先進国

Highlights 1. How will the pandemic resolve? 2. Will services spending recover to its pre-pandemic trend? 3. Will we spend our excess savings? 4. How will central banks react to inflation? 5. Will cryptocurrencies continue to eat gold’s lunch? 6. How fragile is Chinese real estate? 7. Will there be another shock? Fractal analysis: Personal goods versus consumer services. Feature Chart of the WeekWill Services Spending Recover To Its Pre-Pandemic Trend? “Judge a man by his questions, not by his answers” The quotation above is often misattributed to Voltaire instead of its true author, Pierre-Marc-Gaston de Lévis. Irrespective of the misattribution, we agree with the maxim. Asking the right questions is more important than finding answers to the wrong questions. In this vein, this report takes the form of the seven crucial questions for 2022 (and our answers). 1.  How Will The Pandemic Resolve? As new variants of SARS-CoV-2 have arrived like clockwork, the number of new global cases of infection and the virus reproduction rate have formed a near-perfect mathematical ‘sine wave’. This near-perfect sine wave will propagate into 2022 (Chart I-2). Chart I-2The Pandemic's Sine-Wave Will Propagate Into 2022 But how will this sine wave of infections translate into mortality, morbidity, and stress on our healthcare systems? As we explained in RNA Viruses: Time To Tell The Truth, the answer depends on the specific combination of contagiousness, immuno-evasion, and pathogenicity of each variant. Yet none of this should come as any surprise. Flus and colds also come in waves, which is why we call them flu and cold seasons. And the morbidity of a given flu and cold season depends on the aggressiveness of that season’s flu and cold variant. So, just like the flu and the cold, Covid will become an endemic respiratory disease which comes in waves. The trouble is that our under-resourced health care systems can barely cope with a bad flu season, let alone with an additional novel disease that can be worse than the flu. Hence, until we add enough capacity to our healthcare systems, expect more disruptions to economic activity from periodic non-pharmaceutical interventions such as travel bans, vaccine passports, and face-mask mandates. 2.    Will Services Spending Recover To Its Pre-Pandemic Trend? The pandemic has given us a crash course in virology and epidemiology. We now understand antigens, antibodies, and ‘reproduction rates.’ We understand that a virus transmits as an aerosol in enclosed unventilated spaces, and that singing, and yelling eject this viral aerosol. We understand that vaccinations for RNA viruses have limited longevity, do not prevent reinfections, and that certain environments create ‘super-spreader’ events. Armed with this new-found awareness, a significant minority of people have changed their behaviour. Services which require close contact with strangers – going to the dentist or in-person doctors’ appointments, going to the cinema or to amusement parks, or using public transport – are suffering severe shortfalls in demand. Given that this change in behaviour is likely long-lasting, demand for these services is unlikely to regain its pre-pandemic trend in 2022 (Charts I-3 - I-6). Chart I-3Dental Services Are Far Below The Pre-Pandemic Trend Chart I-4Physician Services Are Far Below The Pre-Pandemic Trend   Chart I-5Recreation Services Are Far Below The Pre-Pandemic Trend Chart I-6Public Transportation Is Far Below The Pre-Pandemic Trend Therefore, to keep overall demand on trend, spending on goods will have to stay above its pre-pandemic trend. This will be a tough ask. Durables, by their very definition, last a long time. Even clothes and shoes, though classified as nondurables, are in fact quite durable. Meaning that are only so many cars, iPhone 13s, gadgets, clothes and shoes that any person can own before reaching saturation. If, as we expect, spending on goods falls back to its pre-pandemic trend, but spending on services does not recover to its pre-pandemic trend, then there will be a demand shortfall in 2022 (Chart of the Week). 3. Will We Spend Our Excess Savings? If spending falls short of income – as it did through the pandemic – then, by definition, our savings have gone up. Many people claimed that this war chest of savings would unleash a tsunami of spending. Well, it didn’t. And, it won’t. Previous episodes of excess savings in 2004, 2008, and 2012 had no impact on the trend in spending (Chart I-7). The explanation comes from a theory known as Mental Accounting Bias. The theory states that we segment our money into different accounts, which are sometimes physical, sometimes only mental, and that our willingness to spend money depends on which mental account it occupies. This contrasts with standard economic theory which assumes that money is perfectly fungible, meaning that a dollar in a current (checking) account is no different to a dollar in a savings or investment account. In practice, money is not fungible, because we attach different emotions to our different mental accounts. A dollar in our current account we will gladly spend, but a dollar in our savings account we will not spend. Hence, the moment we move the dollar from our current account into our savings account, our willingness to spend it collapses. This explains why consumption trends have no connection with windfall income receipts once those income receipts end up in our savings mental or physical account. Pulling all of this together, the war chest of savings accumulated during the pandemic is unlikely to change the overall trend in spending. 4.    How Will Central Banks React To Inflation? The real story of the current ‘inflation crisis’ is that while goods and commodity prices have surged exactly as expected in a positive demand shock, services prices have not declined as would be expected in the mirror-image negative demand shock. The result is that aggregate inflation has surged even though aggregate demand has not (Chart I-8 and Chart I-9). Chart I-8Goods Prices Have Reacted To A Positive Demand Shock... Chart I-9...But Service Prices Have Not Reacted To A Negative Demand Shock Why have services prices remained resilient despite a massive negative demand shock? One answer, as explained in question 2, is that much of the shortfall in services demand is due to behavioural changes, which cannot be alleviated by lower prices. If somebody doesn’t go to the dentist or use public transport because he is worried about catching Covid, then lowering the price will not lure that person back. In fact, the person might interpret the lower price as a signal of greater risk, and might become more averse. In technical terms, the price elasticity of demand for certain services has flipped from its usual negative to positive.  This creates a major problem for central banks, because if the price elasticity of services demand has changed, then surging aggregate inflation is no longer a reliable indicator of surging aggregate demand. To repeat, inflation is surging even though aggregate demand is barely on its pre-pandemic trend. Hence in 2022, central banks face a Hobson’s choice. Choke demand that does not need to be choked, or turn a blind eye to inflation and risk losing credibility. 5.    Will Cryptocurrencies Continue To Eat Gold’s Lunch? Most of the value of gold comes not from its economic utility as a beautiful, wearable, and electrically conductive metal, but from its investment value as a hedge against the debasement of fiat money. The multi-year investment case for cryptocurrencies is that they are set to displace much of gold’s investment value. Still, to displace gold’s investment value, cryptocurrencies need to match its other qualities: an economic utility, and limited supply. A cryptocurrency’s economic utility comes from its means of exchange for the intermediation services that its blockchain provides. For example, if you issue a bond or smart-contract using the Ethereum blockchain, then you must pay in its cryptocurrency ETH. Which gives ETH an economic utility. Furthermore, the number of blockchains that will succeed as go-to places for intermediation services will be limited, and each cryptocurrency has a limited supply. Thereby, the supply of cryptocurrencies that have a utility is also limited. With an economic utility, a limited supply, and drawdowns that are becoming smaller, cryptocurrencies can continue to displace gold’s dominance of the $12 trillion anti-fiat investment market. Therefore, the cryptocurrency asset-class can continue its strong structural uptrend, albeit punctuated by short sharp corrections (Chart I-10). Chart I-10Cryptocurrencies Will Continue To Displace Gold's Investment Value The corollary is that the structural outlook for gold is poor. 6.    How Fragile Is Chinese Real Estate? A decade-long surge in Chinese property prices has lifted Chinese valuations to nosebleed levels. According to global real estate specialist Savills, prime real estate yields in China’s major cities are now barely above 1 percent, and the world’s five most expensive cities are all in China: Hangzhou, Shenzhen, Guangzhou, Beijing, and Shanghai (Chart I-11). Without a social safety net and with limited places to park their money, Chinese savers have for years been encouraged to buy homes, in the widespread belief that property is the safest investment, whose price only goes up. With the bulk of people’s wealth in property acting as a perceived economic safety net, even a modest decline in house prices would constitute a major shock to the household sector’s hopes and expectations of what property is. Therefore, in contrast to the US housing debacle in 2008, the Chinese government will ensure that its property market adjustment does not come from a collapse in home prices. Rather, it will come from a collapse in property development and construction activity. This will have negative implications for commodities, emerging Asia, developing countries that produce raw materials, and machinery stocks worldwide. 7.    Will There Be Another Shock? Most strategists claim that shocks, such as the pandemic, are unpredictable. We disagree. Yes, the timing and source of an individual shock is unpredictable, but the statistical distribution of shocks is highly predictable. We define a shock as any event that causes the long-duration bond price in a major economy to rally or slump by at least 20 percent.1 Using this definition through the last 60 years, the statistical distribution of the number of shocks in any ten-year period is Poisson (3.33) and the time between shocks is Exponential (3.33). This means that in any ten-year period, the likelihood of suffering a shock is a near-certain 95 percent; in any five-year period, it is an extremely high 80 percent; in a two-year period it is a coin toss at 50 percent; and even in one year it is a significant 30 percent (Chart I-12). Therefore, on a multi-year horizon, another shock is a near-certainty even if we do not know its source or precise timing. The question is, will it be net deflationary, or net inflationary? Our high-conviction view is that it will be net deflationary. Meaning that even if it starts as inflationary, it will quickly morph into deflationary. The simple reason is that it is not just Chinese real estate that is fragile. Through the past ten years, world prime residential prices are up by 70 percent while rents are up by just 25 percent2 (Chart I-13). Meaning that the bulk of the increase in global real estate prices is due to skyrocketing valuations. The culprit is the structural collapse in global bond yields – which, in turn, is due to persistently ultra-low policy interest rates combined with trillions of dollars of quantitative easing. Chart I-13Property Price Inflation Has Far Exceeded Rent Inflation This means that bond yields have very limited scope to rise before pulling the bottom out of the $300 trillion global real estate market. Given that this dwarfs the $90 trillion global economy, it would constitute a massive deflationary backlash to the initial inflationary shock. Some people counter that in an inflationary shock, property – as the ultimate real asset – ought to perform well even as bond yields rise. However, when valuations start off in nosebleed territory as now, the initial intense headwind from deflating valuations would obliterate the tailwind from inflating incomes. Investment Conclusions To summarise, 2022 will be a year in which: Covid waves continue to disrupt the economy; a persistent shortfall in spending on services is not fully countered by excess spending on goods; China’s construction boom comes to an end; inflation takes time to cool, pressuring central banks to raise rates despite fragile demand; and the probability of another shock is an underestimated 30 percent. We reach the following investment conclusions: Overweight the China 30-year bond and the US 30-year T-bond. There will be no sustained rise in long-duration bond yields, and the risk to yields is to the downside. Long-duration equity sectors and stock markets that are least sensitive to cyclical demand will continue to rally (Chart I-14). Chart I-14The US Stock Market = The 30-Year T-Bond Multiplied By Profits Overweight the US versus non-US. Underweight Emerging Markets. Underweight old-economy cyclical sectors such as banks, materials, and industrials. Commodities will struggle. Underweight commodities that haven’t corrected versus those that have (Chart I-15). Chart I-15Underweight Commodities That Haven't Yet Corrected Overweight the US dollar versus commodity currencies. Cryptocurrencies will continue their structural uptrend at the expense of gold. Goods Versus Services Is Technically Stretched Finally, this week’s fractal analysis corroborates the massive displacement from services spending into goods spending, highlighted by the spectacular outperformance of personal goods versus consumer services. This outperformance is now at the point of fragility on its 260-day fractal structure that has signalled previous reversals (Chart I-16). Therefore, a good trade would be to short personal goods versus consumer services, setting a profit target and symmetrical stop-loss at 12.5 percent. Chart I-16Underweight Personal Goods Versus Consumer Services   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 20 percent. 2 Based on Savills Prime Index: World Cities – Capital Values, and World Cities – Rents and Yields, June 2011 through June 2021. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area     Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed     Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations     Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

The S&P 500 return is becoming concentrated once again. Over the past three months, the combined return from the 257 S&P stocks that rallied was 316 index points, 62 (20%) of which came from only two tickers: MSFT and AAPL. As a group, FAANG-like stocks represent high-quality defensive Growth due to their sheer size, liquidity, predictable and growing cash flows, and sound balance sheets.  High-quality growth stocks outperform in an environment of slowing growth and falling 10-year US Treasury yield as it justifies the valuations premium FAANGs command (see Charts 1 & 2). Further, FAANGs also provide downside protection during times of heightened risk aversion (please see here).  However, the BCA house view remains that US Treasury rates will rise over the course of 2022, and that economic growth will remain above trend. In this scenario, Growth will underperform Value, and Small caps will outperform Large caps. Bottom Line: We recommend staying away from FAANG-like stocks in 2022, and funneling funds into the other 495 S&P 500 stocks. ​​​​​ ​​​​

特別レポート

Highlights As investors’ hunt for yield continues, REITs emerge as an attractive asset class. Characterized by an attractive risk-adjusted return (comparable to public equities), and high dividend yields, REITs can add value to investors’ portfolios. The macro backdrop is supportive: Moderate levels of inflation and rising rates have historically been positive for REITs’ performance. Valuations, albeit currently looking frothy, are reflective of a recovery that was broad-based and swift. REITs’ risk premium is attractive, currently 540 basis points. Fundamentals remain supportive of a positive outlook on REITs. Even though cap rates (which historically have moved in lockstep with interest rates) could rise given our macro outlook, the cap-rate spread remains close to its historical average. The pandemic has accelerated some existing trends in the real-estate sector and established new ones. Those will create opportunities for investors. For example, the decline of retail and rise of e-commerce, working from home, and migration away from city centers are observable patterns with investable opportunities. Accordingly, the Global Asset Allocation (GAA) service upgraded the Real Estate sector to Overweight in its July 2021 Quarterly Outlook. In the near-term – given current elevated levels of inflation – we prefer REITs with short-term leases (such as self-storage and residential REITs) over those with long-term leases (such as retail and office) since the former can adjust rents more quickly. Structurally, we favor sectors supported by the growth of the digital economy. The post-pandemic environment should be positive for sectors such as data centers and industrial REITs. Feature In today’s environment of accommodative monetary policy, low interest rates, unattractive valuations and poor return prospects for income-generating assets, investors have been forced to dial up their risk appetite. Real estate stands out as a particularly attractive alternative. The Global Asset Allocation (GAA) service turned positive on real estate in July given the favorable macro backdrop in which: Inflation – while likely to come down from current elevated levels – will be higher in future than in recent decades; There is tight supply in some segments of commercial real estate (CRE); Rental growth is accelerating. This Special Report focuses on REITs, which are the simplest way for most investors to get liquid exposure to the real estate market.  The report is structured as follows. We first look at the broad US REITs market (mainly equity REITs) and analyze its historical risk-return characteristics, fundamentals, and valuations. We then assess how REITs fared in previous environments of rising rates and inflation. In the second section, we analyze various sectors of the REITs market, identifying likely losers and winners from our base-case expectations for inflation and growth, and based on our views of how long-term demand for real estate will shift following the pandemic. While we have concerns about potential weaknesses in some segments of commercial real estate (e.g., retail), we highlight opportunities in more technology-driven segments of CRE. Introduction The REITs market in the US as of Q3 2021 has a market value of close to $1.5 trillion. The bulk of this is equity REITs – trusts that own and operate income-producing assets and earn income mostly through rents. The remaining are mortgage REITs which lend money directly to real-estate owners or indirectly by purchasing mortgages or securitized securities such as mortgage-backed securities (MBS) and earn income on those investments. While technically considered equities, the business model of mortgage REITs makes them more like bonds than equities. The composition of the REITs market has changed over the years. While the traditional retail and residential segments dominated the market in the first years of the millennium, structural changes have shifted the balance towards segments such as infrastructure, data centers and industrial (Chart 1). The pandemic accelerated trends that were already in play: For example, the rise of e-commerce, digitalization of services, increased teleworking, and reshoring of manufacturing and supply chains. These have had adverse effects on traditional real estate segments such as retail. Historical Risk And Return, Valuations, Fundamentals & Correlations Since 1973, US all-equity1 REITs have outperformed both public equities and fixed-income assets (both government bonds and investment-grade corporate bonds) on an absolute basis, providing investors with an 11.9% annualized return versus 10.8%, 6.8%, and 7.6% respectively. On a risk-adjusted basis however, REITs’ performance was equal to that of their public equity counterparts, but lower than fixed-income assets because of REITs’ higher volatility. The negative skewness and excess kurtosis also indicate a high probability of large negative returns.  Mortgage REITs (split between Home Financing and Commercial Financing), on the other hand, have returned only 5.2% on an annualized basis, while racking up annualized volatility 3.5 percentage points higher than their all-equity counterparts (Table 1). Table 1Historical Risk-Return Characteristics In order to generate the sort of yields investors expect, mortgage REITs resort to leverage (about 6-8 times) which increases volatility (Chart 2). For example, REITs focusing on residential/home financing buy low credit-risk securities (with almost zero default risk), add leverage, and hedge changes in interest rates via derivatives. Mortgage REITs focusing on commercial financing use less leverage, but take on additional credit and default risk embedded in their underlying assets. Both types of REITs remain highly exposed to the economic cycle and financial conditions. Despite disappointing returns (mainly stemming from narrowing net interest spreads), mortgage REIT investors have been entranced by the high dividend yields. These have averaged 11.3% over the past four decades and are still close to 8% today, much higher than the yields of their all-equity counterparts and other assets (Chart 3). Chart 2Mortgage REITs Are Volatile... Chart 3...And Have High Dividend Yields   Table 2Attractive Dividend Yields Across Sectors Dividend yields for all-equity REITs are also attractive in today’s low-yielding investment environment, even though they are at all-time lows – currently they average 2.9%, 150 basis points higher than for public equities. In fact, all REIT sectors and subsectors (with the exception of the lodging/resorts sector) currently have dividend yields higher than those of public equities (Table 2). Even though REITs are considered equities, analyzing them requires different indicators. Whereas equity investors rely on multiples such as price-to-earnings (P/E) or price-to-book (P/B), for REITs price-to-funds from operations (P/FFO) is a more important valuation tool. FFO is favored over earnings since it adds back depreciation and amortization expenses, and adds to net income any gains (or subtracts any losses) from sales of underlying assets. REITs traded at a steady 17x FFO between the end of the Global Financial Crisis (GFC) and the start of the pandemic. FFO fell by 30% in the first two quarters of 2020 compared to Q4 2019, pushing the P/FFO multiple to 24.7 – an all-time high.  But FFO as of Q3 2021 has inched back above its pre-pandemic level (Chart 4). The risk premium for REITs (calculated as the FFO yield minus the real 10-year treasury yield) – currently at 5.4% – remains higher than the pre-GFC bottom of 3.5%. (Chart 5). Chart 4Valuations Reflect A Swift Recovery Chart 5REITs Risk Premium Is Still Elevated     With the exception of the lodging/resorts sector, REITs’ FFO as of Q3 2021 is higher than one year ago. The occupancy rate for major sectors of the REITs market is starting to rise. Overall net operating income (NOI) for Q3 2021 was 4.5% higher than its pre-pandemic (Q4 2019) level (Chart 6). Chart 6Occupancy Rates Are Rising Again This however is the result of a large year-on-year increase in inorganic or non-same-store net operating income (NOI) – income from assets owned for less than 12 months (either recently acquired or developed) (Chart 7). M&A activity has been increasing, and amounted to almost $47 billion over the past four quarters – driven by activity in the infrastructure, self-storage, and free-standing2 segments (Chart 8). Chart 8...As M&A Activity Rose Chart 9REITs Have Low Leverage...   The real-estate sector has historically been seen as risky due to its high leverage, but leverage has been on the decline. Over the past decade, REITs’ reliance on equity capital has increased, with the equity/assets ratio rising from 32% in 2008 to 43% in 2021. The ratio of debt to book assets stands at around 49%, much lower than the 58% during the GFC (Chart 9). REITs have also extended the average maturity of their debt from 5 years in 2008 to over 7.5 years today. The fall in interest rates over the past two decades has benefited equity REITs: As rates fell, so did the interest they paid on their debt. Liquidity ratios also improved, with REITs’ coverage ratio (earnings relative to interest expense) at 6x, cash levels and undrawn lines of credit relative to interest expense close to 2x and 7x, respectively (Chart 10).  In summary, REITs are an attractive asset class, since leverage is lower, earnings continue to rise, and cap rates – while declining – remain high compared to the risk-free rate. REITs, however, remain highly correlated to public equities: The current 3-year rolling correlation between REITs and public equities is above its historical average of 0.57 (Chart 11). This high correlation undermines the diversification benefit of REITs to investors’ portfolios. Moreover, investors should note that the correlation between REITs and direct real estate (DRE) has averaged only 0.1 over the past four decades. Even when DRE is lagged to account for its appraisal-based methodology, correlation does not rise. Chart 10...And Ample Liquidity Buffers Chart 11REITs Remain Highly Correlated To Equities In a previous Special Report we showed however that, while both direct and indirect real estate exposure can add value to investors’ portfolios on a risk-adjusted basis, direct real estate should be favored given its low correlation to other financial assets (such as equities and bonds) as well as the illiquidity premium that investors with no need for immediate liquidity can harvest. The Macro Outlook Our base case is that interest rates will inch higher over the next 12 months and that inflation will moderate but remain higher than during the past decade. How would such an environment affect the outlook for real estate – and REITs in particular? Interest rates and cap rates tend move in lockstep (with the exception of a divergence from mid-2003 until the GFC). This implies that rising rates could lead to higher cap rates, and thus lower property values (Chart 12, panel 1). The current cap-rate spread (the difference between the cap rate and the 10-year Treasury yield) is close to its long-term average of 365 basis points. This should help mitigate downward pressure on property values and act as a buffer when rates rise (Chart 12, panel 2). As long as rising rates are reflective of strengthening economic growth – and we expect US growth to remain above trend for the next two years at least (Chart 13) – and do not hurt the health of corporate tenants or increase defaults, demand for real estate should rise. Chart 12Interest Rates And Cap Rates Tend To Move In Lockstep Chart 13Above-Trend Growth Should Bolster Demand For Real Estate Historically, rising rates coincided with strong performance from REITs. On average, REITs returned 25.4% during episodes of rising interest rates, even higher than the return from equities of 24.5%. However, that figure is distorted by some outliers:  REITs returned over 100% between 1976 and 1980, and in 2003-2007 (Table 3). The median return of REITS was only 7.1% versus 22.5% for equities. Excluding those two periods lowers REITs’ mean return to 9.4%. Valuation data begins only in 2000, but we can see that REITs were attractively valued in 2003, trading at about 9x P/FFO. By the peak of the market in Q1 2007, they were trading at more than 17x P/FFO. Table 3REITs Fared Well In Previous Periods Of Rising Interest Rates REITs however fared poorly in periods of rising inflation. In a Special Report published in mid-2019, we showed that REITs were a poor hedge against very high inflation and that, much like equities, once the economy overheats and inflation rises sharply (which we define as CPI above 3.3%), REITs produced negative excess returns over cash (Chart 14 and Table 4). For investors able to be more granular in REIT allocations, drilling down to sub-categories of the market might be beneficial, particularly given the low correlation between REIT sectors (Chart 15). Table 4REITs Are Not A Good Inflation Hedge (II) Chart 15Low Correlation Between REIT Sectors The real estate market is diverse. Each sector is driven by different dynamics, reacts differently to the business cycle and changes in consumer behavior, and therefore has different return characteristics. Annual returns by sector have ranged from 4% to 19% since 1994 (Table 5). Moreover, sectors do not react in the same way to rising interest rates or inflation. Properties with short-term leases, such as hotels, storage, and apartments, can reprice and adjust rents as prices rise. On the other hand, those on the other end of the lease spectrum, e.g., retail and healthcare, have less flexibility to do so (Diagram 1). REITs with shorter-term leases (an equally-weighted basket of lodging, self-storage, and residential) outperfomed those with longer-term leases (an equally-weighted basket of healthcare, industrial, retail, and office) during periods of rising interest rates (Chart 16). Table 5REIT Sector Historical Returns Diagram 1Short-Term Leases Outperform...   Chart 16...During Periods Of Rising Interest Rates Bottom Line: The REITs market has recovered after the slump early in the pandemic. Current multiples appear expensive. However, they may just reflect a recovery that has been broad-based and swift. Cap rates historically have moved in lockstep with rising rates. If rates rise, as we expect, cap rates are likely to rise in tandem, putting downward pressure on property prices. The cap rate spread however remains close to its historical average and this should act as a buffer when rates rise. Moderate levels of inflation and rising rates are usually a positive for REITs’ performance. However, just like equities, once inflation rises too high (historically above 3.3%), REITs’ returns fall. We prefer REITs with short-term leases compared to those with long-term leases, as the former can reprice and adjust rental pricing more quickly. The Post-Covid Environment The pandemic has accelerated some existing trends in the real-estate sector and established new ones. Some sectors will struggle in this new environment, while others will flourish. In this section, we describe the likely post-pandemic world and how it will impact various segments of the real-estate market. We also assess where there are opportunities that investors can capitalize on.   Retail The “death of retail” is not a new phenomenon. As technological advances led to the rise of e-commerce, consumer spending shifted from in-store to online. Over the past two decades, non-store retail sales in the US have grown at an annualized 9.5%, compared to 3.1% for in-store sales. E-commerce has risen to almost 14% of total retail sales (Chart 17). This shift is reflected in the halving of the weight of retail REITs in the REITs index over the past decade. The composition of the sector has also changed and is no longer dominated by regional malls and shopping centers but by free-standing properties: These include restaurants, theaters, fitness centers, pharmacies, etc.  (Chart 18). Chart 17The Rise Of E-Commerce... Chart 18...Had An Adverse Impact On The Retail Sector   The headwinds facing the sector – particularly shopping centers –  have not abated. The size of vacant shopping center space has increased to 220 million square feet, approximately 11% of total retail space available: This is close to its post-GFC high. Private multi-retail capex continues to decline and is below its post-GFC low (Chart 19). Retail REITs’ occupancy rate is among the lowest among CRE: 94% as of Q3 2021, although it is higher than during the past two recessions. Funds from operations (FFO) and net operating income (NOI) have been declining over the past few years, with the exception of free-standing properties which saw low but positive growth (Chart 20). Chart 19Plenty Of Vacant Inventory In Shopping Centers... Chart 20...But There Could Be Opportunities In Free-Standing Properties   The pandemic exacerbated some other underlying trends and threats. Smaller in-store retailers have shifted to an online presence, aided by companies like Shopify, which saw the numbers of merchants on its platform grow from 1.07 to 1.75 million in 2020. Consumers are also likely to favor shopping in smaller-scale, local shops as they find convenience in stores close to home. Additionally, given the positive correlation between household density and retail space, as households migrate from city centers to the suburbs there will be less need for retail space within city centers. Bottom Line: We recommend investors underweight the retail sector within their broad real estate exposure. The structural headwinds are not likely to disappear. Within retail, we would favor free-standing properties over shopping centers and regional malls.   Office There has long been a close link between office demand and employment. As the labor market tightens, demand for offices increases and rents tend to rise (Chart 21). Investors in office REITs have earned 9.6% annualized returns, 90 basis points annualized below the overall return of the all-equity REITs index, over the past two decades. The sector is currently flush with supply. Estimates show that almost 18% (close to 800 million square feet) of total office space is vacant, yet capex has continued to increase over the past decade (Chart 22). Chart 21The Pandemic Has Changed Office Demand Dynamics Chart 22...Leaving The Sector With Empty Space   The pandemic, however, might be the catalyst for change. After social restrictions were imposed and offices shut down, the BLS estimates that in May 2020 as many as 35-40% of US employees were telecommuting, strictly because of the pandemic (Chart 23). Since then, as restrictions were lifted and vaccination rates rose, this number has come down to 12%,3 as more employees returned to some sort of pre-pandemic normalcy. The US Household Pulse survey (published by the US Census Bureau), however, shows close to 40% of employees working at home as of the end of September (Chart 24). Chart 25Mobility Data Showing No Full Return To Offices The true number of employees who telework likely lies in between the BLS’s 15% and the Census Bureau’s 40%. A study by Jonathan Dingel and Brent Neiman estimated, based on job characteristics,4 that 37% of jobs in the US can be done entirely from home (46% if weighted by wages). Whether employees will favor a work-from-home versus a return-to-office environment is still unclear. Most surveys show a 50-50 split. High-frequency data such as the Google Mobility Trends show that the number of people going to their workplace has not yet returned to normal (Chart 25). It is likely however that office utilization rates will not return to pre-pandemic levels. This might incentivize firms to search either for offices with flexible leases or co-shared space. Chart 26Are Employers Leaving City Centers With Their Employees? Companies face the choice of downsizing and so reducing business costs, or keeping the same premises which would allow for lower office density and enable social distancing between employees who return to the office. Estimates by CBRE suggest that office demand will not fall by as much as the reduction in the time employees will be in the office. CBRE argues that, while the average US employee is likely to spend 24% less time in an office, demand for office space will fall by only 9%. This calculation factors in more space per employee to allow for social distancing and collaborative working. Additionally, as more employees move away from inner cities, employers could move with them. This trend is reflected in suburban office prices which have risen by 15.1% since the beginning of 2020, compared to those in central business districts (CBD) which have risen by a mere 0.2% (Chart 26). Bottom Line: Investors in office space should be wary of corporates which are unwilling to return to offices operating at full capacity, and instead focus on single-tenant assets with long-term leases.   Healthcare Chart 27Like Equities, Healthcare REITs Are A Defensive Play REITs within this sector are focused on hospitals, senior and nursing homes, and laboratories. Since 1994, healthcare REITs have returned 10.7% annualized, with 21.1% annual volatility. These numbers, however, mask the underlying reality. Healthcare, being a defensive sector, outperformed the broad REITs market only during the dot-com recession and the GFC. In the short-lived pandemic-driven recession in 2020, healthcare REITs underperformed the broad index by 15%. On the other hand, during bull markets, particularly post the GFC, healthcare REITs significantly underperformed the broad market (Chart 27). The sector also has a high dividend yield, which has averaged 6.7% over the past 25 years, 160 basis points higher than the broad index’s historic average (Chart 28). In a Special Report published last year, we explained the structural reasons for our longstanding overweight position on Healthcare equities. We expect demand for healthcare services to continue to rise as life expectancy increases, populations age, and retiring baby boomers spend their accumulated wealth (mainly on healthcare) (Chart 29). Chart 28Healthcare REITs Have High Dividend Yields Chart 29An Aging Population Will Support Demand For Healthcare Elder care facilities will play a major role in supporting the increasingly aging population over the coming years. The pandemic has emphasized the need for high-quality senior housing: In our previous report, we highlighted that lack of funding and mismanagement – particularly in for-profit nursing homes – were reasons why they had almost four times as many Covid infections as those run by the government or non-profits. Chart 30...Increasing Investment In Healthcare Facilities Chart 31Healthcare REITs' Fundamentals Are Recovering The private sectors has already began to step in to meet this demand: Healthcare private construction expenditure has risen over the past few years and is likely to rise further (Chart 30). Cap rates continue to inch lower, but still have a decent spread over 10-year Treasurys (Chart 31, panel 1). Fundamentals have also began to improve: FFO and NOI growth seem to have bottomed, after dipping into negative territory as a result of the pandemic (panels 2 & 3). The sector has been going through a phase of consolidation: There have been significant acquisitions over the past few quarters, particularly of distressed operators (panel 4). Bottom Line: There is a structural long-term case to favor REITs in this sector, particularly an aging population with ample savings to spend on healthcare. Federal support and oversight have helped bolster confidence (for both occupants of care homes and investors) during the pandemic, and are likely to continue.   Lodging/Resorts Chart 32Income Has Been The Only Source Of Return For Lodging REITs Chart 33The Travel Industry Has Not Yet Recovered Lodging REITs have been the worst performing sector over the past 27 years. Since 1994, they have returned only an annualized 4.1%, 640 basis points lower than the all-equity REITs index, with annual volatility 14 percentage points higher. They have steadily underperformed the market since 1997. Property prices within the sector have consistently declined, and income has been the only source of return (Chart 32). Lodging demand is closely linked to travel, which has been deeply impacted by the pandemic. The number of US domestic airline passengers is still only half that of the pre-pandemic period (Chart 33). With vaccines rolled out and most pandemic restrictions likely to be lifted eventually, the travel sector is set to rebound, albeit not equally across segments. Chart 34Personal Travel Likely To Recover Before Business Travel Chart 35The Hotel Industry's Recovery Personal and leisure travel is likely to return first: More people are now comfortable about going on vacation and want to make up for the “lost travel” of the past two years (Chart 34). Hotel occupancy rates, while still below 2019 levels, continue to rise, and revenue per available room (RevPAR) is close to 2019 levels (Chart 35). Business travel, on the other hand, might not recover as fast. The shift to remote working and videoconferencing is likely to push companies to review travel budgets. Business travel, which halved between 2019 and 2020, is forecast to return to its pre-pandemic level only in 2024/2025. This is likely to have a larger adverse impact on higher-end, major-city hotels. Chart 36The Pandemic's Effect On The Lodging Sector The industry has been facing other headwinds for the past few years. The threat from online lodging platforms, such as Airbnb, has put downward pressure on occupancy rates, which have been declining recently after having hovered around the mid-60% level over the past 30 years. Bottom Line: Real spending on hotels and motels remains 26% below trend (Chart 36). A revival in leisure travel, the easing of restrictions, and pent-up demand will support the sector in the short-term. However, domestic business travel and international tourism might be slow to recover. Investors in lodging and resorts should reduce exposure to major-city assets and focus instead on rural or resort-based getaways.   Residential Residential REITs are primarily focused on apartments, rather than single-family homes or manufactured (mobile) homes  – although the share of apartments has been declining over the past few years (Chart 37). Since 1994, residential REITs have outperformed the broad market by an annualized 1.8 percentage points. More recently, since the single-family homes segment was added to the sector (in December 2015), residential REITs have continued to outperform the broad market, driven by a 21.4% annualized return from the manufactured homes segment, 19.4% from single-family homes, and 12.3% from apartments. The sector’s outperformance should not come as a surprise. The housing sector has been undersupplied for decades: The ratio of annual housing starts to the total number of households is 1.2% –  0.7 percentage points below its pre-GFC average (Chart 38). This has pushed up prices, increasing unaffordability, particularly for first-time buyers (Chart 39). This increased the percentage of US housing inventory occupied by renters rather than owners (Chart 40). Chart 37Apartments Make Up The Majority Of Residential REITs Chart 38Housing Undersupply Is No New Issue...   Chart 39...Making Home Prices Unaffordable... Chart 40...Particularly For Young Adults   Chart 41The Pandemic Pushed Renters Outside Of Major Cities The pandemic, and its impact on shopping and work, has pushed city residents to the suburbs. This is reflected in the gap between the rental vacancy rate in large cities versus that in the suburbs (Chart 41). It is also noticeable in REITs’ performance: Ones dominated by suburban housing have outperformed those focused on city centers over the past year. Home prices, appreciating faster than rental growth, will remain a tailwind for residential REITs (Chart 42). Supply shortages will keep prices high. Fundamentals also remain supportive of a positive outlook on the sector: The cap rate on residential REITs is about 260 basis points over the 10-year Treasury yield, and both FFO and NOI growth seem to have troughed (Chart 43). Chart 42Rising Home Price Will Be A Tailwind For Residential REITs Bottom Line: Investors should favor the residential sector within the REITs market, favoring single-family homes and manufactured homes over apartments, and out-of-city over downtown properties. Chart 43Improving Fundamentals For The Residential Sector   Data Centers Data centers are facilities that provide space for customers’ servers and other network and computing equipment. Due to the high and complex technical set-up specifications, leases are usually longer (upwards of five years). Properties that support the digital economy have attracted a lot of demand over the past few years. New technologies such as artificial intelligence, virtual reality, and autonomous vehicles will prove a tailwind over the coming years. Since data first became available (January 2016), data centers have outperformed the REITs benchmark by almost 60 percentage points (Chart 44). The pandemic has accelerated those trends, as social restrictions led offices, schools, and stores to close. This led to an increase in internet traffic and data creation. Estimates by OpenValut show that broadband usage increased by 51% in 2020 compared to 2019, partly due to remote learning and teleworking. Demand for data centers is expected to continue to grow. Fundamentals for the sector remain supportive: The cap rate – albeit now lower than post the GFC– is still near that of the broad benchmark (Chart 45, panel 1) and both NOI and FFO continue to grow (panels 2 & 3). Chart 44Sectors Supporting A Digitalized Economy Will Be Long-Term Outperfomers Chart 45...Supporting Fundamentals' Growth     Bottom Line: Internet traffic remains the primary driver of the performance of data-center REITs. The move towards a more digitalized economy is likely to prove a tailwind for the sector. This should also immunize the sector over the economic cycle as dependence on data increases structurally. A new normal in remote working and learning, as well as continued investment in new technologies, support an allocation to the sector.     Industrial Technological advances, particularly the rise of e-commerce, have also helped the industrial sector, increasing the need for logistics and fulfillment centers. Research by Prologis shows that e-commerce requires more than 3x the logistics space of brick-and-mortar sales. That is why investment in the sector has been rising over the past decade (Chart 46). Demand shows no signs of cooling: The occupancy rate of industrial REITs is at an all-time high, 4 percentage points higher than its 20-year average (Chart 47). Rental growth for industrial properties – particularly down the value chain closer to the end-consumer – has been robust due to the scarcity of permittable land. Chart 46Increased Demand For Warehouses Has Translated Into More CAPEX... Chart 47...And Pushed Up Occupancy Rates   The pandemic has also revealed how vulnerable current supply chains are and has accelerated a trend BCA Research has highlighted for years: The decline of globalization. Going forward, companies will move to reshore some of their production to gain greater control over supply chains (Chart 48). This will amplify the need for industrial space. Bottom Line: We expect the industrial sector to continue to outperform the broad REITs market, supported by continued investment in fulfillment and logistics centers. Fundamentals remain strong: Same-store NOI is growing at over 6% a year, and acquisitions have increased, with more than $5.5 billion over the past four quarters (Chart 49). The industrial sector has been one of the quickest to revive projects put on hold during the pandemic, with the development pipeline as of Q3 2021 34% higher than in Q4 2019. Chart 48The End Of Globalization, And Supply Chain Reshoring Will Increase The Need For Industrial Space Chart 49Increased M&A Activity In The Industrial Sector Amr Hanafy Senior Analyst Amrh@bcaresearch.com Footnotes 1  All-equity REITs refer to equity REITs plus infrastructure and timberland REITs. 2  Free-standing REITs own stand-alone properties away from malls and are a subsector of the retail sector. 3 This does not include those whose telework was unrelated to the pandemic, such as those who worked entirely from home prior to the pandemic. 4 Jonathan I. Dingel and Brent Neiman, "How Many Jobs Can Be Done At Home?" NBER Working Paper No. 26948, April 2020.