September 8, 2009
Default risks for REITs
REITs and residential real estate are at different points on the continuum of risk and return. REITs are riskier than residential real estate but also have the potential for higher returns. It is not surprising, then, that there is growing concern that there may be a collapse in commercial real estate following the same trajectory as that of the residential real estate market.
How might we examine the implied risks ahead for REITs? One approach is to consider the projected volatility in REIT ETF indexes as a measure of default risk. I have previously discussed that projected downside risk from Monte Carlo simulations and implied volatility provide meaningful estimates of default risk. Implied volatility is the volatility that must be assumed in order to reconcile options prices with market prices for an instrument. It is not surprising that the cost to purchase a put option on a stock or index reflects the market’s assessment of default risk. A put option is similar to buying insurance against loss from price declines. When we reconcile options prices with a Monte Carlo simulation, we can look at projected probabilities of losses at various levels. We can look, for example, at the projected level of loss in the worst 1% of outcomes over a year. This is qualitatively referred to as ‘tail loss’ or ‘tail risk.’
Implied volatility and projected volatilities from Monte Carlo simulations signaled the potential for notable collapses in finance, homebuilding, and other sectors in early 2008. The put and call options on ICF, a REIT ETF that expires in February 2010, have an implied volatility of 44% vs. 26% for the S&P500. Our Monte Carlo projections generate numbers consistent with these.
The projected 1-year / 1% worst loss for ICF as of August 2009 is -84%. In other words, the simulation projects that there is a 1-in-100 chance that ICF will lose at least 84% of its value over the next twelve months. In my analysis of projected tail losses vs. credit ratings, I suggested that investors wishing to avoid taking on significant default risk not invest in assets with a 1-year / 1% projected loss worse than -60%. There is high current default risk implied for even ‘diversified’ REIT indexes, since diversification across multiple REITs provides very limited protection—REITs as a group are exposed to similar risk factors. To put this into context, the projected 1-year / 1% loss level projected today for ICF is near what our model was projecting for Ford and the home builder Lennar in March of 2008.
The high level of projected volatility and default risk for REITs is largely driven by the broad increase in risk across all markets and, to a lesser extent, by the increased correlation between REITs and broad equity asset classes. The default risks for REITs scale with their projected volatilities, so some REITs are much riskier than others.
REITs have gone from being a bubble asset to a crashed market, and the increased correlation between REITs and other major asset classes has reduced their diversification value. As of the end of July 2009, Monte Carlo simulations showed REITs to be fairly valued, on average. Specifics of boom and bust aside, one of the basic features of REITs that investors largely ignored during the bubble years is their riskiness as an asset class. They have about twice the volatility of the S&P500, and this feature has remained consistent through both boom and bust. REITs are consistently more risky than small cap stocks or international stocks. In the more volatile and highly correlated market conditions that we encounter today, the default risks associated with REITs are particularly high. Options going out 2-3 years for the S&P500 suggest that this volatility will continue.
From the perspective of Strategic Asset Allocation, REITs have a place in a well-diversified portfolio, but they should never exceed 15% of the total allocation, even for the most aggressive portfolios operating in the most benign market conditions. For the risk tolerance of a typical individual investor, an allocation to REITs should range between no more than 5% to 10% (see here). In today’s higher-volatility market environment (which long-dated options suggest will persist for some time), this allocation should be limited even further. REITs have the advantage that they hedge against inflation, but there are far less risky ways to gain an inflation hedge. It is likely that correlations between REITs and other asset classes will decline over time from their very high levels in 2008-2009, but that time horizon is unclear.
From the perspective of Tactical Asset Allocation, REITs appear quite reasonably valued when we compare ten-year returns to Monte Carlo projections. That said, the relative values of REITs are not at all consistent—some remain over-valued and others look under-valued.
One striking result from our analysis is the wide disparity among REITs in terms of Beta and total volatility. The classification of REITs as a single asset class makes sense, but risk varies greatly among REITs. These effects translate to differences in valuation—there are nuanced ways to find REITs that can add tactical value. The substantial out-performance since July 2006 of REITs that Monte Carlo simulation could have flagged as undervalued at that time is notable. The out-performance of higher-Beta REITs is also interesting but this discrepancy is difficult to explain and thus of limited value from a tactical standpoint.
The fact that some REITs are undervalued does not mean that they cannot become substantially more undervalued before things equilibrate. The very high implied and projected volatilities in REITs mean that the ride will be very bumpy. Add to this the fundamentals-based concerns about the state of the credit markets, and there is good reason for those considering investing in REITs to experience trepidation.
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