VNQ: REIT Crash May Continue As Inflation Rebounds (2024)

Over most of the past two years, the real estate sector has been the worst-performing of all significant equity segments. REITs also lag significantly behind year-to-date and over recent months. The popular REIT ETF (NYSEARCA:VNQ) is currently down 8% year-to-date and is trading around 35% below its peak value set at the beginning of 2022.

I initially became very bearish on VNQ (i.e., "strong sell") in January of 2022, just after it hit its peak value, as detailed in "VNQ: Commercial Property Prices May Plummet As Interest Rates Rise." Since then, I have maintained that bearish outlook as the commercial property market began to freeze in mid-2022. I reiterated this position in April as CRE transaction volumes plummeted and the CMBS market began to experience larger strains. Over this period, more analysts covering VNQ have started to understand the immense impact of higher mortgage rates; however, the allure of "high dividend yields" (even if those dividends do not come from a secure source) has encouraged continued investment into the sector.

VNQ's woes accelerated over the past month as the ETF fell by an additional ~6.5%, breaking below its previous key support level. This price action coincided with a significant spike in mortgage rates, correlated to the crash in bonds below that market's support level. Considering this, it appears to be another solid time to take an updated look at the sector concerning its valuation and economic fundamentals to determine better if VNQ is near its bottom or may continue to fall.

The Bond Market is Driving Commercial REITs

The relationship between bonds, particularly inflation-indexed bonds, and REITs is very strong because lower bond prices (or higher yields) increase property borrowing costs. In my view, this has little to do with the Federal Reserve because long-term rates are more critical for valuing REITs relative to bonds. Further, most commercial property borrowers do not borrow money in the < 1-year maturity market (although some do), with 5-20 years being the most common - segments of the yield curve beyond the Fed's direct control.

Inflation-indexed bonds, such as Treasury "Inflation-Protected" Securities or "TIPS," traded in the ETF (TIP), are particularly relevant to REITs. For the most part, REITs are expected to see their EPS rise at the rate of inflation, given rents and expenses both rise with inflation. In reality, REITs' incomes do not always increase with inflation due to fluctuations in the property market. Still, theoretically, rents should not deviate from the CPI permanently without extreme changes in population levels. Thus, REIT incomes are essentially "inflation-indexed," although exogenous factors such as the work-from-home trend (bearish for office REITs) and the housing shortage (bullish for residential REITs) bias that figure. Still, the general trend for VNQ is highly influenced by inflation-indexed Treasuries and, of course, CMBS prices. See below:

Significantly, both TIP and the commercial mortgage-backed security ETF (CMBS) have pushed against their "2022 minimum" price support levels over the past week. This indicates that this crucial bond market segment is losing its floor and may fall much lower as investors capitulate. Of course, lower bond prices push relevant long-term yields higher, as seen in the 10-year TIPs and 15-year mortgage rates.

The 10-year inflation-indexed security rate is the rate paid by these Treasury bonds after the inflation adjustment, so its true yield is inflation (~4% today) plus ~2.18%. Property market investors face two key related factors as this rate increases: 1) higher borrowing costs on purchases and 2) superior real yields in the bond market (discouraging investment into REITs). Further, as commercial properties become less attractive and their performance wanes due to higher long-term rates, banks are less interested in lending to the market. Indeed, given other related strains in banks today, most are looking to reduce exposure to the commercial property loan market, exacerbating pressure facing commercial properties.

Bank exposure to commercial properties is still high today, although it is experiencing little-to-no growth monthly. This factor is essential because the commercial property market relies on continued financing growth to keep up with property development and price changes. Crucially, the peak in commercial property prices (and VNQ) was in early 2022; declining bank deposits since then have been a significant negative catalyst for liquidity-sensitive assets such as properties. See below:

The decline in bank deposits is caused by the Fed's inflation-fighting efforts of "light" QT and short-term interest rate hikes. These efforts effectively reduce the amount of money circulating in the US economy, although the "money supply" remains far above its pre-COVID level. However, while this is the only way the Fed can slow inflation, it tends to pull money out of financial markets, lowering bond and equity valuations. Until inflation is back at the 2% target, investors should expect this key macro-trend to continue, inevitably pulling liquidity out of financial assets.

Notably, the long-term inflation expectation rate has increased over the past two months despite the Fed's tightening efforts. The sharp increase in oil and gasoline prices is likely the leading cause due to that commodity's massive impact on inflation. For many geopolitical and logistical reasons, I expect most energy commodities will rise over the next year, pushing inflation higher even if the economy slows. An oil-driven inflation rebound is not guaranteed. However, if it occurs, it would have a significant indirect bearish impact on REITs due to oil's more direct bearish effect on bonds and the Fed's ability to manage inflation. Indeed, the sharp rebound in energy commodities is likely the primary catalyst for VNQ's recent decline, with bonds as the intermediate asset. See below:

VNQ faces many macroeconomic trends that can influence its performance. The bond market is one of those trends, but it is, to me, the most important one because of its relationship with property market capitalization rates. While it may not be so clear to many investors, oil is also vital for REITs because, today, it is the primary driver of bond prices. Of course, liquidity strains in commercial banks (due to the falling M2) are also a significant financial market trend impacting REITs as commercial mortgage rates rise disproportionately to rates as a whole.

To simplify my point, consider that VNQ's dividend yield today is around 3.8% based on Vanguard's unadjusted yield for VNQ. That is its yield based on its current dividends, as its TTM yield is not accurate going forward as REIT incomes dip on higher rates and other issues. Since 2021, VNQ's yield has risen from around 2% to 3.8% (1.8%), while the "real yield" has risen by ~3.2% (from -1% to 2.2%). See below:

VNQ's yield spread to inflation-indexed Treasuries has declined from its "normal" 3% level to ~1.5% today, indicating VNQ is overvalued inflation-indexed bonds. Even if we assume the "yield spread" between the two should be 2.5%, that would still leave VNQ's dividend about 1% below where it should be based on both inflation and longer-term interest rates. VNQ's price would need to decline by ~20% (as required to push its yield from 3.8% to 4.8%).

Property Market Factors Influencing VNQ

Overall, I believe VNQ is overvalued compared to inflation-indexed bonds. Inflation-indexed bonds may continue to decline due to energy market issues, possibly creating a 20-30% downside for VNQ. 20% based on its compressed yield spread and an additional 10% due to "energy-inflation" risk factors. Of course, strong rental income growth for REITs could offset this risk. However, below-inflation income growth for REITs would mean VNQ is even more overvalued. In other words, the analysis above assumes VNQ's dividend rises with inflation, so deviations in that change unrelated to interest rates would also impact VNQ.

For one, office REITs are seeing rents decline due to rising vacancy rates associated with the work-from-home shift. This change is slow because companies usually will pay rent on unused space (making it "occupied") until the lease expires, so the full impact of work-from-home will not be seen in office REIT incomes until ~2027 to 2030, and longer for those with very long-term leases. Most office REITs have lost incredible value due to this issue, rising overhead costs, and the interest rate impact on valuations and financing. I believe some office REITs are unlikely to survive, while others could be undervalued.

With office REITs on the worse end of the spectrum, residential REITs have been toward the best. Of course, many specialized or niche REITs have outperformed residential. Still, given the enormity of residential REITs' size, they're likely to play a significant role in influencing VNQ. Since the late 1990s, rents have risen much faster than inflation, by around 33% overall. Since the 2008 property market crash, rents have accelerated as fewer people could afford to buy homes. Today, rents are very high compared to the CPI, but it is unclear if they will continue to rise disproportionately. See below:

This "real rent" index, or rent-to-CPI index, measures changes in rent compared to inflation changes. The index rebounded after briefly falling ~2020-2021; however, that was likely due to the rent payment pause in many states. The rise in rents is associated with falling rent vacancies and low existing home inventories, particularly since 2008. See below:

Homes are in short supply today, and they're the most unaffordable as ever, effectively keeping new buyers out of the market. Due to the national housing shortage, demand for multifamily apartments is relatively high and should be maintained. Of course, some areas of the US are seeing rents fall while others are seeing rents increase due to changes in population levels so some residential REITs will fare better than others. Still, since 2023 began, asking rents are no longer rising YoY nationally, indicating that residential REITs may see incomes fall despite rising inflation. Overall, I am neutral on the rent outlook because the housing shortage may continue to benefit multifamily rent demand, but it seems that the trend could be ending or reversing as renters cannot afford to pay any more than they currently are. Thus, residential rent growth will only result in more outstanding delinquency issues.

The Bottom Line

Overall, my bearish outlook for VNQ is affirmed for two reasons. One, VNQ appears to be overvalued compared to inflation-indexed bonds and should lose value as investors flock toward better risk-reward dividend assets. This issue could worsen if inflation rebounds due to the oil price shock. Secondly, VNQ's dividend may decline over the coming year due to negative trends in REIT operating incomes. Virtually all REITs face more significant overhead costs associated with maintenance and management but no longer see rent revenues rise accordingly. Office REITs are faring poorly on that front, but even "safe" multifamily residential appears weaker as US households face financial strains limiting rent spending abilities.

Some REIT segments in VNQ, such as data centers, telecom, and potentially industrials, could see rental incomes rise faster than inflation. That said, those segments usually have very high valuations, making them more exposed to the rise in interest rates. Industrial REITs may also face strains as the contracting manufacturing PMI index indicates a significant slowdown in US factories. Thus, if REIT dividend capacity declines as expected while interest rates may continue to rise, I believe VNQ could see more significant losses over the next year than it has over the past two years. With that in mind, VNQ appears to be a particularly poor investment choice today; however, I would not bet against it. Instead, I would prefer to short some particularly overvalued individual REITs.

Harrison Schwartz