VNQ: Why REITs struggle to hedge against inflation
The Vanguard Real Estate ETF (NYSEARCA:VNQ) seeks to provide high income and moderate capital appreciation. It does this by tracking the performance of a benchmark index that measures the performance of publicly traded companies. REITs in stocks and other real estate related investments. This index is called the Real Estate Spliced Index and VNQ has done a great job tracking it. Note that the returns below are valid until April 30, 2022.
Yes, there is sometimes a lag, but that is to be expected with the fees ETFs have to pay. These same fees are absent from benchmarks, so you will almost always see a slightly lower return for passive ETFs. Although the ETF has performed well, recent performance has been fragile. Interestingly, this happened just as inflation was rising.
Is VNQ a hedge against inflation or not? The short answer is no. The longer answer is below.
Valuation matters for inflation hedging
We often see investors bundle all forms of assets together as inflation hedges. This has spanned from real estate to art, precious metals and even cryptocurrencies. In 2021, we even heard that all stocks were a hedge against inflation. When we check real-world performance, we find that none of this is true. To hedge against inflation, REITs must have 2 major characteristics:
1) Their cash flow must increase with inflation
2) Their valuation should not compress with inflation
REITs tend to do very well on point 1) but often not so well on point 2).
Will VNQ Holdings increase its cash flow with inflation?
Ignoring investment in the VNQ mutual fund equivalent, the top 5 holdings include Prologis (PLD), American Tower Corporation (AMT), Crown Castle International Corporation (CCI), Equinix, Inc. (EQIX).
All have grown their cash flow and cash flow per share quite well over the past few years.
While these results are impressive, we believe the biggest tailwind here was the extremely low cost of capital. Debt rollovers have been extremely accretive, so much so that it’s impossible not to buy assets for a positive return. Digital Realty Trust, Inc. (DLR) is another top 10 holding is a prime example. DLR occupancy in 2015 was 94.3%.
It fell to 87.1% in 2020, then to 84.8% in September 2021.
In Q1-2022, we fell to 83.3%! Despite this, cash flow per share increased, thanks to European debt financing at less than 1% on average. The favorable interest rate winds are now in the rearview mirror. Cash flow per share will increase for these REITs, but expect a lot more difficulty doing so.
Will VNQ Holdings suffer from a valuation squeeze?
There are many different valuation models for REITs and for us most suggest that we are in a period of extreme valuation compression. We will cite just one below as an example. REIT yields and valuation changes can be predicted by changes in BAA bond yields (lowest IG rating). BAA bond yields are a big competition for REITs and we can gauge the performance of REITs based on where those yields are. As you can see below, these yields have become vertical.
There is a very good model for predicting future REIT returns based on current BAA returns. We think this model should be used with some skepticism when yields are jumping so quickly, but nonetheless, some scrutiny is warranted.
It compares the spread between the REIT dividend yield (of the index) and the BAA bond yields. In all cases, BAA bond yields are assumed to be higher (and usually are) than the Equity REIT index yield. Peak returns are seen when REIT yields are less than 0.6% below BAA bond yields. So, in our current setup, if REIT index returns were above 4.44% (5.04% minus 0.6%), we could expect spectacular returns from REITs.
Where are we really now? The Equity REIT Index returned only 3.13% at the end of April, so the gap in the last column is negative 2.1%. Indeed, BAA bond yields were 5.16% at the time. The drop in REIT prices this month actually took the REIT index’s yield to 3.4% and we are now in the second column from the left. Thus, our two-year expected annual total returns should be around 5% for REITs. So this REIT success, while surprising to some, stems directly from the BAA model. In fact, we talked a long time ago about what would happen if interest rates rose very quickly.
Despite the increase in cash flow, VNQ holdings suffered a severe and sudden valuation squeeze as BAA bond yields stifled them. Much of the REIT liquidation is now in the rearview mirror. But future returns will still be guided by the high level of corporate bond yields. We don’t believe the final peak in BAA bond yields is behind us and as a result, VNQ will struggle to hedge against inflation. Once the valuation compression is done, we will see a better correlation with inflation.
Please note that this is not financial advice. It may seem, seem, but surprisingly, it is not. Investors are required to do their own due diligence and consult a professional who knows their objectives and constraints.