Style Rotation With REITS

Once confined to equities, style rotation as an investment strategy is slowly spreading to other asset classes as new index products are introduced. At some point, we expect it will come to the market for commercial property securities, especially now that the popularity of Real Estate Investment Trusts (REITS) is growing around the world. So how might REIT sector rotation unfold? Let's start with the four main categories of commercial property securities. Office properties are the most glamorous of the lot, and if they are in a central business district, often come with long term leases and creditworthy tenants. However, office building projects also take a long time to come together, and too often arrive in large numbers just as an economic cycle is peaking. At the other end of the spectrum are apartment REITs. The supply of this type of property is more flexible, and while leases are shorter than in the case of offices, it has the advantage of relatively constant demand (people always need a roof over their heads). For this reason, apartments are considered the most defensive of the four property types. In between offices and apartments lie industrial and retail properties. Industrial properties in REIT form are often in short supply. Like apartments their supply is relatively easy to expand, and like offices they often have quite creditworthy tenants. Retail properties are the wild card of the bunch, as they are more location dependent, and, given their typical lease structure (base plus a percentage of sales), they can generate quite high rents when times are good.

So how might an investor think about putting together a rotational strategy using these four property types? While real estate valuations have historically been considered a contemporaneous economic indicator, as more property has become securitized in the form of REITS, let's assume that, like equities, rolling REIT returns increasingly become a leading indicator of the future economic conditions investors expect. In our monthly market valuation update, we describe the four stages of a typical economic cycle as follows:

If REIT sector returns are indeed forward looking, we would expect rolling three month returns for a given sector to peak in the period before the occurrence of the economic conditions most favorable to its valuation. For example, rolling returns for office properties should peak when the economy is strengthening and interest rates are bottoming, since the next period (when the economy is peaking) will produce the highest demand for office space and the highest average rents. The following table shows how this logic applies to the other three main segments of the commercial property market:

As you can see, this table describes a cycle in which as the economy hits bottom and begins to turn, the demand for industrial space is the first to recover. Rising employment and incomes subsequently generate rising retail sales, and later a demand for more office space. Finally, as the economy turns down, there is a defensive move into apartments properties. As always, describing this cycle is much easier than generating superior risk adjusted from an active investment strategy that tries to anticipate its turning points. If one only invests when rolling three month returns for a sector are high, most of the potential upside will logically have accrued to other investors. The key point is that superior returns are generated by superior forecasts - not by waiting to see where the herd is headed and then joining it. Unfortunately, consistently producing superior forecasts of the future performance of publicly traded securities is exceptionally difficult. In this regard, real estate securities are no different from any other segment of the financial market - we believe that over the long run most investors will be better off buying a broadly based index fund, and leaving the thrills and spills of sector rotation strategies to others.

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