DNY59
Co-produced by Austin Rogers
There is a mountain of cash sitting on the sidelines.
Yes, even after the stock market’s recent rally back near all-time highs. Trillions of dollars is sitting in money market accounts, earning 5%+ yields. Earning over 5% on virtually risk-free cash is an irresistible proposition for many investors and savers.
That’s why nearly $6 trillion is currently housed in money market funds (“MMFs”).
The Daily Spark
Notice that this level of cash in MMFs is 50% higher than the peak reached during the Great Financial Crisis in 2009.
But what happens if and when the Federal Reserve starts to lower their key Fed Funds Rate, on which money market yields are based?
The obvious answer is that cash in MMFs will start to flow out of these vehicles into other destinations.
Admittedly, this process usually takes a while. It almost never happens all at once. Understanding the standard cycle of the Fed Funds Rate helps to explain this.
The usual pattern is that cash flows into MMFs as the Fed pushes their policy rate higher. Then, when the Fed is rapidly cutting rates, there is almost always some economic weakness at play that spooks investors out of stocks, causing further inflows into MMFs.
On average, it takes about a year after the Fed cuts rates for MMFs to turn from inflows to outflows.
The Daily Chartbook
Why? Because that’s how long it takes the average investors to feel that the coast is clear, the damage is done, and it’s “safe” to invest in stocks again. Also, for savers with their cash in MMFs, it takes a while to realize that the MMF no longer pays an attractive yield, which may spur them to seek out other types of savings vehicles.
Now, will all $6 trillion eventually flow into stocks? No, almost certainly not.
Some of it will stay in money market funds. Some will go into bonds, some into real estate, and some in bank accounts.
For the funds that go into stocks, which types of stocks are favored?
In 2010 and 2011, amid the biggest outflow from MMFs in decades, much of this money flowed into real estate investment trusts (“REITs”) because of their characteristically high yields. This surge in flows into REITs fueled the Vanguard Real Estate ETF (VNQ) to outperform both the S&P 500 (SPY) and high-yield dividend stocks (VYM) from 2009 through 2019.
Notice from this chart that the outperformance in REITs began immediately after the Great Recession ended and a new bull market began. That is because outflows from MMFs became inflows into REITs.
In 2010 and 2011, the SPY saw total assets under management increase by 10%, but the VNQ enjoyed AUM growth of 99%!
In other words, during the period of high outflows from MMFs, dramatically more money flowed into REITs than into the stock market more broadly.
The same thing happened during the MMF net outflow period from 2002 through 2006: massive outperformance of the Vanguard Real Estate Index Fund (VGSIX) over the SPY.
During this period, the SPY increased its total assets under management by 110%. Not bad!
But the Vanguard Real Estate Fund increased its total assets under management by 732%!
Where did this money come from? Largely, it came from MMFs.
Why does this relationship exist? Because even though REITs do not fundamentally behave like bond alternatives, investors treat them like bonds.
When bond yields rise, investor demand for REITs falls. And when bond yields fall, investor demand for REITs rises.
To reiterate: the fundamental reality for REITs is very different than the “rates up, REITs down” formulation. Many REITs drop in price when interest rates rise even when they have little to no fundamental vulnerability to rising interest rates. But we can’t deny that this relationship exists and has rarely been broken.
We believe REITs should enjoy a strong year in 2024 as valuations continue to rebound off their lows and interest rates continue their downward slide. But this historical analysis of MMF outflows leading to REIT stock inflows indicates that the real tailwind for REITs has not yet begun.
If money flows out of MMFs and into REITs as they did in 2002-2006 and 2010-2011, then REITs should enjoy a multi-year period of very strong performance, perhaps even total return outperformance over the broad market.
Three Particularly Attractive REITs
One could of course simply buy the VNQ to gain access to all REITs in one click, but there are downsides to doing this. For one, if you buy the average, you get average performance. And for another thing, VNQ actually has a relatively poor record of dividend growth compared to many individual REITs.
There are a select group of individual REITs about which we remain highly bullish, even after the REIT rebound since November 2023.
One of those names is Alexandria Real Estate Equities (ARE), owner and developer of Class A, state-of-the-art, unbeatably located life science research facilities in the United States.
Despite one of the strongest balance sheets in the REIT sector, a best-in-class management team led by co-founder Joel Marcus, and highly resilient assets, ARE trades at nearly its lowest valuation since the Great Financial Crisis.
Below we see price to cash from operations, which is not the same as adjusted funds from operations (“AFFO”) but comes the closest to REIT cash flow among the metrics offered by YCharts.
ARE’s price/AFFO of 17x is well below its 5-year average (not peak!) of 25.5x. This implies incredibly 50% upside just to get back to its 5-year average valuation!
Right now, ARE suffers from negative sentiment due to its misclassification as an office REIT. But life science real estate enjoys far stronger fundamentals than office.
The market also seems to worry that much of the empty office space across the country will be turned into life science buildings that increase competition for limited life science tenant demand. But we argue that the quality and location strength of ARE’s properties acts as a moat. The best biotech companies in the world want to conduct their R&D activities at the best life science facilities in the world.
Another fantastic buying opportunity is in the experiential net lease REIT, EPR Properties (EPR), which owns entertainment, recreation, and education properties such as movie theaters, family entertainment centers, theme parks, and private schools.
Both fundamentals and sentiment took a beating during COVID-19, but while EPR’s fundamentals have bounced back, investor sentiment remains weak. Here’s EPR’s price-to-sales ratio:
You might think that price-to-sales is a bad metric to use for REITs. For many REITs, that is true. But outside of the COVID-19 pandemic, EPR has very stable AFFO margins. For example, in the first three quarters of 2023, EPR sported an AFFO margin of about 60%. Compare that to 2019’s AFFO margin in the mid-60% area.
With AFFO margins holding more or less steady over time (e.g. only a slight deterioration in AFFO margins between 2019 and 2023), EPR’s price-to-AFFO chart should look a lot like its P/S chart.
Sure enough, EPR’s P/AFFO currently sits at 9.2x, compared to an average of about 13.6x in 2019. Over the past 5 years, including the depths of the pandemic, EPR’s P/AFFO averaged about 11.5x. In other words, EPR has 25% upside just to its average valuation from the last 5 very difficult years.
Finally, consider a REIT with among the most conservative financial management in the entire public real estate space: NNN REIT (NNN), formerly known as “National Retail Properties.”
NNN owns single-tenant, net leased retail properties such as convenience stores, fast food restaurants, wholesale clubs, and RV dealerships. And the REIT’s BBB+ rated balance sheet is one of the best structured in all of REITdom, given NNN’s ~13-year weighted average debt maturity. That is even longer than its weighted average remaining lease term of ~10 years!
NNN’s financial conservatism is illustrated by its impressive 33-year dividend growth record.
Despite this, NNN remains near its cheapest valuation since the GFC:
NNN may not be at rock-bottom valuations, but it isn’t far above them either.
And given NNN’s 5.25% dividend yield, growth does not need to be incredible for investors to enjoy high single-digit or low double-digit total returns from here.
Bottom Line
The REIT rally has only just begun. It will almost certainly happen in fits and starts — in a zigzag pattern instead of straight up and to the left. That’s how rallies almost always occur.
Right now, REITs have enjoyed a slight rebound based simply on long-term interest rates retreating a bit from their highs. But eventually, if history repeats, REITs should enjoy a multi-year bull market as a result of money market fund outflows moving into yield vehicles, especially REITs.
We are buying ahead of the crowd and will wait patiently until the market rewards us. The market always rewards smart capital allocation in the long run.
