Where to Invest in Real Estate? There are More Options Than You Think
The broader markets bounced back in the second quarter, as many companies reported benign earnings amidst a backdrop of more evidence of a soft economic landing. After the widely anticipated resolution of the debt ceiling, the Federal Reserve “paused” interest rate hikes which further fueled the rally in growth stocks.
Mortgage REITs performed well during 2Q2023 as the index increased by ~8%. This subsector outperformed the broader REIT index, the Russell 2000, and the DJIA. Although the second quarter provided some relief, non-bank mortgage stocks continued to be weighed down by issues in the banking sector that have little to do with the fundamentals in non-bank mortgage servicers and REITs.
Related to equities, we continued to focus on REITs and companies with exposure to residential mortgages and related investments. We believe several residential mortgage REITs could be able to pay double digit dividends with added stability on both the asset and liability sides of the balance sheet. We also believe the deeply discounted price to book ratios could normalize, creating attractive total return potential.
We continued to avoid material risk in commercial real estate – namely CMBS with excessive credit risk and equity REITs. Equity REITs tend to have concentrated commercial real estate exposure which we believe will be under pressure as the market adjusts to higher cap rates/rental yield requirements. We believe this dynamic could even provide headwinds for sub-sectors in the equity REIT market that are widely considered safe from a demand standpoint (like data centers and industrial).
We recently increased our position in Agency RMBS, given the unusually wide spread versus Treasury bonds. While this part of the market lacks the upside of some equity sub-sectors, we believe it is prudent to move “would-be” cash into longer duration parts of the mortgage market at this juncture. As the economy inevitably slows, interest rates could eventually subside which would disproportionately benefit deeply discounted Agency RMBS bonds via faster than anticipated prepayments.
We do see some opportunities in parts of the equity REIT market that could benefit from shortages in U.S. residential housing. For example, certain manufactured housing REITs should be in a good position to take advantage of a lack of affordable housing for retirees.
We believe investors could benefit from owning securities that have solid/ relatively predictable fundamentals, above-average income, and double-digit return potential. We continue to see plenty of opportunities to achieve returns without taking undue risk. In addition, fund managers who have the flexibility to invest in debt as well as equity should make use of the extra arrows in their quiver as the year progresses.