For other factor investing REIT results, see our REIT Blog archives.)

A Quarter-End Factor-Investing Summary

  • Value — emphasizing undervalued stocks detracted from REIT performance in 4Q17.
  • Growth — high-momentum stocks underperformed. Most REITs specialize in a specific real-estate sector. In 4Q, underweighting REITs in the Retail sector because of its poor momentum hurt performance.
  • Size — underweighting the largest-cap REITs was a headwind as well.

REIT Portfolio Construction

A bottom-up, quantitative investment philosophy can help investors build better REIT portfolios. We believe that successful investing requires two things: (1) careful research of factor-based investment strategies designed to align with investors’ objectives and (2) the steadfast discipline to stick to those strategies across market cycles and regimes.

We conduct granular research on hundreds of individual factors in the space (i.e., price-to-FFO, ROIC, debt-to-market, accruals, dividend payout ratio, etc.) and then we organize the most effective individual factors into multi-factor investment themes. The themes then serve as the building blocks of our strategies, with each theme providing a unique perspective on an individual stock. When combined, the themes give us an overall factor profile for a given stock.2

A multi-factor portfolio’s performance relative to the market3 is typically driven by the factors. When the favored characteristics perform well, it generally translates to excess return. When they underperform, the strategy will typically lag. Value & Momentum4 underperformed in the quarter and weakened returns.

Cumulative Excess Return vs. Benchmark
Highest-Scoring OSAM Momentum (thick line)
Cheapest OSAM Value (thin line)
graph


Outside of factor-specific return drivers, positioning on the market cap spectrum does play a role in performance relative to the benchmark. Because the benchmark is weighted based solely on the market cap of its constituents, it always favors the largest REITs. Our research shows that the largest REITs often underperform the rest of the REIT market. In those periods when large s outperform, the multi-factor REIT strategy’s smaller cap size is a detractor.

Market Cap-Weighted minus Equal-Weighted
graph


In factor-based REIT portfolios, industry and stock exposures are a result of the screening process, which selects equities with the highest combination of valuation, momentum, and quality. Sector allocations and stock selection benefited the REIT strategy in 4Q17.
Our underweight to the Retail sector was the main driver of underperformance. Retail saw poor Funds from Operations (FFO), weak growth, and poor momentum, all of which caused it to become the most underweighted sector. But when Retail ticked up in 4Q17, that underweight was a headwind. Not owning 3 of the larger names (Simon, General Growth Properties, and Macerich) took away 60bps.

Mostly due to valuation, Infrastructure was the next largest driver of REIT underperformance. Within this sector, the portfolio underweighted the “tower” REITs. If Infrastructure’s tower REITs had split out to become a separate sector, “towers” would be the most expensive sector in the NAREIT benchmark. By underweighting the 2 largest “tower” REITs (American Tower & Crown Castle), 60bps slipped away from Infrastructure’s excess returns.

Residential REITs was the portfolio’s highest relative performer this quarter. Benefitting from a small underweight to the sector, Residential added 72bps to performance. But there was also positive effect from stock selection as a whole — our REIT investments were up 6.1%, whereas the whole sector was down 20bps.

At one point, Data Centers was one of the strategy’s largest sector overweights because it had some of the cheapest valuations combined with some of the highest-ranking growth characteristics. Valuations became expensive in early 2017, so the portfolio decreased its position to an “underweight.” Even though valuations have been stretched thin, the sector’s performance continued its run during the first 3 quarters of the year and underweighting Data Centers caused the REIT portfolio to struggle. But that run-up was reversed slightly in 4Q17, when Data Centers underperformed the rest of the market, benefitting the portfolio.

Drilling down to individual stocks now, here are the Top 5 and Bottom 5 individual contributors to performance versus the NAREIT All Equity REIT Index® during the quarter:

Top 5 (Contributors)

  1. NEXPOINT RESIDENTIAL
  2. SBA COMMUNICATIONS
  3. CORENERGY
  4. WELLTOWER
  5. VENTAS

Bottom 5 (Detractors)

  1. CORECIVIC
  2. CROWN CASTLE
  3. PS BUSINESS PARKS
  4. SABRA HEALTH CARE
  5. INFRAREIT

Portfolio Positioning

By using our key themes to build REIT portfolios, the strategy is well-positioned versus its benchmark and versus the overall market. These combined advantages distinguish portfolio from its benchmark. From our research of the competitive REIT landscape, we’ve seen how high Active Share REIT strategies — though few and far between — provide an excellent opportunity for differentiated exposure.5


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  1. More details at investopedia.com/terms/r/reit.asp
  2. For example, our REIT strategy seeks U.S. real estate stocks that meet certain quality criteria — for earnings quality, financial strength, and earnings growth — and then focuses in on stocks with the combination of strong, consistent momentum, and discounted valuation.
  3. The FTSE NAREIT All-Equity REITs index is a free float-adjusted market capitalization-weighted index that contains all tax-qualified REITs with more than 50% of total assets in qualifying real estate assets, other than mortgages secured by real property, that also meet minimum size and liquidity criteria.
  4. See our 3Q17 Newsletter for research spanning the past 12 months.
  5. Our live-time REIT portfolio has a 74% Active Share (as of 12/31/17).