IYR: Cost Of Capital Only Comes Down In Adverse Economic Scenario (NYSEARCA:IYR)

Ariel Skelley The iShares U.S. Real Estate ETF (NYSEARCA:NYSEARCA:IYR) thankfully has limited exposure to the most sensitive areas in commercial real estate like offices, whose REITs have been beaten down badly enough where they barely feature in a value-weighted ETF anymore. Nonetheless, we have concerns about rates. In our last coverage, we were still oriented around commodity and supply chains, but things are very different now. Supply side elements aren’t the concern anymore. The concern is simply now that inflation rates aren’t falling, and we believe that they will continue to be stubborn save a credit event, higher interest rates, or some other shock to employment. The good news is that IYR is exposed mostly to specialty REITs, and those for the most part will resist a downturn while benefiting from cheaper costs of capital. IYR Breakdown The sectoral exposures are the following: Sectors (iShares.com) The only vague category is industrial REITs. We believe that the majority of that exposure is covered by just one REIT, Prologis (PLD), which is this ETF’s largest holding at 8.28%. Prologis is a logistics real estate REIT which rents out to logistics companies as tenants. It’s relatively resilient since there is secular growth in ecommerce, but it is going to be sensitive if a deep downturn happened. In terms of performance, IYR has come off the highs in 2021, and has followed generally the cost of capital situation in the US. Of course, real estate is levered to the cost of capital, since it’s a market that depends on leverage both in development and on the demand side. Outside of the industrial exposures, the other large ones are retail and telco REITs. Telco REITs are properties that include towers, and the tenants are the major ISPs and mobile companies in the US. These tend to be entirely recession resistant assets. Retail REITs are REITs whose tenants are retailers, which are going to be significantly less recession resistant. Healthcare is another category featuring at above 10%. Exposures altogether are pretty uniform, and the first appearance of office REITs seems to be with Douglas Emmett (DEI), so exposure there is thankfully limited since offices are a major question mark with employees still refusing to return to offices in a lot of cases. Altogether, data centers, telco, healthcare, other specialized and the industrial REITs look pretty solid. That’s more than 50% of the portfolio. Bottom Line The concern then is primarily around the rate situation. As it stands, there is no sign of inflation going down. Besides inflation being observed as stubborn above the 3% mark, more predictive is the inflation rate expectations, which expect the current rate as a geometric average for the next 5 years based on the Michigan surveys. Expectations of inflation cause inflation, so inflation is most likely going to stay above 3% indefinitely. We thought maturity walls might start weighing on the economy at current rates, but that is being counteracted by demand for even poor credit. A credit event in commercial real estate could bring down rates, thankfully not too big an exposure for IYR, or simply unemployment in the economy could take down rates, and therefore permit and invite lower interest rates. We think that while not entirely insulated, there is a comparative benefit to IYR in that it has several real estate classes feature heavily whose fundamentals wouldn’t be very impacted by an economic hit, while benefiting from a lower cost of capital environment that would accompany it. Residential real estate would suffer in asset values because there’d be a lot of residential assets coming to market. Retail REITs would suffer, and at some point logistic REITs would suffer if the recession was deep enough. At the same time, plenty of exposures in IYR would not suffer fundamentally while benefiting from lower cost of capital, where higher cost of capital has been the sole reason for the IYR’s underperformance over the last few years. However, a REIT ETF has never made much sense to us, since REITs are already portfolios. Another layer isn’t needed. Moreover, in terms of building a resilient exposure, selectivity is clearly key. Either make a big call on parts of the commercial real estate markets, like in office REITs, to make money on those discounted issues, or just stick to the surefire specialty REITs that can handle a recession while benefiting from lower costs of capital. Otherwise, IYR has some downside in a negative economic scenario, which we don’t consider to be especially likely, while also being real estate and therefore exposed to the realization dawning on markets that inflation rates are not going to come down on their own. Even higher rates may be needed.

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