The Long and Short
REITs remain undervalued even as spreads move tighter
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
Investment grade corporate bond spreads have steadily moved tighter since last October, making it more difficult to generate portfolio income. Currently, the option-adjusted spread on the investment grade index is at 95 bp, which sits at a percentile ranking of 21% of its 5-year range. The only segments of the market offering spreads at higher percentiles are mostly in the financial sectors. Those include REITs, currently at an OAS of 112 bp. With opportunities to earn spread increasingly limited, the REIT sector still appears undervalued and offers some of the better spreads in the market.
The current OAS on REITs shows a 5-year percentile rank of 32%, exceeded only by finance companies and banks (Exhibit 1). Of course, the vast majority of the investment grade market trades at spreads much tighter compared to their 5-year range.
Exhibit 1: Only finance companies and banks show higher ranks than REITs
Source: Santander US Capital Markets LLC, Bloomberg/Barclays sector indices
REITs also show a reasonable tradeoff of OAS per unit of interest rate risk or duration (Exhibit 2). Only finance companies look better on that metric.
Exhibit 2: Investment grade sector OAS and duration
Color = recommendation: Green – undervalued, Red – overvalued, Yellow – neutral.
Size = Market Value within the IG Index
Source: Santander US Capital Markets LLC, Bloomberg/Barclays US Corp Index.
While REITs face a more challenging rate environment and significant secular concerns in pockets of the market, such as office and retail REITs, the overall fundamentals of the industry have improved since the height of the global pandemic. Aggregate leverage (debt-to-EBITDA) has come down off the 2020 to 2021 peaks to a more normalized range among the investment grade constituents of the index. Occupancy levels have also stabilized to more typical levels among investment grade issuers within each of the separate operating segments. Furthermore, high quality operators in the more challenged segments—such as office and retail—have proven more insulated from the mounting issues impacting global demand. Fourth-quarter earnings collectively demonstrated the broad sector’s operating stability, and cash flows appear to support tighter spreads throughout the industry constituents.
Investors have a wide range of spread and duration available in outstanding REIT bonds, opening up plenty of opportunity to substitute the better relative value in REITs for much richer valuations in other parts of the investment grade market (Exhibit 3).
Exhibit 3: Spread and duration for all outstanding investment grade REIT bonds
Source: Santander US Capital Markets LLC, Bloomberg/Barclays sector indices
The spread advantage in REIT debt also comes through clearly in fair value curves, where REITs trade wide to broad ‘BBB’ debt especially in the intermediate and long end of the yield curve (Exhibit 4). Given their unique funding needs, investment grade REITs typically issue the bulk of the debt in their capital structures in the 5- to 10-year part of the yield curve. Thirty-year issuance is somewhat limited, and typically reserved for the highest-quality issuers within each of their respective operating segments (ARE, EQR, PLD, AVB and others) but still make up a fair portion of global REIT issuance. While the curve has flattened amidst increasing reach for yield in corporate bond market, those higher-quality issuers still offer well above average spread in the long-end, and particularly in the 10-yr part of the curve, relative to the broader investment grade corporate segment.
Exhibit 4. ‘BBB’ REITs fair value curve (blue) versus broad ‘BBB’
Source: Santander US Capital Markets LLC, Bloomberg Fair Value Yield Curves
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