A real estate market trading strategy for the end of the year
Good morning everyone. Today's analysis focuses on the Real Estate equity sector, which has shown a bearish trend for an extended period. We will try to explain the causes of the negative performances and why the sector could represent a good investment opportunity for the end of the year.
Happy reading to all!
1. TECHNICAL ANALYSIS ISHARES US REAL ESTATE ETF
We start the article by analyzing the iShares US Real Estate ETF, an American ETF that replicates an index of US real estate stocks (with the ticker IYR). As you can see in the chart below, the ETF has shown a downward trend since February 2, 2023. In particular, from that peak, the price has formed a bearish technical figure known as a "descending triangle". From the peak of July 27, 2023, the price has suffered a sharp fall, culminating in the low reached on October 30, after breaking the triangle's support. Between July 27 and October 30, the ETF recorded a negative performance of -18.90%. However, on October 30, we observed a brief rebound, with an increase of +8.49%.
Technical Analysis IYR. Daily Chart
In the following figure, the ETF's exposure breakdown and the top 10 holdings are illustrated.
Holdings and exposure breakdowns. Source: iShares
2. WHAT ARE REITs?
The companies that are part of the ETF are known as "REITs", an acronym for "Real Estate Investment Trust". There are three types of REITs:
• Equity REITs: These REITs buy and manage real estate properties
• Mortgage REITs: These REITs invest in mortgages and/or mortgage-backed securities
• Hybrid REITs: These REITs invest in both real estate properties and mortgages
Equity REITs generate their earnings mainly through lease rents, while Mortgage REITs profit from the interest derived from the mortgages they provide to real estate operators.
The companies that are part of the IYR ETF belong to the category of equity REITs. These can invest and manage different types of properties:
• Telecommunication Tower REITs: They manage structures that support antennas for telecommunications. An example is American Tower (AMT)
• Industrial REITs: They manage industrial properties such as warehouses and logistics centers. An example is Prologis (PLD)
• Retail REITs: They manage retail properties such as shopping centers and outlets. An example is Realty Income Corporation (O)
• Data Center REITs: They manage data centers that are generally rented to tech sector companies. An example is Equinix (EQIX)
• Self Storage REITs: They manage storage spaces. An example is Public Storage (PSA)
• Residential REITs: They manage apartments and residential properties. An example is Camden Property Trust (CPT)
• Healthcare REITs: They manage healthcare facilities, including hospitals. An example is Omega Healthcare (OHI)
• Office REITs: They manage office spaces. An example is Boston Properties (BXP)
• Real Estate Services: These REITs provide various services, including real estate consulting
3. THE IMPACT OF INTEREST RATES ON REITs
The following graph highlights an important aspect: the real estate sector ranks second to last in terms of performance since the beginning of the year. In particular, it has recorded a negative performance of -8.46%.
The performances of the 11 equity sectors of the S&P500 since the beginning of the year. Source: Finviz
The following graph reveals a significant fact: since January 2022, the real estate sector has continuously recorded a performance lower than its benchmark index, the S&P500.
The IYR ETF, since January 2022, has recorded a negative performance of -29.13%; better the S&P500, with a -6.6%. Daily Chart
The real estate sector has recorded disappointing performances due to the increase in interest rates. In general, the IYR ETF tends to suffer from an increase in expectations of a tightening of monetary policy, while it benefits in the opposite case. To illustrate this point, it is useful to create a bond sentiment index that reflects monetary policy expectations: LDQH/LQD. LQDH is an ETF that replicates the movement of US investment grade corporate bonds covered by the “interest rate” risk, while LQD represents the movement of the same bonds, but without coverage from that risk. The logic suggests that: • If there are expectations of a restrictive monetary policy, the bonds covered by the “rates” risk will perform better than those not covered. In the opposite case, the opposite will happen. This logic is confirmed by the following chart, which shows the correlation between LQDH/LQD and the Federal Reserve’s interest rates.
The positive correlation between LQDH/LQD and interest rates. Daily Chart
The following chart clearly illustrates how the REITs ETF, IYR, has performed negatively following the increase in expectations of restrictive monetary policy. In fact, every time LQDH/LQD has recorded an increase, the IYR ETF has shown a decrease.
The negative correlation between IYR and LQDH/LQD since 2022. Daily Chart
Moreover, the IYR ETF has continuously underperformed compared to its benchmark, the S&P500, every time monetary policy expectations have shown an upward trend.
LQDH/LQD and S&P500/IYR since 2022. Daily Chart
There are various factors that explain why REITs tend to suffer when interest rates rise. It is well known that a rise in interest rates tends to curb the investments and consumption of households and companies. This phenomenon has a negative impact on economic growth, as it causes a slowdown in industrial production and retail sales, both important data that impact GDP.
In a period of economic slowdown, companies reduce the demand for new properties for production and retail outlets due to contracting production and consumption. This translates into lower profits for industrial and retail REITs, which are among the most sensitive to changes in the economic cycle.
Even data center REITs, which are linked to tech companies, can feel the impact of rising interest rates. In fact, with higher rates, these companies may be less inclined to go into debt to expand, thus reducing the demand for data center spaces.
Office REITs could suffer from an increase in the unemployment rate related to the economic slowdown, and this could lead to a decrease in the demand for office spaces.
Residential REITs also suffer the negative impact of rising interest rates. In fact, in a context of higher rates, many tenants may find themselves in default, especially due to the increase in the unemployment rate, which leads to a reduction in household income.
In addition to the aspects already mentioned, there is another important element to consider: the REITs sector offers high dividends to shareholders, making the sector particularly attractive. However, an increase in interest rates also entails an increase in government bond yields. Consequently, many investors may choose to invest their capital in government bonds, which offer attractive coupons and are at the same time safer than stocks.
Another aspect to consider is that the dividend is a part of the company's profit. Therefore, if profits slow down, one can expect dividends to decrease as well; this provides a further incentive for investors to orient their investments towards government bonds.
Another aspect that can influence REITs when interest rates rise is related to their typical recourse to debt for the purchase of income-generating properties. If interest rates rise, the cost of debt (especially variable debt) becomes more burdensome, negatively affecting the balance sheets of companies. Moreover, with the increase in interest on debt, REITs may be less incentivized to expand, which means that an increase in interest rates can have a negative impact on the very growth of companies.
4. YEAR-END RALLY: WHY THE REAL ESTATE SECTOR COULD PROVE TO BE A GOOD CHOICE
If the much-anticipated year-end rally were to occur, the real estate sector could emerge as one of the best performers. The reason is simple: if the rally were to occur, it would probably be triggered by the statements of the Federal Reserve Chairman, Jerome Powell, during the last meeting on November 1, which were positively received by the markets.
As can be seen in the following chart, the LQDH/LQD strength index recorded a bearish breakout of its bullish trendline after the last meeting. During the same period, IYR recorded a performance close to +10%.
The bearish breakout of the LQDH/LQD index trendline, accompanied by a rise in IYR. Daily Chart
If, in the coming weeks, LQDH/LQD were to continue to fall, IYR should benefit from it, thanks to expectations of a less restrictive monetary policy. A possible strategy, as illustrated in the following chart, could consider LQDH/LQD as a benchmark indicator and IYR as an asset on which to apply the strategy:
1. Wait for a retracement of LQDH/LQD on the bullish trendline, which could become a dynamic resistance, and then wait for a new bearish movement.
2. Enter the market on IYR, waiting for a bounce on the bearish trendline, which could become a dynamic support.
All of this, of course, assumes that the correlation coefficient remains in negative territory.
Operational hypothesis; this is not to be understood as financial advice. Daily Chart.
We conclude the analysis by emphasizing that the catalyst that pushed the real estate sector into bearish territory could now become the engine of a possible rise. But will it really be so? It is important to consider one more element: the meeting on November 1 was not the last one of the FED. The last meeting of the year will be held on December 13 and, as shown in the following chart, the forecasts indicate a maintenance of rates between 525 and 550 basis points (with a probability of 90.2%).
Target rate probabilities for 12 dec
This last meeting could determine the fate of the stock market for the end of 2023, influencing the famous Christmas rally. For any questions, please feel free to comment. See you soon!
Happy reading to all!
1. TECHNICAL ANALYSIS ISHARES US REAL ESTATE ETF
We start the article by analyzing the iShares US Real Estate ETF, an American ETF that replicates an index of US real estate stocks (with the ticker IYR). As you can see in the chart below, the ETF has shown a downward trend since February 2, 2023. In particular, from that peak, the price has formed a bearish technical figure known as a "descending triangle". From the peak of July 27, 2023, the price has suffered a sharp fall, culminating in the low reached on October 30, after breaking the triangle's support. Between July 27 and October 30, the ETF recorded a negative performance of -18.90%. However, on October 30, we observed a brief rebound, with an increase of +8.49%.
In the following figure, the ETF's exposure breakdown and the top 10 holdings are illustrated.
2. WHAT ARE REITs?
The companies that are part of the ETF are known as "REITs", an acronym for "Real Estate Investment Trust". There are three types of REITs:
• Equity REITs: These REITs buy and manage real estate properties
• Mortgage REITs: These REITs invest in mortgages and/or mortgage-backed securities
• Hybrid REITs: These REITs invest in both real estate properties and mortgages
Equity REITs generate their earnings mainly through lease rents, while Mortgage REITs profit from the interest derived from the mortgages they provide to real estate operators.
The companies that are part of the IYR ETF belong to the category of equity REITs. These can invest and manage different types of properties:
• Telecommunication Tower REITs: They manage structures that support antennas for telecommunications. An example is American Tower (AMT)
• Industrial REITs: They manage industrial properties such as warehouses and logistics centers. An example is Prologis (PLD)
• Retail REITs: They manage retail properties such as shopping centers and outlets. An example is Realty Income Corporation (O)
• Data Center REITs: They manage data centers that are generally rented to tech sector companies. An example is Equinix (EQIX)
• Self Storage REITs: They manage storage spaces. An example is Public Storage (PSA)
• Residential REITs: They manage apartments and residential properties. An example is Camden Property Trust (CPT)
• Healthcare REITs: They manage healthcare facilities, including hospitals. An example is Omega Healthcare (OHI)
• Office REITs: They manage office spaces. An example is Boston Properties (BXP)
• Real Estate Services: These REITs provide various services, including real estate consulting
3. THE IMPACT OF INTEREST RATES ON REITs
The following graph highlights an important aspect: the real estate sector ranks second to last in terms of performance since the beginning of the year. In particular, it has recorded a negative performance of -8.46%.
The following graph reveals a significant fact: since January 2022, the real estate sector has continuously recorded a performance lower than its benchmark index, the S&P500.
The real estate sector has recorded disappointing performances due to the increase in interest rates. In general, the IYR ETF tends to suffer from an increase in expectations of a tightening of monetary policy, while it benefits in the opposite case. To illustrate this point, it is useful to create a bond sentiment index that reflects monetary policy expectations: LDQH/LQD. LQDH is an ETF that replicates the movement of US investment grade corporate bonds covered by the “interest rate” risk, while LQD represents the movement of the same bonds, but without coverage from that risk. The logic suggests that: • If there are expectations of a restrictive monetary policy, the bonds covered by the “rates” risk will perform better than those not covered. In the opposite case, the opposite will happen. This logic is confirmed by the following chart, which shows the correlation between LQDH/LQD and the Federal Reserve’s interest rates.
The following chart clearly illustrates how the REITs ETF, IYR, has performed negatively following the increase in expectations of restrictive monetary policy. In fact, every time LQDH/LQD has recorded an increase, the IYR ETF has shown a decrease.
Moreover, the IYR ETF has continuously underperformed compared to its benchmark, the S&P500, every time monetary policy expectations have shown an upward trend.
There are various factors that explain why REITs tend to suffer when interest rates rise. It is well known that a rise in interest rates tends to curb the investments and consumption of households and companies. This phenomenon has a negative impact on economic growth, as it causes a slowdown in industrial production and retail sales, both important data that impact GDP.
In a period of economic slowdown, companies reduce the demand for new properties for production and retail outlets due to contracting production and consumption. This translates into lower profits for industrial and retail REITs, which are among the most sensitive to changes in the economic cycle.
Even data center REITs, which are linked to tech companies, can feel the impact of rising interest rates. In fact, with higher rates, these companies may be less inclined to go into debt to expand, thus reducing the demand for data center spaces.
Office REITs could suffer from an increase in the unemployment rate related to the economic slowdown, and this could lead to a decrease in the demand for office spaces.
Residential REITs also suffer the negative impact of rising interest rates. In fact, in a context of higher rates, many tenants may find themselves in default, especially due to the increase in the unemployment rate, which leads to a reduction in household income.
In addition to the aspects already mentioned, there is another important element to consider: the REITs sector offers high dividends to shareholders, making the sector particularly attractive. However, an increase in interest rates also entails an increase in government bond yields. Consequently, many investors may choose to invest their capital in government bonds, which offer attractive coupons and are at the same time safer than stocks.
Another aspect to consider is that the dividend is a part of the company's profit. Therefore, if profits slow down, one can expect dividends to decrease as well; this provides a further incentive for investors to orient their investments towards government bonds.
Another aspect that can influence REITs when interest rates rise is related to their typical recourse to debt for the purchase of income-generating properties. If interest rates rise, the cost of debt (especially variable debt) becomes more burdensome, negatively affecting the balance sheets of companies. Moreover, with the increase in interest on debt, REITs may be less incentivized to expand, which means that an increase in interest rates can have a negative impact on the very growth of companies.
4. YEAR-END RALLY: WHY THE REAL ESTATE SECTOR COULD PROVE TO BE A GOOD CHOICE
If the much-anticipated year-end rally were to occur, the real estate sector could emerge as one of the best performers. The reason is simple: if the rally were to occur, it would probably be triggered by the statements of the Federal Reserve Chairman, Jerome Powell, during the last meeting on November 1, which were positively received by the markets.
As can be seen in the following chart, the LQDH/LQD strength index recorded a bearish breakout of its bullish trendline after the last meeting. During the same period, IYR recorded a performance close to +10%.
If, in the coming weeks, LQDH/LQD were to continue to fall, IYR should benefit from it, thanks to expectations of a less restrictive monetary policy. A possible strategy, as illustrated in the following chart, could consider LQDH/LQD as a benchmark indicator and IYR as an asset on which to apply the strategy:
1. Wait for a retracement of LQDH/LQD on the bullish trendline, which could become a dynamic resistance, and then wait for a new bearish movement.
2. Enter the market on IYR, waiting for a bounce on the bearish trendline, which could become a dynamic support.
All of this, of course, assumes that the correlation coefficient remains in negative territory.
We conclude the analysis by emphasizing that the catalyst that pushed the real estate sector into bearish territory could now become the engine of a possible rise. But will it really be so? It is important to consider one more element: the meeting on November 1 was not the last one of the FED. The last meeting of the year will be held on December 13 and, as shown in the following chart, the forecasts indicate a maintenance of rates between 525 and 550 basis points (with a probability of 90.2%).
This last meeting could determine the fate of the stock market for the end of 2023, influencing the famous Christmas rally. For any questions, please feel free to comment. See you soon!