April 27, 2006
A BULL MARKET IN MIXED REAL ESTATE SIGNALS
Real estate may appear to be a singular industry to the masses, but it has multiple personalities if you dig a bit deeper.
True, Mr. Market hasn't been much for distinguishing among the various corners of real estate in recent years. A bull market in virtually anything associated with property has diminished the incentive to emphasize differences. But now there are pressing questions about where real estate goes from here, and what it means for Fed policy and the economy. Those questions are resurrecting a focus on the divisions that were always relevant in real estate, but otherwise ignored when profits came easily.
In one corner is the ever-popular REIT industry, a long-running favorite of optimists, thanks in no small part to a bull market that's run longer than many thought possible. On the opposite side of the sentiment scale these days is the homebuilding industry, populated by the likes of such companies as DR Horton and Toll Brothers.
While REITs and homebuilders are both in the business of real estate, no one will confuse their investment performance of late. The Morningstar homebuilder industry index is down so far this year by 6.3% through yesterday, April 26. REITs, on the other hand, remain firmly in the black, and strikingly so. So far this year, the Morningstar REIT index has climbed 8.6%--well above average for stocks generally, to judge by the S&P 500's year-to-date climb of 5.1%.
Is this divergence something more than just a curiosity? Real estate, after all, is front and center as a key industry to which the Federal Reserve looks in deciding if additional interest-rate hikes are necessary, or so we've been told by several investment strategists and economists. True, there are many factors that weigh on the central bank's monetary policy, but arguably the property market carries a bigger-than-usual weight these days.
In fact, the Fed may be more than a little sensitive in 2006 to charges that it's been asleep at the switch in letting asset bubbles run out of control on the fuel of easy money over the years. The grand example is the stock market boom of the late-1990s. Just about the time that speculative juices were gearing up for an unprecedented run in the decade's final years, Fed Chairman Alan Greenspan made his famous comment about "irrational exuberance" in a 1996 speech.
But talking about the threat and doing something to cool it before it bursts are two different things. Under Greenspan's tenure, the Fed choose to mop up the damage afterwards, much to the consternation of critics--including The Economist--who argue that pre-emptive efforts were required, and should be going forward. The counterargument is that central banks can't effectively prick bubbles, as argued by Adam Posen of the Institute for International Economics in a recent paper.
Still, there's something less than a consensus on this point, and it's not exactly clear if Bernanke may be willing to lean a bit more on the pre-emptive side of policy.
And so the debate goes on. Which brings us to the current bubble. Or is it just a healthy bull market? Whatever you call it, real estate has had a good run in the 21st century, perhaps too good. In the minds of some, the Fed must act to slow the property market or risk a correction that could trigger a recession in the general economy. Not everyone agrees that the Fed is targeting real estate when it comes to monetary policy, but it's tough not to suspect that property is having some effect on the central bank's thinking.
But that then raises the question of which real estate market? There are countless ways to measure this slice of the economy. Two of the more obvious ones that investors watch are homebuilding stocks and REITs. Until recently, both were flying. For the five years through April 26, homebuilding and REIT stocks have been among the best performing industries, with homebuilders posting an annualized 30.3% return while REITs advanced with a 20.1% gain through yesterday, according to Morningstar industry data.
But the bloom has come off the rose for homebuilders this year. Year-to-date, the group has shed more than 6%. REITs, by contrast, keep rising, adding 8.6% so far in 2006 as of yesterday, based on Morningstar's calculations.
Ted Aronson, founder of Philadelphia money manager Aronson+Johnson+Ortiz, tells CS that homebuilders in 2005 represented "the biggest industry bet we ever took." At one point, the group was weighted at five percent over the benchmark. No more. These days, it's down to around two percent over the benchmark on average in portfolios run by AJO, which is a quantitative shop with a value orientation. "That's a significant shift," he says of the downshift in weight. A key reason for the change: homebuilding stock prices have been falling. That's been picked up in AJO's model, which is driven by a mix of valuation and momentum factors.
"It's mostly a simple function of our quantitative, multi-factor approach to investing, which has about a third of its weight on momentum," Aronson explains. As homebuilding stocks' valuations were getting richer and richer, we still owned them because their momentum was good. When their momentum stopped being a positive, we blew them out in no time."
REITs have stumbled recently as well, but are still in the black so far this year. In fact, there's reason to separate REITs from homebuilders beyond just recent performance differences. REITs and homebuilders are in different corners of a vast industry. For the most part, REITs reflect businesses focused on commercial properties, such as office buildings, warehouses, and so on. Although some REITs manage apartment portfolios, the largest slice is dedicated to the non-residential side of the street.
"Homebuilders and REITs are totally different," says Barry Vinocur, editor of Realty Stock Review and REIT Wrap in an email to CS. "You might even make the case that what's good for one isn't for the other. For instance, as rates tick up and home affordability presumably decreases that's perceived as not good for homebuilders; however, it's good news for the apartment guys. By extension, anything that increases apartment renters might also be good for the self-storage business," which is one of the various segments that REITs focus on.
So, are homebuilders a better gauge of the prevailing real estate winds? Or are REITs better served with that task?
Bull markets are easy. Unfortunately, the future looks set to become a bit more difficult.
© 2006 by James Picerno. All rights reserved.
Posted by jp at April 27, 2006 10:58 AM
Don't count on Bernanke being pre-emptive. In a response to Rep Ron Paul today before congress, he stated that the last few years have not show inflation and that proves that the Fed hasn't been printing too much money....because inflation hasn't shown up in the Gov't tortured use of "core" cpi. He didn't even mention asset price inflation and that real estate and stocks are now selling for record levels as % of GDP. The guy is dangerous and the dollar is sniffing that out.
Commercial REIT's are expensive but the term "bubble" has been way overused. They probably have some modest downside due to long rates trending higher, but won't really suffer until a recession is on the horizon.
Posted by: James at April 27, 2006 12:26 PM