REITs

This week we are sending you a Style Chart Pack, which now includes a standalone macro section, as well as macro, fundamentals, valuations, technicals, and uses of cash charts for the S&P 500, Defensives vs. Cyclicals, Growth vs. Value, and Small vs. Large. In the front section of this publication, we will review recent equity performance, and attempt to answer real estate sector-related questions that are foremost in investors’ minds.

Executive Summary Buying a home is now more expensive than renting in many parts of the world. In the US and UK, disappearing homebuyers combined with a flood of home-sellers will weigh on home prices over the next 6-12 months. Falling employment and falling house prices risk becoming a self-reinforcing negative feedback loop that turns a mild recession into a severe recession. To stop such a vicious cycle running out of control, policymakers will eventually bring down mortgage rates. For this reason, on a time horizon of 6-12 months, overweight bonds. A collapse in Chinese property development and construction activity will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. Structurally underweight. On the other hand, stay structurally overweight the China 30-year government bond. Fractal trading watchlist: US Biotech versus Utilities. Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! Bottom Line: The decade-long global housing boom is over. Feature For the first time since 2018, the number of Brits wanting to buy a home is less than the number of Brits wanting to sell their home. The balance of homebuyers versus homes for sale is the main driver of any housing market. When multiple homebuyers are competing for a home for sale, the subsequent bidding war puts upward pressure on house prices. But when, multiple homes for sale are competing for a homebuyer, the subsequent discounting war puts downward pressure on house prices. The balance of homebuyers versus homes for sale is the main driver of any housing market. This makes the number of homebuyers versus homes for sale the best leading indicator of house prices. The recent collapse of this leading indicator in the UK warns that UK house prices are likely to soften through the remainder of 2022 and into 2023 (Chart I-1). Chart I-1With Fewer UK Homebuyers Than UK Home-Sellers, UK House Prices Are Set To Drop With Fewer UK Homebuyers Than UK Home-Sellers, UK House Prices Are Set To Drop With Fewer UK Homebuyers Than UK Home-Sellers, UK House Prices Are Set To Drop Homebuyers Are Disappearing While Home-Sellers Are Flooding The Market Disappearing homebuyers combined with a flood of home-sellers is also evident in the US. According to Realtor.com: “Weary US homebuyers face not only sky-high home prices but also rising mortgage rates, and that financial double whammy is hitting homebuyers hard: Compared with just a year ago, the cost of financing 80 percent of a typical home rose 57.6 percent, amounting to an extra $745 per month.” Compared with just a year ago, the cost of financing 80 percent of a typical US home rose 57.6 percent, amounting to an extra $745 per month. Unsurprisingly, US mortgage applications for home purchase have recently plunged by a third (Chart I-2) and homebuyer demand has declined by 16 percent since last June.1 Meanwhile, the inventory of homes actively for sale on a typical day in June has increased by 19 percent, the largest increase in the data history. Chart I-2With The Cost Of Financing A US Home Purchase Surging, Mortgage Applications Have Collapsed With The Cost Of Financing A US Home Purchase Surging, Mortgage Applications Have Collapsed With The Cost Of Financing A US Home Purchase Surging, Mortgage Applications Have Collapsed The flood of new homes on the market means that the dwindling pool of homebuyers will have more negotiating leverage on the asking price (Chart I-3 and Chart I-4). This will balance the highly lopsided negotiating dynamics in the raging seller’s market of the past two years. The shape of things to come can be seen in Austin, Texas, which was one of the hottest markets during the early pandemic real estate frenzy. Chart I-3US Homebuyers Are Disappearing... US Homebuyers Are Disappearing... US Homebuyers Are Disappearing... Chart I-4...While US Home-Sellers Are Flooding The Market ...While US Home-Sellers Are Flooding The Market ...While US Home-Sellers Are Flooding The Market “Prices are definitely starting to go down again… last Friday, an Austin home was listed at $825,000. The next day, at the open house, no one came. A few months ago, there would have been 20 or more buyers showing up. The sellers didn’t want to test the market, so on Sunday, they dropped it to $790,000. It sold for $760,000.” Buying A Home Is Now More Expensive Than Renting The nub of the problem for homebuyers is that the mortgage rate is higher than the rental yield. In simple terms, buying a home is now more expensive than renting (Chart I-5). The housing bulls counter that the high mortgage rate will force rental yields to adjust upwards by rents going up, but this argument is flawed. Chart I-5Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! Buying A Home Is Now More Expensive Than Renting! The most important driver of rent inflation is the unemployment rate (inversely). Because, to put it bluntly, you need a steady job to pay the rent! Today, the Federal Reserve’s inflation problem, in a nutshell, is that rent inflation is too high even versus the tight jobs market (Chart I-6). Chart I-6The Fed Needs To Push Up Unemployment To Pull Down Rent Inflation The Fed Needs To Push Up Unemployment To Pull Down Rent Inflation The Fed Needs To Push Up Unemployment To Pull Down Rent Inflation Although the Fed cannot say this explicitly, its mechanism to bring down inflation is to push up unemployment, and thereby to pull down rent inflation, which constitutes almost half of the core inflation basket. In this case, the rental yield (rent divided by house price) would adjust upwards by the denominator – house prices – going down. The most important driver of rent inflation is the unemployment rate (inversely). Yet the housing bulls also argue that the housing boom is the result of a structural undersupply of homes. They claim that as this structural undersupply persists, it will underpin house prices. But this ‘housing shortage’ narrative is another myth, which we can debunk with two simple observations. Through the past decade, home prices have risen simultaneously and exponentially everywhere in the world. Now ask yourself, is it plausible that there could be a structural undersupply of homes everywhere in the world at the precisely the same time? If this doesn’t debunk the housing shortage narrative, then try this second observation. Through the past decade, gross rents have tracked nominal GDP. Theory says that gross rents should track nominal GDP, because the quality of the housing stock improves broadly in line with GDP, and therefore so too should rents. If there really was a structural undersupply of housing, then gross rents would be structurally outperforming nominal GDP. But that hasn’t happened in any major economy (Chart I-7). Chart I-7Rents Have Tracked GDP, So There Is No 'Structural Undersupply' Of Homes Rents Have Tracked GDP, So There Is No 'Structural Undersupply' Of Homes Rents Have Tracked GDP, So There Is No 'Structural Undersupply' Of Homes As an aside, if rents track GDP, then why do they constitute almost half of the core inflation basket?  The answer is that the rents included in inflation are ‘hedonically adjusted’, meaning that are supposedly deflated for quality improvements – though there is always a niggling doubt whether the statisticians do this adjustment correctly! Pulling all of this together, the synchronized global housing boom of the past decade was not the result of a structural undersupply. Instead, it was the result of a valuation boom – meaning, plummeting rental yields, which in turn were the result of plummeting mortgage rates, which in turn were the result of plummeting bond yields. But now that mortgage rates are much higher than rental yields, this ‘virtuous’ cycle risks turning vicious. Falling employment and falling house prices risk becoming a self-reinforcing negative feedback loop that turns a mild recession into a severe recession. To stop such a vicious cycle running out of control, policymakers will eventually have no other choice than to bring down mortgage rates. For this reason, on a time horizon of 6-12 months, overweight bonds. But The Prize For The Biggest Housing Boom Goes To… China The housing booms in the UK, US and other Western economies, extreme as they are, are small fry compared to the housing boom in China. Chinese real estate, now worth $100 trillion, is by far the largest asset-class in the world. And Chinese rental yields, at around 1 percent, are well below the yield on cash. Begging the question, how can Chinese real estate valuations be in such stratospheric territory, with a yield even less than that on ‘risk-free’ cash? The simple answer is that investors have been led to believe that Chinese real estate is a risk-free investment! Without a social safety net and with limited places to park their money, Chinese savers have for years been encouraged to buy homes, in the widespread belief that property is the safest investment, whose price is only supposed to go up (Chart I-8). Chart I-8Chinese Real Estate Is Perceived To Be A 'Risk Free' Investment Chinese Real Estate Is Perceived To Be A 'Risk Free' Investment Chinese Real Estate Is Perceived To Be A 'Risk Free' Investment With the bulk of Chinese households’ wealth in property acting as a perceived economic safety net, even a 10 percent decline in house prices would constitute a major shock to the household sector’s hopes and expectations of what property is. In turn, the ensuing ‘negative wealth effect’ would be catastrophic for household spending in the world’s second largest economy. Therefore, in contrast to the US housing debacle in 2008, the Chinese government will ensure that its property market adjustment does not come from a collapse in home prices. Rather, it will come from a collapse in property development and construction activity, combined with keeping interest rates structurally low. This will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. Structurally underweight. On the other hand, Chinese bonds are an excellent investment for those investors who can accept the capital control risks. Stay structurally overweight the China 30-year government bond. Fractal Trading Watchlist Biotech and Utilities are both defensive sectors, based on the insensitivity of theirs profits to economic fluctuations. But whereas Biotech is ‘long duration’, Utilities is ‘shorter duration’. Over the coming months, as the economy falters and bond yields back down, long duration defensives, such as Biotech, are likely to be the winners. This is supported by the recent underperformance reaching the point of fractal fragility that has indicated previous major turning points (Chart I-9). The recommended trade is long US Biotech versus Utilities, setting a profit target and symmetrical stop-loss at 20 percent. This replaces our long US Biotech versus Tech position, which achieved its 17.5 percent profit target, and is now closed. Chart I-9Biotech Is Set To Be A Big Winner Biotech Is Set To Be A Big Winner Biotech Is Set To Be A Big Winner Chart 1CNY/USD Has Reversed CNY/USD Has Reversed CNY/USD Has Reversed Chart 2US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 3CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 4Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 5The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 6The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 7FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 8Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 9The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 10The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 11Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Chart 12AT REVERSAL AT REVERSAL AT REVERSAL Chart 13AT REVERSAL AT REVERSAL AT REVERSAL Chart 14The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 15The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 16A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 17Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 18Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 19Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 20Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 21The Rally In USD/EUR Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End Chart 22The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 23A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 24GBP/USD At A Turning Point GBP/USD At A Turning Point GBP/USD At A Turning Point Chart 25Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 26Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Realtor.com gauge homebuyer demand by so-called ‘pending listings’, the number of listings that are at various stages of the selling process that are not yet sold. Fractal Trading System Fractal Trades The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Real Estate Is A Poor Inflation Hedge The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive The real estate sector is experiencing a robust post-pandemic recovery fueled by easy monetary and fiscal policy, with vacancy rates falling, earnings growing, and balance sheets looking healthy.  Despite being a real asset, our in-depth analysis shows that the sector appears to be a poor inflation hedge and underperforms the market when inflation is elevated. There is a great dispersion within the sector – correlations across REIT segments are low. Residential REITs offer solid protection against inflation: Rent growth outpaces inflation thanks to chronic housing underbuilding and a recent rebound in new household formation.  Likewise, we expect the Industrial REITs segment to offer inflation protection.  Following recent supply disruptions, companies are shifting away from the “just-in-time” to “just-in-case” model, spurring strong demand for warehousing, fulfillment, and logistics centers, and pushing up rents.  Office and Retail REITs segments will be the two industry laggards due to structural shifts in consumer and worker behavior. Bottom Line: Today we downgrade the S&P Real Estate sector from overweight to neutral while keeping a granular intra-sector allocation. Specifically, we recommend investors overweight Specialized, Industrial, and Residential REITs, while underweighting Office and Retail segments. Feature Related Report  US Equity StrategyHave US Equities Hit Rock Bottom? The last few months have been marred by a violent sell-off in US equities, with stubbornly high inflation, and the Fed’s well-telegraphed hawkishness being front and center of the market rout. While this is a toxic brew for most equity sectors, Real Estate finds itself in a crosscurrent of two opposing trends. It is a high-yielding real asset that, at least in principle, is well-positioned to withstand inflation (most landlords are able to raise rents at least in line with inflation). However, tightening monetary policy and rising mortgage rates present unique challenges for the sector, suppressing demand for real estate and compressing the present value of future cash flows, thus handicapping capital appreciation. The recent downside surprise in the NAHB housing market reading is a case in point: 69 reported while the consensus range was 75 -77, signaling a sharp deceleration in house price growth. There is also a pronounced turn in sales activity (Chart 1). However, just as the real economy is not the stock market, the housing market is only one of the segments of the Real Estate sector. In this report, we will provide an overview of the entire sector, including valuations and fundamentals, and will consider the effects of inflation and rate regimes on sector performance. We will also take a look at the various segments of the REIT equity sector and the key drivers of their performance in our quest for the best inflation hedge. Chart 1Real Estate Sales Have Turned Down Real Estate Sales Have Turned Down Real Estate Sales Have Turned Down The US REIT Overview The REIT Sector Has Experienced Strong Growth Over The Past Decade There are more than 225 REITs in the US registered with the SEC, 175 of which trade on the NYSE. The ever-expanding cohort of NYSE-traded REITs has experienced explosive growth over the past 10 years, as a result of investors' search for yield, and this cohort now has a combined equity market capitalization of more than $1.4 trillion (Chart 2). These are mostly equity REITs – trusts that own and operate income-producing assets and earn income mostly through rents. Thirty of these equity REITs comprise the S&P 500 Real Estate sector. The Real Estate sector is small at 3% of S&P 500 market capitalization but its share has been growing steadily over time (Chart 3). Chart 2Equity REITs Have Gained Popularity Over The Past Decade The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 3Real Estate Is A Small Sector But Its Share Has Been Growing Steadily Real Estate Is A Small Sector But Its Share Has Been Growing Steadily Real Estate Is A Small Sector But Its Share Has Been Growing Steadily REITs Are Equities, But Not Quite The business model of most REITs is rather simple: Lease space and collect rent on the properties, then distribute income as a dividend to shareholders. There are a number of IRS provisions that REITs have to comply with, of which the following are most relevant to investors: Invest at least 75% of total assets in real estate, cash, or US Treasuries; Derive at least 75% of gross income from rents, interest on mortgages that finance property, or real estate sales; and Pay a minimum of 90% of taxable income in the form of shareholder dividends each year.1 REITs are total return investments as they provide income as well as capital appreciation. Sector Composition The S&P 500 Real Estate sector consists of two industries – REITs, which represent roughly 98% of the sector, and Real Estate Management and Development, which is about 2% of the sector. We will focus on the REITs. The S&P 500 REIT industry is comprised of eight broad categories (Chart 4), of which Specialized REITs are by far the largest, at 45% of the sector market capitalization. The composition of the REIT market has changed over the years. While the traditional retail and residential segments dominated the market in the first years of the millennium, structural changes have shifted the balance towards specialized segments such as infrastructure, data centers, as well as industrial REITs (Chart 5). The pandemic and a shift toward remote work have accelerated many of the existing trends, such as a decline in the office segment. Consolidations of health care facilities and hospitals have reduced the Health Care REIT segment. Chart 4The S&P 500 REIT Industry Composition The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 5REITs Composition Is Changing Over Time The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Sector Performance Since 2010, in the aftermath of the GFC, the Real Estate sector has underperformed the S&P 500 by 20% (Chart 6). However, within the sector, there is a wide divergence in relative performance, with Industrial REITs beating the index by 10%, while Office, Hotels, and Health Care REITs lagging by some 50%. More recently, the Real Estate Sector has performed more or less in line with the S&P 500 (Table 1), in contrast to the wild swings in relative performance experienced by other sectors. Like their corporate brethren in the Health Care sector, defensive Health Care REIT performance was stellar, beating the S&P 500 by 10% over the past 12 months. Hotel REITs bounced back strongly after a prolonged period of underperformance because of a nascent post-pandemic recovery in travel. Clearly, there is significant dispersion in both long- and short-term performance within the sector – correlations across segments are low (Chart 7). It is important to understand the key drivers of each segment for better asset selection. Chart 6In The Aftermath Of The GFC, The Real Estate Sector Has Underperformed In The Aftermath Of The GFC, The Real Estate Sector Has Underperformed In The Aftermath Of The GFC, The Real Estate Sector Has Underperformed Chart 7Correlations Across REIT Segments Are Low Correlations Across REIT Segments Are Low Correlations Across REIT Segments Are Low Table 1Performance Relative To The S&P 500 The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive REIT Dividend Yield And TINA One of the main attractions of REITs is their IRS-mandated high dividend payout. Indeed, currently, the Real Estate sector dividend yield is 2.9%, a whole 130 bps higher than for the S&P 500. In fact, all REIT sectors and subsectors (with the exception of the lodging/resorts sector) currently have dividend yields higher than those of public equities (Chart 8). However, for many investors, yield comparison goes beyond equities alone. For multi-asset investors, the REIT yield is usually competing with the yield on other fixed-income instruments (Chart 9). Currently, REITs offer yields on par with investment-grade bonds, but arguably they are more attractive thanks to capital appreciation potential. Chart 8Almost All REIT Segments Yield More Than The S&P 500 The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 9REIT Yield Is Attractive The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Performance Of The Real Estate Sector In Different Inflation And Rate Regimes Real estate is a real asset and resilience to inflationary pressures is literally embedded in its name. Unfortunately, empirical analysis of the performance of Real Estate sectors during periods of high inflation disappoints. Chart 10 demonstrates that Real Estate is quite simply not a good inflation hedge. The sector tends to have the strongest performance when inflation is in the 2-3.5% range, beating the S&P 500 54% of the time. As inflation rises, RE tends to lag the broad market. This result is surely confounding. The likely explanation is that rising inflation is literally an invitation to tighter monetary policy. As rates rise, Real Estate underperforms (Chart 11). Higher interest rates decrease the value of real estate assets by discounting future cash flows at a higher rate, thus impairing the capital appreciation component of the Real Estate total return. As such, cap rates and interest rates move in lockstep (Chart 12). Chart 10Real Estate Is A Poor Inflation Hedge The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 11REITs Tend To Underperform When Rates Are Rising The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive   Thus, when inflation is high and rates are on the rise, the sector is caught in the crosscurrents: While overall, the ability to raise rents insulates the sector from the adverse effects of inflation, higher rates dampen capital appreciation. Hence, it is not surprising that high inflation and the rising rate regime are unfavorable for the sector (Chart 13), with the sector’s median three-month performance in this regime since 1970 lagging the S&P 500 by 1.8%. In this regime, RE beats the market only 38% of the time. Chart 12Cap Rates And Interest Rates Move In Lockstep Cap Rates And Interest Rates Move In Lockstep Cap Rates And Interest Rates Move In Lockstep Chart 13High Inflation And Rising Rates Are Unfavorable For Real Estate The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive While the S&P 500 Real Estate Sector is a poor inflation hedge, for investors with the ability to be more granular in REIT allocations, drilling down to sub-categories of the market might be beneficial. The real estate market is diverse and different segments do not react the same way to rising interest rates or inflation. Bottom Line: It appears that in a battle between inflation (favorable for the sector yield) and rising rates (unfavorable for capital appreciation), rates have the upper hand. Fundamentals And Valuations Even though REITs are technically equities, their analysis requires different metrics. Whereas equity investors rely on multiples such as price-to-earnings (P/E) or price-to-book (P/B), for REITs price-to-funds from operations (P/FFO) is a more important valuation tool. FFO is favored over earnings since it adds back depreciation and amortization expense. FFO also adds any gains (or subtracts any losses) from sales of underlying assets to net income. REITs traded at a steady 17x FFO between the end of the GFC and the start of the pandemic. FFO fell by 30% in the first two quarters of 2020 compared to Q4 2019, pushing the P/FFO multiple to 24.7 – a level that appears to be an expensive “post-pandemic normal” (Chart 14). The risk premium for REITs (calculated as the FFO yield minus the real 10-year Treasury yield) – currently at 5.4% – remains higher than the pre-GFC bottom of 3.5%. Consider Chart 15: On this basis, REITs are attractive. Chart 14REITs Are Trading At An Easy Money Post-Pandemic High REITs Are Trading At An Easy Money Post-Pandemic High REITs Are Trading At An Easy Money Post-Pandemic High Chart 15Risk Premium Is Still Reasonable Risk Premium Is Still Reasonable Risk Premium Is Still Reasonable In terms of profitability, the sector appears to be thriving: Occupancy rates are rising (Chart 16) and FFO is growing. However, it is important to note that US economic growth is slowing, and that may reverse the fortunes of the sector, weakening demand for properties, and lifting vacancy rates. Bottom Line: Earnings continue to rise, and cap rates – while declining – remain high compared to the risk-free rate. A post-pandemic recovery is underway. However, slowing economic growth has a potential to reverse these favorable trends. Chart 16Occupancy Rates Are Rising Again Occupancy Rates Are Rising Again Occupancy Rates Are Rising Again REIT Balance Sheets Are Healthy The real estate sector has historically been seen as risky due to its high leverage, but leverage has been on the decline. Over the past decade, REIT reliance on equity capital has increased, with the equity/asset ratio rising from 32% in 2008 to 45% in 2022. The ratio of debt-to-book assets stands at around 48% , much lower than 58% during the GFC (Chart 17). REITs have also extended the average maturity of their debt from five years in 2008 to over 7.5 years today. The fall in interest rates over the past two decades has benefited equity REITs: As rates fell, so did the interest they paid on their debt. Liquidity ratios also improved, with coverage ratio (earnings relative to interest expense) rising to a solid 6.5x. Bottom Line: REIT balance sheet health has improved significantly as the share of equity financing continues to grow. Also, a downward trend in interest rates has made existing debt more manageable. Chart 17A Shift Towards Equity Financing And Falling Rates Have Fortified REIT Balance Sheet A Shift Towards Equity Financing And Falling Rates Have Fortified REIT Balance Sheet A Shift Towards Equity Financing And Falling Rates Have Fortified REIT Balance Sheet REIT Segments And Their Economic Drivers The pandemic has accelerated some existing trends in the real estate sector and established new ones. Some sectors will struggle in this new environment, while others will flourish. There is a broad dispersion across the REIT segments in terms of yield vs capitalization, and the ability to withstand inflation and rising rates. REIT Segments In Charts – Residential and Industrial Appear Most Attractive Vacancy Rates are declining across all segments. The industrial segment has the lowest vacancy rate at 4.1%, followed by residential at 4.9%. Offices have the highest vacancy rates at 12.2% (Chart 18). Rents are rising. Apartments have experienced the steepest increase from 1.3% growth in 2020 to 11.3% in Q1-2022. Industrial rent growth has accelerated from 5.3% to 11%. Office rent growth is decelerating (Chart 19). Chart 18Vacancy Rates Recovered For All Segments But Office The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 19Residential And Industrial Rent Increases Outpace Inflation The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Acquisitions are increasing at a robust pace with apartments experiencing the most activity (Chart 20). Sales Prices are also increasing (Chart 21). Industrial sales prices on average were up 15% from one year ago, while multifamily property prices rose 10.5%. Both these assets are earning rental income and returns that are higher than the current inflation rate, which makes them attractive assets to hold at a time of high inflation. Chart 20Sales Activity Is Robust The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 21Industrial And Residential Properties Are Most Popular Among Investors The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive The Cap Rate is experiencing compression (Chart 22) as higher rents boost sales prices, making properties more expensive. As a result, multi-family properties, which boast the highest rent growth and the lowest occupancy rate, have the lowest cap rate at 3.2%. Low demand for office space due to the pandemic has pushed the cap rate to 4.9%. Total Return is a combination of the rising value of a property and its yield, which moves in the opposite direction. As of April, Apartments had the highest total annual return of 12.7%, followed by Industrial at 10.7%. The total return of all commercial segments, except for Office, has exceeded the rate of inflation. Furthermore, we will comment on each of the segments to explain the trends observed in the charts (Chart 23). Chart 22Cap Rates Are Relatively Low Across The Board The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 23Industrial and Residential Produced The Highest Total Returns The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Specialized REITs Are A Play On The Digitalization Of The Economy While other segment names are self-explanatory, Specialized is a little trickier. The specialized REITs segment accounts for properties not classified elsewhere. These REITs own and manage a unique mix of property types such as movie theaters, farmland, and energy pipelines. Also, a REIT that consists of, say, both office and retail properties, would also be classified as Specialized. This is the broadest and most diversified category, and it is not surprising that it accounts for nearly half of the sector by market cap. It is also the highest-yielding category with a dividend yield of 4.7%. The specialized category is particularly attractive as it includes many high-tech geared categories, such as communication networks and data centers. Properties that support the digital economy have attracted a lot of demand over the past couple of years, and FFO growth is strong (Chart 24). With a host of new technologies in the wings, demand for data centers is expected to continue to grow. Due to the high and complex technical set-up specifications, leases are usually longer (upwards of five years). Since lease terms are long, owners can’t reset rent to keep up with inflation. On the other hand, strong demand for data centers is pushing new rents up. Fundamentals for the segment are supportive: The cap rate, at 4.4%, is in line with the REIT benchmark (Chart 25). Chart 24Strong Demand For Data Centers Strong Demand For Data Centers Strong Demand For Data Centers Chart 25Data Center Cap Rate Is In Line With The Benchmark Data Center Cap Rate Is In Line With The Benchmark Data Center Cap Rate Is In Line With The Benchmark   Bottom Line: We favor the Specialized REIT segment. It is well diversified and resilient to market swings. It also has significant exposure to the technology sector and benefits from a shift towards a more digitalized economy. This should also immunize the sector over the economic cycle as dependence on data increases structurally. Key tickers for this segment are: AMT, CCI. Retail REITs Are Battling Headwinds From E-commerce The “death of retail” is not a new phenomenon – consumer spending continues to shift from in-store to online. Over the past two decades, non-store retail sales in the US have grown at an annualized 9.5%, compared to 3.1% for in-store sales. E-commerce has risen to almost 14% of total retail sales. This shift is reflected in the halving of the weight of retail REITs in the Real Estate sector over the past decade. The headwinds facing the sector – particularly shopping centers – have not abated. The retail REIT occupancy rate is among the lowest in the CRE: 96% as of Q4-2021. However, with little construction underway, rent growth is not likely to decline, and will rise to mid-3%. With rents not keeping up with inflation, retail properties are a poor inflation hedge. Bottom Line: We recommend investors underweight the retail sector within their broad real estate exposure. The structural headwinds are not likely to disappear, while inflation will remain a major headwind. Key tickers for this segment are: O, SPG. Office REITs – Workers Are Not Coming Back There has long been a close link between office demand and employment. As the labor market tightens, demand for offices increases, and rents rise. However, “this time is different” due to the tectonic shift brought about by the pandemic. According to the NAR, not all workers are returning to the office (Chart 26): 17% of office employees are still telecommuting. Worse yet, there is an ongoing decline in small business formatting, impairing demand for new office space. As a result, the sector is currently flush with supply, and the occupancy rate is down from 94% to 89% (Chart 27). Yet, asking rents continue to recover, albeit slowly, and lag the rate of inflation: As of April 2022, the average year-over-year growth was 1.3%.2 Given the ongoing construction of about 150 MSF, the vacancy rate will likely remain above 10%, but rents will continue to increase modestly as more workers return to the office.3 Chart 26Many Workers Are Not Returning To The Office The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Chart 27The Pandemic Has Changed Office Demand Dynamics The Pandemic Has Changed Office Demand Dynamics The Pandemic Has Changed Office Demand Dynamics Bottom Line: Underweight the office sector within broad real estate exposure. A shift to remote work, elevated vacancy rates, and ongoing construction are likely to put the brakes on rent growth. Real rent growth is expected to be negative – this segment is a poor inflation hedge. Key tickers for this segment are: ARE, BXP. Residential REITs – Housing Shortages Are A Tailwind Residential REITs are primarily focused on apartments, but single-family homes and mobile homes fall under the same category (Chart 28). This segment is the closest proxy to the US housing market. The housing sector has been undersupplied for decades: The ratio of annual housing starts to the total number of households is 1.2 – 0.7 percentage points below its pre-GFC average (Chart 29). Chart 28Apartments Make Up The Majority Of Residential REITs Apartments Make Up The Majority Of Residential REITs Apartments Make Up The Majority Of Residential REITs Chart 29Housing Undersupply Is Not A New Issue... Housing Undersupply Is Not A New Issue... Housing Undersupply Is Not A New Issue...   This has pushed up prices, increasing unaffordability, particularly for first-time buyers (Chart 30). This increased the percentage of US housing inventory occupied by renters rather than owners (Chart 31). Chart 30...Making Home Prices Unaffordable ...Making Home Prices Unaffordable ...Making Home Prices Unaffordable Chart 31Pushing More People Towards Renting Pushing More People Towards Renting Pushing More People Towards Renting Recently, housing shortages have been further exacerbated by a post-pandemic rebound in new household formation (Chart 32). Rising mortgage rates tend to further increase the demand for rental units. Vacancy rates are bound to fall further, leading to sustained double-digit rent and price growth.  As of April, multi-family rents are up 9.4% year-over-year, higher than this inflation rate of 8.5%. Bottom Line: Chronic underbuilding and a recent rebound in new household formation have spurred demand for housing, putting upward pressure on rents, making the category an excellent inflation hedge. Key tickers for this segment are: AVB, EQR. Chart 32Household Formation Has Rebounded Household Formation Has Rebounded Household Formation Has Rebounded Industrial Property Industrial REITs manage industrial facilities, with the logistics segment being a key growth driver thanks to high exposure to e-commerce. Industrial properties include warehouses, fulfillment centers, and last-mile delivery and distribution. Research by Prologis shows that e-commerce requires more than 3x the logistics space of brick-and-mortar sales. That is why occupancy rates have been rising over the past decade, and are currently at an all-time high, four percentage points higher than their 20-year average (Chart 33). The pandemic has also revealed how vulnerable current supply chains are and has accelerated a trend BCA Research has highlighted for years: The decline of globalization. Going forward, companies will move to re-shore some of their production to gain greater control over supply chains transitioning from “just-in-time” to “just-in-case” inventory management to minimize supply disruptions. This shift will amplify the need for industrial space. As a result, Industrial REIT rent growth has been robust, with rents up 11% year-over-year, with 37% of 390 markets posting double-digit rent growth. Rent growth lower down the value chain closer to the end-consumer has been particularly strong: Asking rents for logistics space are up on average 12.4% year-over-year mostly due to the scarcity of permittable land (Chart 34). Chart 33Increase Demand For Warehouses Pushed Up Occupancy Rates Increase Demand For Warehouses Pushed Up Occupancy Rates Increase Demand For Warehouses Pushed Up Occupancy Rates Chart 34Logistics Rent Growth Is The Fastest Due To Scarcity The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive Bottom Line: We expect the Industrial sector to continue to outperform the broad REIT market, supported by strong demand for fulfillment and logistics centers which is pushing rents up. Industrial REITs are an excellent inflation hedge. Key tickers for this segment are: PLD, DRE. Investment Implications The real estate sector is experiencing a robust post-pandemic recovery fueled by easy monetary and fiscal policy, with vacancy rates falling, earnings growing, and balance sheets looking healthy. However, despite being a real asset, the sector appears to be a poor inflation hedge, underperforming the market when inflation is elevated. High inflation is often accompanied by rising rates, which reduce the value of future cash flows, impair capital appreciation, and offset income gains brought about by rent increases. Further, slowing growth may become a significant headwind, reversing gains in occupancy rates. Out of an abundance of caution, we are downgrading Real Estate from overweight to equal weight. However, Real Estate is a diverse sector, with segments almost uncorrelated to each other. As such, we recommend a granular allocation within the sector. Overweight Specialized, Industrial, and Residential segments which benefit from positive long-term trends, enjoy low vacancy rates, and positive real rent growth. We also recommend underweight allocations to Office and Retail segments, which suffer from adverse trends brought about by changes in consumer behavior, that translate into elevated vacancy rates and negative real rent growth. Bottom Line: The Real Estate sector is sensitive to rising rates and is a poor inflation hedge. We are downgrading the sector from overweight to equal weight. However, the sector is diverse, and commercial real estate sectors have a low correlation to each other. Within the sector, we favor Specialized, Industrial, and Residential segments that benefit from favorable long-term trends, and offer strong wage growth and potential for capital appreciation. These segments are likely to be strong inflation hedges.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     Investopedia 2     Commercial Market Insights, April 2022, National Association of REALTORS® Research Group 3    Ibid   Recommended Allocation Recommended Allocation: Addendum  The Real Estate Sector Deep Dive The Real Estate Sector Deep Dive

Highlights As investors’ hunt for yield continues, REITs emerge as an attractive asset class. Characterized by an attractive risk-adjusted return (comparable to public equities), and high dividend yields, REITs can add value to investors’ portfolios. The macro backdrop is supportive: Moderate levels of inflation and rising rates have historically been positive for REITs’ performance. Valuations, albeit currently looking frothy, are reflective of a recovery that was broad-based and swift. REITs’ risk premium is attractive, currently 540 basis points. Fundamentals remain supportive of a positive outlook on REITs. Even though cap rates (which historically have moved in lockstep with interest rates) could rise given our macro outlook, the cap-rate spread remains close to its historical average. The pandemic has accelerated some existing trends in the real-estate sector and established new ones. Those will create opportunities for investors. For example, the decline of retail and rise of e-commerce, working from home, and migration away from city centers are observable patterns with investable opportunities. Accordingly, the Global Asset Allocation (GAA) service upgraded the Real Estate sector to Overweight in its July 2021 Quarterly Outlook. In the near-term – given current elevated levels of inflation – we prefer REITs with short-term leases (such as self-storage and residential REITs) over those with long-term leases (such as retail and office) since the former can adjust rents more quickly. Structurally, we favor sectors supported by the growth of the digital economy. The post-pandemic environment should be positive for sectors such as data centers and industrial REITs. Feature In today’s environment of accommodative monetary policy, low interest rates, unattractive valuations and poor return prospects for income-generating assets, investors have been forced to dial up their risk appetite. Real estate stands out as a particularly attractive alternative. The Global Asset Allocation (GAA) service turned positive on real estate in July given the favorable macro backdrop in which: Inflation – while likely to come down from current elevated levels – will be higher in future than in recent decades; There is tight supply in some segments of commercial real estate (CRE); Rental growth is accelerating. This Special Report focuses on REITs, which are the simplest way for most investors to get liquid exposure to the real estate market.  The report is structured as follows. We first look at the broad US REITs market (mainly equity REITs) and analyze its historical risk-return characteristics, fundamentals, and valuations. We then assess how REITs fared in previous environments of rising rates and inflation. In the second section, we analyze various sectors of the REITs market, identifying likely losers and winners from our base-case expectations for inflation and growth, and based on our views of how long-term demand for real estate will shift following the pandemic. While we have concerns about potential weaknesses in some segments of commercial real estate (e.g., retail), we highlight opportunities in more technology-driven segments of CRE. Introduction The REITs market in the US as of Q3 2021 has a market value of close to $1.5 trillion. The bulk of this is equity REITs – trusts that own and operate income-producing assets and earn income mostly through rents. The remaining are mortgage REITs which lend money directly to real-estate owners or indirectly by purchasing mortgages or securitized securities such as mortgage-backed securities (MBS) and earn income on those investments. While technically considered equities, the business model of mortgage REITs makes them more like bonds than equities. The composition of the REITs market has changed over the years. While the traditional retail and residential segments dominated the market in the first years of the millennium, structural changes have shifted the balance towards segments such as infrastructure, data centers and industrial (Chart 1). The pandemic accelerated trends that were already in play: For example, the rise of e-commerce, digitalization of services, increased teleworking, and reshoring of manufacturing and supply chains. These have had adverse effects on traditional real estate segments such as retail. Chart 1 Historical Risk And Return, Valuations, Fundamentals & Correlations Since 1973, US all-equity1 REITs have outperformed both public equities and fixed-income assets (both government bonds and investment-grade corporate bonds) on an absolute basis, providing investors with an 11.9% annualized return versus 10.8%, 6.8%, and 7.6% respectively. On a risk-adjusted basis however, REITs’ performance was equal to that of their public equity counterparts, but lower than fixed-income assets because of REITs’ higher volatility. The negative skewness and excess kurtosis also indicate a high probability of large negative returns.  Mortgage REITs (split between Home Financing and Commercial Financing), on the other hand, have returned only 5.2% on an annualized basis, while racking up annualized volatility 3.5 percentage points higher than their all-equity counterparts (Table 1). Table 1Historical Risk-Return Characteristics Are REITs Still Attractive? Are REITs Still Attractive? In order to generate the sort of yields investors expect, mortgage REITs resort to leverage (about 6-8 times) which increases volatility (Chart 2). For example, REITs focusing on residential/home financing buy low credit-risk securities (with almost zero default risk), add leverage, and hedge changes in interest rates via derivatives. Mortgage REITs focusing on commercial financing use less leverage, but take on additional credit and default risk embedded in their underlying assets. Both types of REITs remain highly exposed to the economic cycle and financial conditions. Despite disappointing returns (mainly stemming from narrowing net interest spreads), mortgage REIT investors have been entranced by the high dividend yields. These have averaged 11.3% over the past four decades and are still close to 8% today, much higher than the yields of their all-equity counterparts and other assets (Chart 3). Chart 2Mortgage REITs Are Volatile... Mortgage REITs Are Volatile... Mortgage REITs Are Volatile... Chart 3...And Have High Dividend Yields ...And Have High Dividend Yields ...And Have High Dividend Yields   Table 2Attractive Dividend Yields Across Sectors Are REITs Still Attractive? Are REITs Still Attractive? Dividend yields for all-equity REITs are also attractive in today’s low-yielding investment environment, even though they are at all-time lows – currently they average 2.9%, 150 basis points higher than for public equities. In fact, all REIT sectors and subsectors (with the exception of the lodging/resorts sector) currently have dividend yields higher than those of public equities (Table 2). Even though REITs are considered equities, analyzing them requires different indicators. Whereas equity investors rely on multiples such as price-to-earnings (P/E) or price-to-book (P/B), for REITs price-to-funds from operations (P/FFO) is a more important valuation tool. FFO is favored over earnings since it adds back depreciation and amortization expenses, and adds to net income any gains (or subtracts any losses) from sales of underlying assets. REITs traded at a steady 17x FFO between the end of the Global Financial Crisis (GFC) and the start of the pandemic. FFO fell by 30% in the first two quarters of 2020 compared to Q4 2019, pushing the P/FFO multiple to 24.7 – an all-time high.  But FFO as of Q3 2021 has inched back above its pre-pandemic level (Chart 4). The risk premium for REITs (calculated as the FFO yield minus the real 10-year treasury yield) – currently at 5.4% – remains higher than the pre-GFC bottom of 3.5%. (Chart 5). Chart 4Valuations Reflect A Swift Recovery Valuations Reflect A Swift Recovery Valuations Reflect A Swift Recovery Chart 5REITs Risk Premium Is Still Elevated REITs Risk Premium Is Still Elevated REITs Risk Premium Is Still Elevated     With the exception of the lodging/resorts sector, REITs’ FFO as of Q3 2021 is higher than one year ago. The occupancy rate for major sectors of the REITs market is starting to rise. Overall net operating income (NOI) for Q3 2021 was 4.5% higher than its pre-pandemic (Q4 2019) level (Chart 6). Chart 6Occupancy Rates Are Rising Again Occupancy Rates Are Rising Again Occupancy Rates Are Rising Again This however is the result of a large year-on-year increase in inorganic or non-same-store net operating income (NOI) – income from assets owned for less than 12 months (either recently acquired or developed) (Chart 7). M&A activity has been increasing, and amounted to almost $47 billion over the past four quarters – driven by activity in the infrastructure, self-storage, and free-standing2 segments (Chart 8). Chart 7 Chart 8...As M&A Activity Rose ...As M&A Activity Rose ...As M&A Activity Rose Chart 9REITs Have Low Leverage... REITs Have Low Leverage... REITs Have Low Leverage...   The real-estate sector has historically been seen as risky due to its high leverage, but leverage has been on the decline. Over the past decade, REITs’ reliance on equity capital has increased, with the equity/assets ratio rising from 32% in 2008 to 43% in 2021. The ratio of debt to book assets stands at around 49%, much lower than the 58% during the GFC (Chart 9). REITs have also extended the average maturity of their debt from 5 years in 2008 to over 7.5 years today. The fall in interest rates over the past two decades has benefited equity REITs: As rates fell, so did the interest they paid on their debt. Liquidity ratios also improved, with REITs’ coverage ratio (earnings relative to interest expense) at 6x, cash levels and undrawn lines of credit relative to interest expense close to 2x and 7x, respectively (Chart 10).  In summary, REITs are an attractive asset class, since leverage is lower, earnings continue to rise, and cap rates – while declining – remain high compared to the risk-free rate. REITs, however, remain highly correlated to public equities: The current 3-year rolling correlation between REITs and public equities is above its historical average of 0.57 (Chart 11). This high correlation undermines the diversification benefit of REITs to investors’ portfolios. Moreover, investors should note that the correlation between REITs and direct real estate (DRE) has averaged only 0.1 over the past four decades. Even when DRE is lagged to account for its appraisal-based methodology, correlation does not rise. Chart 10...And Ample Liquidity Buffers ...And Ample Liquidity Buffers ...And Ample Liquidity Buffers Chart 11REITs Remain Highly Correlated To Equities REITs Remain Highly Correlated To Equities REITs Remain Highly Correlated To Equities In a previous Special Report we showed however that, while both direct and indirect real estate exposure can add value to investors’ portfolios on a risk-adjusted basis, direct real estate should be favored given its low correlation to other financial assets (such as equities and bonds) as well as the illiquidity premium that investors with no need for immediate liquidity can harvest. The Macro Outlook Our base case is that interest rates will inch higher over the next 12 months and that inflation will moderate but remain higher than during the past decade. How would such an environment affect the outlook for real estate – and REITs in particular? Interest rates and cap rates tend move in lockstep (with the exception of a divergence from mid-2003 until the GFC). This implies that rising rates could lead to higher cap rates, and thus lower property values (Chart 12, panel 1). The current cap-rate spread (the difference between the cap rate and the 10-year Treasury yield) is close to its long-term average of 365 basis points. This should help mitigate downward pressure on property values and act as a buffer when rates rise (Chart 12, panel 2). As long as rising rates are reflective of strengthening economic growth – and we expect US growth to remain above trend for the next two years at least (Chart 13) – and do not hurt the health of corporate tenants or increase defaults, demand for real estate should rise. Chart 12Interest Rates And Cap Rates Tend To Move In Lockstep Interest Rates And Cap Rates Tend To Move In Lockstep Interest Rates And Cap Rates Tend To Move In Lockstep Chart 13Above-Trend Growth Should Bolster Demand For Real Estate Above-Trend Growth Should Bolster Demand For Real Estate Above-Trend Growth Should Bolster Demand For Real Estate Historically, rising rates coincided with strong performance from REITs. On average, REITs returned 25.4% during episodes of rising interest rates, even higher than the return from equities of 24.5%. However, that figure is distorted by some outliers:  REITs returned over 100% between 1976 and 1980, and in 2003-2007 (Table 3). The median return of REITS was only 7.1% versus 22.5% for equities. Excluding those two periods lowers REITs’ mean return to 9.4%. Valuation data begins only in 2000, but we can see that REITs were attractively valued in 2003, trading at about 9x P/FFO. By the peak of the market in Q1 2007, they were trading at more than 17x P/FFO. Table 3REITs Fared Well In Previous Periods Of Rising Interest Rates Are REITs Still Attractive? Are REITs Still Attractive? Chart 14 REITs however fared poorly in periods of rising inflation. In a Special Report published in mid-2019, we showed that REITs were a poor hedge against very high inflation and that, much like equities, once the economy overheats and inflation rises sharply (which we define as CPI above 3.3%), REITs produced negative excess returns over cash (Chart 14 and Table 4). For investors able to be more granular in REIT allocations, drilling down to sub-categories of the market might be beneficial, particularly given the low correlation between REIT sectors (Chart 15). Table 4REITs Are Not A Good Inflation Hedge (II) Are REITs Still Attractive? Are REITs Still Attractive? Chart 15Low Correlation Between REIT Sectors Low Correlation Between REIT Sectors Low Correlation Between REIT Sectors The real estate market is diverse. Each sector is driven by different dynamics, reacts differently to the business cycle and changes in consumer behavior, and therefore has different return characteristics. Annual returns by sector have ranged from 4% to 19% since 1994 (Table 5). Moreover, sectors do not react in the same way to rising interest rates or inflation. Properties with short-term leases, such as hotels, storage, and apartments, can reprice and adjust rents as prices rise. On the other hand, those on the other end of the lease spectrum, e.g., retail and healthcare, have less flexibility to do so (Diagram 1). REITs with shorter-term leases (an equally-weighted basket of lodging, self-storage, and residential) outperfomed those with longer-term leases (an equally-weighted basket of healthcare, industrial, retail, and office) during periods of rising interest rates (Chart 16). Table 5REIT Sector Historical Returns Are REITs Still Attractive? Are REITs Still Attractive? Diagram 1Short-Term Leases Outperform... Are REITs Still Attractive? Are REITs Still Attractive?   Chart 16...During Periods Of Rising Interest Rates ...During Periods Of Rising Interest Rates ...During Periods Of Rising Interest Rates Bottom Line: The REITs market has recovered after the slump early in the pandemic. Current multiples appear expensive. However, they may just reflect a recovery that has been broad-based and swift. Cap rates historically have moved in lockstep with rising rates. If rates rise, as we expect, cap rates are likely to rise in tandem, putting downward pressure on property prices. The cap rate spread however remains close to its historical average and this should act as a buffer when rates rise. Moderate levels of inflation and rising rates are usually a positive for REITs’ performance. However, just like equities, once inflation rises too high (historically above 3.3%), REITs’ returns fall. We prefer REITs with short-term leases compared to those with long-term leases, as the former can reprice and adjust rental pricing more quickly. The Post-Covid Environment The pandemic has accelerated some existing trends in the real-estate sector and established new ones. Some sectors will struggle in this new environment, while others will flourish. In this section, we describe the likely post-pandemic world and how it will impact various segments of the real-estate market. We also assess where there are opportunities that investors can capitalize on.   Retail The “death of retail” is not a new phenomenon. As technological advances led to the rise of e-commerce, consumer spending shifted from in-store to online. Over the past two decades, non-store retail sales in the US have grown at an annualized 9.5%, compared to 3.1% for in-store sales. E-commerce has risen to almost 14% of total retail sales (Chart 17). This shift is reflected in the halving of the weight of retail REITs in the REITs index over the past decade. The composition of the sector has also changed and is no longer dominated by regional malls and shopping centers but by free-standing properties: These include restaurants, theaters, fitness centers, pharmacies, etc.  (Chart 18). Chart 17The Rise Of E-Commerce... The Rise Of E-Commerce... The Rise Of E-Commerce... Chart 18...Had An Adverse Impact On The Retail Sector ...Had An Adverse Impact On The Retail Sector ...Had An Adverse Impact On The Retail Sector   The headwinds facing the sector – particularly shopping centers –  have not abated. The size of vacant shopping center space has increased to 220 million square feet, approximately 11% of total retail space available: This is close to its post-GFC high. Private multi-retail capex continues to decline and is below its post-GFC low (Chart 19). Retail REITs’ occupancy rate is among the lowest among CRE: 94% as of Q3 2021, although it is higher than during the past two recessions. Funds from operations (FFO) and net operating income (NOI) have been declining over the past few years, with the exception of free-standing properties which saw low but positive growth (Chart 20). Chart 19Plenty Of Vacant Inventory In Shopping Centers... Plenty Of Vacant Inventory In Shopping Centers... Plenty Of Vacant Inventory In Shopping Centers... Chart 20...But There Could Be Opportunities In Free-Standing Properties ...But There Could Be Opportunities In Free-Standing Properties ...But There Could Be Opportunities In Free-Standing Properties   The pandemic exacerbated some other underlying trends and threats. Smaller in-store retailers have shifted to an online presence, aided by companies like Shopify, which saw the numbers of merchants on its platform grow from 1.07 to 1.75 million in 2020. Consumers are also likely to favor shopping in smaller-scale, local shops as they find convenience in stores close to home. Additionally, given the positive correlation between household density and retail space, as households migrate from city centers to the suburbs there will be less need for retail space within city centers. Bottom Line: We recommend investors underweight the retail sector within their broad real estate exposure. The structural headwinds are not likely to disappear. Within retail, we would favor free-standing properties over shopping centers and regional malls.   Office There has long been a close link between office demand and employment. As the labor market tightens, demand for offices increases and rents tend to rise (Chart 21). Investors in office REITs have earned 9.6% annualized returns, 90 basis points annualized below the overall return of the all-equity REITs index, over the past two decades. The sector is currently flush with supply. Estimates show that almost 18% (close to 800 million square feet) of total office space is vacant, yet capex has continued to increase over the past decade (Chart 22). Chart 21The Pandemic Has Changed Office Demand Dynamics The Pandemic Has Changed Office Demand Dynamics The Pandemic Has Changed Office Demand Dynamics Chart 22...Leaving The Sector With Empty Space ...Leaving The Sector With Empty Space ...Leaving The Sector With Empty Space   The pandemic, however, might be the catalyst for change. After social restrictions were imposed and offices shut down, the BLS estimates that in May 2020 as many as 35-40% of US employees were telecommuting, strictly because of the pandemic (Chart 23). Since then, as restrictions were lifted and vaccination rates rose, this number has come down to 12%,3 as more employees returned to some sort of pre-pandemic normalcy. The US Household Pulse survey (published by the US Census Bureau), however, shows close to 40% of employees working at home as of the end of September (Chart 24). Chart 23 Chart 24 Chart 25Mobility Data Showing No Full Return To Offices Mobility Data Showing No Full Return To Offices Mobility Data Showing No Full Return To Offices The true number of employees who telework likely lies in between the BLS’s 15% and the Census Bureau’s 40%. A study by Jonathan Dingel and Brent Neiman estimated, based on job characteristics,4 that 37% of jobs in the US can be done entirely from home (46% if weighted by wages). Whether employees will favor a work-from-home versus a return-to-office environment is still unclear. Most surveys show a 50-50 split. High-frequency data such as the Google Mobility Trends show that the number of people going to their workplace has not yet returned to normal (Chart 25). It is likely however that office utilization rates will not return to pre-pandemic levels. This might incentivize firms to search either for offices with flexible leases or co-shared space. Chart 26Are Employers Leaving City Centers With Their Employees? Are Employers Leaving City Centers With Their Employees? Are Employers Leaving City Centers With Their Employees? Companies face the choice of downsizing and so reducing business costs, or keeping the same premises which would allow for lower office density and enable social distancing between employees who return to the office. Estimates by CBRE suggest that office demand will not fall by as much as the reduction in the time employees will be in the office. CBRE argues that, while the average US employee is likely to spend 24% less time in an office, demand for office space will fall by only 9%. This calculation factors in more space per employee to allow for social distancing and collaborative working. Additionally, as more employees move away from inner cities, employers could move with them. This trend is reflected in suburban office prices which have risen by 15.1% since the beginning of 2020, compared to those in central business districts (CBD) which have risen by a mere 0.2% (Chart 26). Bottom Line: Investors in office space should be wary of corporates which are unwilling to return to offices operating at full capacity, and instead focus on single-tenant assets with long-term leases.   Healthcare Chart 27Like Equities, Healthcare REITs Are A Defensive Play Like Equities, Healthcare REITs Are A Defensive Play Like Equities, Healthcare REITs Are A Defensive Play REITs within this sector are focused on hospitals, senior and nursing homes, and laboratories. Since 1994, healthcare REITs have returned 10.7% annualized, with 21.1% annual volatility. These numbers, however, mask the underlying reality. Healthcare, being a defensive sector, outperformed the broad REITs market only during the dot-com recession and the GFC. In the short-lived pandemic-driven recession in 2020, healthcare REITs underperformed the broad index by 15%. On the other hand, during bull markets, particularly post the GFC, healthcare REITs significantly underperformed the broad market (Chart 27). The sector also has a high dividend yield, which has averaged 6.7% over the past 25 years, 160 basis points higher than the broad index’s historic average (Chart 28). In a Special Report published last year, we explained the structural reasons for our longstanding overweight position on Healthcare equities. We expect demand for healthcare services to continue to rise as life expectancy increases, populations age, and retiring baby boomers spend their accumulated wealth (mainly on healthcare) (Chart 29). Chart 28Healthcare REITs Have High Dividend Yields Healthcare REITs Have High Dividend Yields Healthcare REITs Have High Dividend Yields Chart 29An Aging Population Will Support Demand For Healthcare An Aging Population Will Support Demand For Healthcare An Aging Population Will Support Demand For Healthcare Elder care facilities will play a major role in supporting the increasingly aging population over the coming years. The pandemic has emphasized the need for high-quality senior housing: In our previous report, we highlighted that lack of funding and mismanagement – particularly in for-profit nursing homes – were reasons why they had almost four times as many Covid infections as those run by the government or non-profits. Chart 30...Increasing Investment In Healthcare Facilities ...Increasing Investment In Healthcare Facilities ...Increasing Investment In Healthcare Facilities Chart 31Healthcare REITs' Fundamentals Are Recovering Healthcare REITs' Fundamentals Are Recovering Healthcare REITs' Fundamentals Are Recovering The private sectors has already began to step in to meet this demand: Healthcare private construction expenditure has risen over the past few years and is likely to rise further (Chart 30). Cap rates continue to inch lower, but still have a decent spread over 10-year Treasurys (Chart 31, panel 1). Fundamentals have also began to improve: FFO and NOI growth seem to have bottomed, after dipping into negative territory as a result of the pandemic (panels 2 & 3). The sector has been going through a phase of consolidation: There have been significant acquisitions over the past few quarters, particularly of distressed operators (panel 4). Bottom Line: There is a structural long-term case to favor REITs in this sector, particularly an aging population with ample savings to spend on healthcare. Federal support and oversight have helped bolster confidence (for both occupants of care homes and investors) during the pandemic, and are likely to continue.   Lodging/Resorts Chart 32Income Has Been The Only Source Of Return For Lodging REITs Income Has Been The Only Source Of Return For Lodging REITs Income Has Been The Only Source Of Return For Lodging REITs Chart 33The Travel Industry Has Not Yet Recovered The Travel Industry Has Not Yet Recovered The Travel Industry Has Not Yet Recovered Lodging REITs have been the worst performing sector over the past 27 years. Since 1994, they have returned only an annualized 4.1%, 640 basis points lower than the all-equity REITs index, with annual volatility 14 percentage points higher. They have steadily underperformed the market since 1997. Property prices within the sector have consistently declined, and income has been the only source of return (Chart 32). Lodging demand is closely linked to travel, which has been deeply impacted by the pandemic. The number of US domestic airline passengers is still only half that of the pre-pandemic period (Chart 33). With vaccines rolled out and most pandemic restrictions likely to be lifted eventually, the travel sector is set to rebound, albeit not equally across segments. Chart 34Personal Travel Likely To Recover Before Business Travel Personal Travel Likely To Recover Before Business Travel Personal Travel Likely To Recover Before Business Travel Chart 35The Hotel Industry's Recovery The Hotel Industry's Recovery The Hotel Industry's Recovery Personal and leisure travel is likely to return first: More people are now comfortable about going on vacation and want to make up for the “lost travel” of the past two years (Chart 34). Hotel occupancy rates, while still below 2019 levels, continue to rise, and revenue per available room (RevPAR) is close to 2019 levels (Chart 35). Business travel, on the other hand, might not recover as fast. The shift to remote working and videoconferencing is likely to push companies to review travel budgets. Business travel, which halved between 2019 and 2020, is forecast to return to its pre-pandemic level only in 2024/2025. This is likely to have a larger adverse impact on higher-end, major-city hotels. Chart 36The Pandemic's Effect On The Lodging Sector The Pandemic's Effect On The Lodging Sector The Pandemic's Effect On The Lodging Sector The industry has been facing other headwinds for the past few years. The threat from online lodging platforms, such as Airbnb, has put downward pressure on occupancy rates, which have been declining recently after having hovered around the mid-60% level over the past 30 years. Bottom Line: Real spending on hotels and motels remains 26% below trend (Chart 36). A revival in leisure travel, the easing of restrictions, and pent-up demand will support the sector in the short-term. However, domestic business travel and international tourism might be slow to recover. Investors in lodging and resorts should reduce exposure to major-city assets and focus instead on rural or resort-based getaways.   Residential Residential REITs are primarily focused on apartments, rather than single-family homes or manufactured (mobile) homes  – although the share of apartments has been declining over the past few years (Chart 37). Since 1994, residential REITs have outperformed the broad market by an annualized 1.8 percentage points. More recently, since the single-family homes segment was added to the sector (in December 2015), residential REITs have continued to outperform the broad market, driven by a 21.4% annualized return from the manufactured homes segment, 19.4% from single-family homes, and 12.3% from apartments. The sector’s outperformance should not come as a surprise. The housing sector has been undersupplied for decades: The ratio of annual housing starts to the total number of households is 1.2% –  0.7 percentage points below its pre-GFC average (Chart 38). This has pushed up prices, increasing unaffordability, particularly for first-time buyers (Chart 39). This increased the percentage of US housing inventory occupied by renters rather than owners (Chart 40). Chart 37Apartments Make Up The Majority Of Residential REITs Apartments Make Up The Majority Of Residential REITs Apartments Make Up The Majority Of Residential REITs Chart 38Housing Undersupply Is No New Issue... Housing Undersupply Is No New Issue... Housing Undersupply Is No New Issue...   Chart 39...Making Home Prices Unaffordable... ...Making Home Prices Unaffordable... ...Making Home Prices Unaffordable... Chart 40...Particularly For Young Adults ...Particularly For Young Adults ...Particularly For Young Adults   Chart 41The Pandemic Pushed Renters Outside Of Major Cities The Pandemic Pushed Renters Outside Of Major Cities The Pandemic Pushed Renters Outside Of Major Cities The pandemic, and its impact on shopping and work, has pushed city residents to the suburbs. This is reflected in the gap between the rental vacancy rate in large cities versus that in the suburbs (Chart 41). It is also noticeable in REITs’ performance: Ones dominated by suburban housing have outperformed those focused on city centers over the past year. Home prices, appreciating faster than rental growth, will remain a tailwind for residential REITs (Chart 42). Supply shortages will keep prices high. Fundamentals also remain supportive of a positive outlook on the sector: The cap rate on residential REITs is about 260 basis points over the 10-year Treasury yield, and both FFO and NOI growth seem to have troughed (Chart 43). Chart 42Rising Home Price Will Be A Tailwind For Residential REITs Rising Home Price Will Be A Tailwind For Residential REITs Rising Home Price Will Be A Tailwind For Residential REITs Bottom Line: Investors should favor the residential sector within the REITs market, favoring single-family homes and manufactured homes over apartments, and out-of-city over downtown properties. Chart 43Improving Fundamentals For The Residential Sector Improving Fundamentals For The Residential Sector Improving Fundamentals For The Residential Sector   Data Centers Data centers are facilities that provide space for customers’ servers and other network and computing equipment. Due to the high and complex technical set-up specifications, leases are usually longer (upwards of five years). Properties that support the digital economy have attracted a lot of demand over the past few years. New technologies such as artificial intelligence, virtual reality, and autonomous vehicles will prove a tailwind over the coming years. Since data first became available (January 2016), data centers have outperformed the REITs benchmark by almost 60 percentage points (Chart 44). The pandemic has accelerated those trends, as social restrictions led offices, schools, and stores to close. This led to an increase in internet traffic and data creation. Estimates by OpenValut show that broadband usage increased by 51% in 2020 compared to 2019, partly due to remote learning and teleworking. Demand for data centers is expected to continue to grow. Fundamentals for the sector remain supportive: The cap rate – albeit now lower than post the GFC– is still near that of the broad benchmark (Chart 45, panel 1) and both NOI and FFO continue to grow (panels 2 & 3). Chart 44Sectors Supporting A Digitalized Economy Will Be Long-Term Outperfomers Sectors Supporting A Digitalized Economy Will Be Long-Term Outperfomers Sectors Supporting A Digitalized Economy Will Be Long-Term Outperfomers Chart 45...Supporting Fundamentals' Growth ...Supporting Fundamentals' Growth ...Supporting Fundamentals' Growth     Bottom Line: Internet traffic remains the primary driver of the performance of data-center REITs. The move towards a more digitalized economy is likely to prove a tailwind for the sector. This should also immunize the sector over the economic cycle as dependence on data increases structurally. A new normal in remote working and learning, as well as continued investment in new technologies, support an allocation to the sector.     Industrial Technological advances, particularly the rise of e-commerce, have also helped the industrial sector, increasing the need for logistics and fulfillment centers. Research by Prologis shows that e-commerce requires more than 3x the logistics space of brick-and-mortar sales. That is why investment in the sector has been rising over the past decade (Chart 46). Demand shows no signs of cooling: The occupancy rate of industrial REITs is at an all-time high, 4 percentage points higher than its 20-year average (Chart 47). Rental growth for industrial properties – particularly down the value chain closer to the end-consumer – has been robust due to the scarcity of permittable land. Chart 46Increased Demand For Warehouses Has Translated Into More CAPEX... Increased Demand For Warehouses Has Translated Into More CAPEX... Increased Demand For Warehouses Has Translated Into More CAPEX... Chart 47...And Pushed Up Occupancy Rates ...And Pushed Up Occupancy Rates ...And Pushed Up Occupancy Rates   The pandemic has also revealed how vulnerable current supply chains are and has accelerated a trend BCA Research has highlighted for years: The decline of globalization. Going forward, companies will move to reshore some of their production to gain greater control over supply chains (Chart 48). This will amplify the need for industrial space. Bottom Line: We expect the industrial sector to continue to outperform the broad REITs market, supported by continued investment in fulfillment and logistics centers. Fundamentals remain strong: Same-store NOI is growing at over 6% a year, and acquisitions have increased, with more than $5.5 billion over the past four quarters (Chart 49). The industrial sector has been one of the quickest to revive projects put on hold during the pandemic, with the development pipeline as of Q3 2021 34% higher than in Q4 2019. Chart 48The End Of Globalization, And Supply Chain Reshoring Will Increase The Need For Industrial Space The End Of Globalization, And Supply Chain Reshoring Will Increase The Need For Industrial Space The End Of Globalization, And Supply Chain Reshoring Will Increase The Need For Industrial Space Chart 49Increased M&A Activity In The Industrial Sector Increased M&A Activity In The Industrial Sector Increased M&A Activity In The Industrial Sector Amr Hanafy Senior Analyst Amrh@bcaresearch.com Footnotes 1  All-equity REITs refer to equity REITs plus infrastructure and timberland REITs. 2  Free-standing REITs own stand-alone properties away from malls and are a subsector of the retail sector. 3 This does not include those whose telework was unrelated to the pandemic, such as those who worked entirely from home prior to the pandemic. 4 Jonathan I. Dingel and Brent Neiman, "How Many Jobs Can Be Done At Home?" NBER Working Paper No. 26948, April 2020.

Obeying The Stop: Close The Intra-Real Estate Pair Trade Obeying The Stop: Close The Intra-Real Estate Pair Trade In the January 19th Special Report we instituted a long S&P REITs / short S&P homebuilders pair trade with a 10% stop loss. Yesterday, our stop was triggered and we are obeying it and closing this pair trade. Among other reasons, one of the macro drivers that compelled us to put this pair trade on was the 10-year US Treasury yield: historically the correlation between the relative share price ratio and interest rates would snap positive especially following a recession. Hence, a pullback in yields was also a key risk we highlighted for this pair trade. The 10-year US Treasury yield peaked near 1.19% and has continued to correct breaking below 1.04%, which at the margin boosts the allure of homebuilding stocks and consequently put our pair trade offside. While the original reasoning for putting this pair trade on remains intact, we refrain from fighting the trend and opt to move to the sidelines for the time being. We will be on the lookout for a better-timed entry point in the near future. Bottom Line: Obey the trailing stop and close the long S&P REITs / short S&P homebuilders pair trade for a loss of 10%.  

2021 High-Conviction Overweight Calls: S&P Real Estate 2021 High-Conviction Overweight Calls: S&P Real Estate Overweight We have been bearish this niche S&P sector and delivered alpha to our portfolio both via the cyclical and high-conviction underweights this year. Nevertheless, we do not want to overstay our welcome and the time is ripe for a bullish commercial real estate (CRE) stance. The bearish story is well known, but some bullish undertones are widely neglected. The rebound in relative share prices is substantially trailing the 2009 episode, when REITs outshined the SPX by 65% one year following the March 2009 trough. Currently, on a similar SPX advance from the March 2020 lows, REITs are lagging the S&P 500 by 22% (top panel). As large parts of CRE have been at the epicenter of the pandemic, any return to even semi-normalcy in 2021 should see these beaten down stocks sling shot passed the SPX. CRE prices will likely recover in the New Year as vulture funds and opportunistic investors are already bargain hunting. Tack on the likely refinancing lifeline bankers will extend to CRE debt originators (middle & bottom panels) and such a backdrop will loosen the noose around distressed property landlords. Bottom Line: Boost the S&P real estate sector to an above benchmark allocation and add it to the high-conviction overweight call list.

Book Gains In the Intra-Real Estate Pair Trade And Move To The Sidelines Book Gains In the Intra-Real Estate Pair Trade And Move To The Sidelines Last week we put a 5% rolling stop on the long S&P homebuilding/short S&P REITs pair trade in order to protect profits. Yesterday, our stop got triggered and we crystalized 10.3% gains since the May 26 initiation date. A slew of better-than-expected homebuilder reports caused the recent spike in this market-neutral trade, confirming that all-time low mortgage rates have brought back residential real estate buyers with a vengeance. While most of the key catalysts for this intra-real estate pair trade remain in place that we first outlined in our late-May report, we obey our risk management metric and choose to move to the sidelines for now. Bottom Line: Lock in two-month gains of 10.3% in the long S&P homebuilding/short S&P REITs pair trade and step aside, but stay tuned. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME – LEN, PHM, NVR, DHI, and BLBG: S5REITS – AMT, PLD, CCI, EQIX, DLR, SBAC, PSA, AVB, EQR, WELL, ARE, O, SPG, ESS, WY, MAA, VTR, DRE, PEAK, BXP, EXR, UDR, HST, REG, IRM, VNO, FRT, AIV, KIM, SLG, respectively.  

Our intra-real estate pair trade long S&P homebuilders / short S&P REITs vaulted roughly to the 15% return mark intraday yesterday, compelling us to institute a 5% rolling stop in order to protect handsome profits since the late-May inception. Our thesis for putting on this market-neutral trade remains intact. The Fed’s ZIRP policy as far as the eye can see is perhaps the biggest catalyst for US homebuilders, especially as the one-off pandemic effects begin to wear off and people are able to take advantage of all-time low mortgage rates that recently breached 3%. In fact, the chart below suggests that the pair trade is poised for additional gains in the coming months. Bottom Line: We continue to recommend the long S&P homebuilders / short S&P REITs pair trade as more gains are in store, but from a portfolio management perspective we are instituting a 5% rolling stop in order to protect gains. Intra-Real Estate Pair Trade Update Intra-Real Estate Pair Trade Update

The Fed’s efforts to jawbone the US dollar are paying off as investors have been shedding their greenback exposure over the past several weeks. In recent research,1 we have also been highlighting that although Powell would never admit it, the Fed is trying to devalue the greenback and reflate the global economy. The knock-on effect of a depreciating USD is to rekindle S&P sales. According to S&P Dow Jones Indices,2 the SPX derives approximately 43% of its sales from abroad making the US dollar among the key macro profitability drivers (Chart 1, middle panel, US dollar shown advanced and inverted). One of the mechanisms to undermine the greenback is to flood the market with dollars. Ample US dollar based liquidity has historically served as a catalyst to reignite global growth and consequently S&P earnings (Chart 1, bottom panel). Chart 1US Dollar - The Key Driver US Dollar - The Key Driver US Dollar - The Key Driver Chart 2Bearish Across All Timeframes Bearish Across All Timeframes Bearish Across All Timeframes The Dollar: A Bearish Case The fate of the US dollar is yet to be sealed, but piling evidence suggests that the path of least resistance will be lower. Looking at structural (five years+) dynamics, swelling twin deficits emit a bearish USD signal. In more detail, prior to COVID-19 outbreak, the US twin deficits were estimated to gradually rise towards the 7.5% mark (Chart 2, top panel, dotted red line), but now the US Congressional Budget Office (CBO) estimates3 that the US fiscal deficit alone will be approximately 11% of nominal GDP for 2020. In other words, the recent pandemic has exacerbated already structurally bearish dynamics for the US dollar. Switching gears from a structural to a medium term horizon (2-3 years), BCA’s four-factor macro model, is sending an unambiguous bearish message regarding the greenback’s fate (Chart 2, middle panel). Finally, on a short-term time horizon, the USD is lagging the money multiplier by approximately 3 months. The COVID-19 induced recession and resulting money printing will likely exert extreme downward pressure on the US dollar (Chart 2, bottom panel). Summarizing, when looking across three different time horizons, the evidence is pointing toward a weakening US dollar for the foreseeable future. SPX Sectors And US Dollar Correlations With a rising probability of a US dollar bear market on the horizon, it pays to look back in time and examine which S&P GICS1 sectors benefited from a depreciating US dollar. The purpose of this Special Report is to shed light on the empirical evidence of SPX sectors and USD correlations and serve as a roadmap of sector winners and losers during USD bear markets. Table 1 provides foreign sales exposure for each of the sectors. All else equal, a falling greenback should be synonymous with technology, materials, and energy sectors outperforming as they are the most internationally exposed sectors. In contrast, should the USD change its course and head north, financials, telecom, REITs, and utilities will be the key beneficiaries. Why? Because most of these industries are landlocked in the US and thus in a relative sense should benefit when the US dollar roars. Table 1S&P 500 GICS1 Foreign Sales As A Percent Of Total Sales* US Dollar Bear Market: What To Buy & What To Sell US Dollar Bear Market: What To Buy & What To Sell To confirm the above hypothesis, we have identified three previous US dollar bear markets (Chart 3) and computed GICS1-level sector relative returns (Table 2). Chart 3US Dollar Bear Markets US Dollar Bear Markets US Dollar Bear Markets Table 2S&P 500 Gics1 Returns* During US Dollar Bear Markets US Dollar Bear Market: What To Buy & What To Sell US Dollar Bear Market: What To Buy & What To Sell Looking at median return profile reveals that our hypothesis held as all three: technology, materials, and energy decisively outperformed the market when the US dollar headed south. Similarly, domestically focused and predominately defensive industries such as utilities and telecoms underperformed the market with the consumer staples sector being a notable outlier – something that we address in the consumer staples section of the report. What follows next is a detailed discussion on each of the GICS1 sectors historical relationship with the US dollar, ranked in order of foreign sales exposure from highest to lowest. For completion purposes, we also provided S&P 500 GICS1 relative sector performance against the US dollar charts since 1970 in the Appendix.     Arseniy Urazov Research Associate arseniyu@bcaresearch.com   Technology (Neutral)  Technology sits atop the foreign sales exposure table garnering 58% of revenues from abroad, which is a full 15% percentage points higher than S&P 500 (Table 1). In two out of the three periods of USD bear markets that we examined, tech stocks bested the broad market and the median outperformance sat over 9%. Nevertheless, the correlation between the US dollar and relative share prices is muted over a longer-term horizon (see Appendix Chart A1 below). Likely, one reason for the inconclusive long-term correlation between tech and the greenback is that the majority of tech gadgets are manufactured overseas (Chart 4, third panel). Therefore, an appreciating currency boosts margins via deflating input costs. Tack on the resilient nature of demand for tech hardware goods and especially software and services which preserves high selling prices and offsets and negative P&L losses from a rising greenback. We are currently neutral the S&P technology sector and employ a barbell portfolio approach preferring software and services and avoiding hardware and equipment. Chart 4Technology Technology Technology Materials (Neutral) The materials sector behaves similarly to its brother the energy sector as both move in the opposite direction of the greenback (Chart 5, top panel). Consequently, materials stocks have outperformed the market during periods of US dollar weakness that we analyzed. The third panel of Chart 5 shows that our materials exports proxy is the flip image of the greenback. This tight inverse relationship is exacerbated by the negative impact of a firming dollar on underlying metals commodity prices (Chart 5, second panel). As a result, materials profit margins widen when the dollar falls and narrow when it rises. Ultimately, S&P materials earnings reflect this USD-commodity dynamic (Chart 5, bottom panel) We are currently neutral the S&P materials index. Chart 5Materials Materials Materials Energy (Overweight) The energy sector enjoys a tight inverse correlation with the US dollar (Chart 6, top panel) as it is the third most globally exposed sector as shown in Table 1 with 51% of sales coming from abroad. As nearly all of the global oil trade is conducted in US dollars, a weakening USD underpins the price of crude oil (Chart 6, second panel). In turn, US energy sector exports rise reflecting the fall in the greenback (Chart 6, third panel). Finally, the S&P energy companies enjoy a boost to their income statements (Chart 6, bottom panel), which explains the sizable median sector outperformance of 43% during dollar bear markets as highlighted in Table 2. We are currently overweight the S&P energy sector and have recently capitalized on 40%+ combined gains in the long XOP/short GDX pair trades.4 Chart 6Energy Energy Energy Industrials (Overweight) US industrials stocks’ foreign sales exposure is on a par with the S&P 500, which explains why the sector only barely outperformed the broad market during periods of dollar weakness. Still, the correlation between this manufacturing-heavy sector and the greenback is negative (Chart 7, top & second panels). Similar to its deep cyclical brethren (materials and energy), the link comes via the commodity channel. A softening dollar boosts global growth, which in turn supports higher commodity prices. Not only do US capital goods producers benefit from overall rising demand (i.e. infrastructure spending), but also via market share gains in global markets as the falling greenback results in a comparative input cost advantage (Chart 7, third panel). Finally, P&L translation gain effects act as another fillip to industrials stocks profits when dollar heads south. We are currently overweight the S&P industrials index. Chart 7Industrials Industrials Industrials Health Care (Overweight) The defensive health care sector is positively correlated with the dollar as its foreign sales revenues are below the ones of the SPX (Chart 8, top panel). Moreover, empirical evidence suggests that the relationship between the sector’s exports and the USD has been mostly positive, which is counterintuitive (Chart 8, middle panel). Keep in mind that pharma and biotech represent roughly half the index and derive 75%+ of their profits domestically as they dictate pricing terms to the US government (it is written into law). This is not the case in Europe where the NHS and the German government for example, have a big say on what pharmaceuticals can charge for their drugs. The bottom panel of Chart 8 summarizes the domestic nature of the health care sector, highlighting the tight positive relationship between the sector’s earnings and the greenback. We are currently modestly overweight the S&P health care sector. Chart 8Health Care Health Care Health Care Consumer Discretionary (Overweight) While the impact of the US dollar on the consumer discretionary sector varied over time switching from a positive to a negative and vice versa, today the sector enjoys a positive correlation with the currency (Chart 9, top panel). The 33% foreign sales exposure may appear as a significant proportion, but it is still a full 10% percentage points below the SPX (Table 1). The implication is that even though the exports benefit from a falling dollar (Chart 9, middle panel), this bump is not enough to drive sector outperformance. Likely, the key reason why consumer discretionary stocks currently enjoy a positive correlation with the dollar is the US large trade deficit. In other words, the US imports the lion’s share of its consumer goods. As the dollar grinds higher, the cost of imports decreases for the US consumer, which provides a boost to companies’ earnings (Chart 9, bottom panel). Tack on the heavy weight AMZN has in the sector (comprising 40% of consumer discretionary sector market cap) and the positive correlation with the currency is explained away. We are currently overweight the S&P consumer discretionary index. Chart 9Consumer Discretionary Consumer Discretionary Consumer Discretionary Consumer Staples (Neutral) While a softening US dollar generally favors cyclical industries as it reignites global trade, the defensive S&P consumer staples sector outperformed the overall market on a median basis during USD bear markets (Table 2). Granted, the results are likely skewed as staples stocks rallied more than 300% in the last two decades of the 20th century. Nevertheless, there is a key differentiating factor at play that helped the consumer staples sector trounce other defensive industries during US dollar bear markets. Staples stocks derive 33% (Table 1) of their sales from abroad, whereas other traditional defensive industries (utilities, telecom services) have virtually no export exposure. In other words, given that staples companies are mostly manufacturers, a depreciating currency acts as a tonic to sales via the export relief valve (Chart 10, bottom panel). We are currently neutral the S&P consumer staples sector. Chart 10Consumer Staples Consumer Staples Consumer Staples Financials (Overweight) Financials sit at the bottom half of our Table 1 in terms of their foreign sales exposure, which underpins the sector’s positive correlation with the greenback (Chart 11, top panel), and explains why the sector underperforms the market during dollar bear markets. One of the transmission channels between this sector’s performance and the currency is via increased credit demand. Currency appreciation suppresses inflation and supports purchasing power, and thus loan demand, in addition to keeping bond yields low (Chart 11, middle panel). The process reverses as the US dollar stars to depreciate. We are currently overweight the S&P financials index. Chart 11Financials Financials Financials Utilities (Underweight) Utilities underperformed in all three dollar bear markets we analyzed. As we highlighted in the energy section of the report, a softening dollar is synonymous with higher crude oil prices, which in turn raise inflation expectations. The ensuing selloff in the 10-year Treasury, compels investors to shed this bond proxy equity sector (Chart 12, middle panel). With virtually no exports, utilities also miss on the positive currency translation effects that other GICS1 sectors enjoy. In fact, utilities underperformed by the widest margin on a median basis across all GICS1 sectors (Table 2). This defensive sector typically attracts safe haven flows when the dollar spikes and investors run for cover. This positive correlation with the dollar is clearly reflected in industry earnings, which rise and fall in lockstep with momentum in the greenback (Chart 12, bottom panel). We are currently underweight the S&P utilities sector. Chart 12Utilities Utilities Utilities Telecommunication Services (Neutral) Telecom services relative performance is positively correlated with the dollar, similarly to its defensive sibling, the utilities sector. In fact, telecom carriers go neck-in-neck with utilities as the former is the second worst performing sector during dollar bear markets (Table 2). A softening dollar has proven to be fatal to the industry’s relative pricing power beyond intra industry competition. In fact, industry selling prices are slated to head south anew if history at least rhymes (Chart 13, middle panel). Importantly, this defensive sector is in a structural downtrend and is trying to stay relevant and avoid becoming a “dumb pipeline” with the eventual proliferation of 5G. Worrisomely, telecoms only manage to claw back some of their severe losses during recessions. But, the latest iteration is an aberration as this safe haven sector has failed to stand up to its defensive stature likely owing to the heavy debt load. We are currently neutral the niche S&P telecom services index that now hides underneath the S&P communication services sector. Chart 13Telecom Services Telecom Services Telecom Services REITs (Underweight) Surprisingly, US REITs enjoy an overall negative correlation with the dollar, especially since 1993, and in fact lead the greenback by about 18 months (Chart 14). Our hypothesis would have been a positive correlation courtesy of the landlocked nature of this sector i.e. no export exposure. Granted, in the three periods of dollar bear markets we examined, REITs slightly outperformed the market by 2.5% on a median basis. While the causal link (if any) is yet to be established and the correlation may be spurious, our sense is that forward interest rate differentials are at work and more than offset the domestic nature of this index. REITs have a high dividend yield and thus outperform when the competing risk free asset the 10-year Treasury yield is falling and vice versa (except during recessions). As a result, REITs outperformance is more often than not synonymous with a depreciating currency as lower Treasury yields would exert downward pressure on the USD ceteris paribus.  We are currently underweight the S&P REITs index. Chart 14REITs REITs REITs   Appendix Chart A1Appendix: Technology Appendix: Technology Appendix: Technology Chart A2Appendix: Materials Appendix: Materials Appendix: Materials Chart A3Appendix: Energy Appendix: Energy Appendix: Energy Chart A4Appendix: Industrials Appendix: Industrials Appendix: Industrials Chart A5Appendix: Health Care Appendix: Health Care Appendix: Health Care Chart A6Appendix: Consumer Discretionary Appendix: Consumer Discretionary Appendix: Consumer Discretionary Chart A7Appendix: Consumer Staples Appendix: Consumer Staples Appendix: Consumer Staples Chart A8Appendix: Financials Appendix: Financials Appendix: Financials Chart A9Appendix: Utilities Appendix: Utilities Appendix: Utilities Chart A10Appendix: Telecommunication Services Appendix: Telecommunication Services Appendix: Telecommunication Services Chart A11 landscapeAppendix: REITs Appendix: REITs Appendix: REITs   Footnotes 1    Please see BCA US Equity Strategy Weekly Report, “The Bottomless Punchbowl” dated May 11, 2020, available at uses.bcaresearch.com. 2    https://us.spindices.com/indexology/djia-and-sp-500/sp-500-global-sales 3    https://www.cbo.gov/system/files/2020-05/56351-CBO-interim-projections.pdf 4    Please see BCA US Equity Strategy Weekly Report, “Gauging Fair Value” dated April 27, 2020, available at uses.bcaresearch.com.  

Highlights Policymakers vs. the virus remains the story at the macro level: Fiscal support is the wild card, but we expect Senate hawks, caught between the House and the White House, will roll over in the end. The economy is perking up, but it is still too vulnerable to stand on its own: The direction is improving as the economy reopens, but the level still stinks and COVID-19 has not gone away. We’ve reached an accommodation with rich index valuations, … : The alternatives are dismal, the preponderance of professional investors have to participate and the possibility of positive virus surprises cannot be dismissed. … but there’s plenty of silliness at the individual stock level: Retail investors, running amok like Donald Duck’s nephews, appear to have triggered some remarkable moves, especially in small stocks. Feature The big picture remains unchanged, but the view from ground level is becoming increasingly disorienting. The dizzying activity in vulnerable industries and select micro-caps resembles nothing so much as a beach bar after final exams. Sun, noise, adrenaline and a sense of overdue release have come together to wash away any and all inhibitions or standard rules. The pull has been especially strong for newcomers to the scene. We suspect that some of the unusual action in individual equities over the last several weeks may have its origins in an upsurge of active retail participation. Waves of retail interest come and go like the tides, albeit irregularly, and the only thing new about the current iteration, with its smart phone apps and zero commissions, is that it is nearly frictionless. We have nothing against retail investors – we’ve been one since directing our paper route earnings to the purchase of odd lots in Ronald Reagan’s first term – and don’t see them as a portent of doom. Their moves are drawing attention, though, so we review freely available daily data to try to gain some insight into their recent activity and ongoing interest. Novices Versus Experts Chart 1Baseline Change In Robinhood Equity Ownership The Democratization Of Equity Investing The Democratization Of Equity Investing Robinhood is a deep-pocketed retail brokerage oriented toward novice investors. Although its customers’ balances are almost certainly small, it has over 10 million of them, and it has made a profound impact on the industry by pioneering commission-free trading. Data on its customers’ holdings are aggregated and uploaded several times throughout the day to the dedicated website robintrack.net. They are cumbersome – the full database contains over 8,000 spreadsheets – so we focused our analysis on Robinhood customers’ holdings in airlines, cruise ships and selected mortgage REITs. We found that the number of Robinhood accounts owning these stocks exploded since late March, but that datapoint cannot be considered in isolation because the number of accounts has been rising. Robinhood added over 3 million new accounts in the first four months of the year, an increase of as much as 30% from its year-end customer base.1 A blizzard of anecdotal reports characterizing day trading as a substitute for following professional sports reinforce the notion that ownership of all stocks has risen. To get a sense of how baseline equity holdings have changed since the S&P 500 peak on February 19th, we looked at the number of Robinhood accounts holding Apple (AAPL) and the iShares (SPY) and Vanguard (VOO) S&P 500 Index ETFs, and found they have all roughly doubled (Chart 1). Making equity investing more democratic may be a noble aim, but democracy can be messy. By contrast, the number of Robinhood accounts holding six large- and mid-cap airlines has risen 48 times, with component holdings of United (UAL) and Spirit (SAVE) leading the way at 87 and 81 times, respectively (Chart 2, top two panels), and Southwest (LUV) and Jet Blue (JBLU) bringing up the rear at 12 and 21 times, respectively (Chart 2, bottom two panels). The number of accounts owning cruise lines is up 177 times, on average, powered by Norwegian (NCLH), which has increased a remarkable 365 times (Chart 3, top panel). If Robinhood’s customers are representative of the retail investor population, betting that the pandemic will not be fatal for passenger airlines and cruise lines has become an extremely popular pursuit. Chart 2Buying The Dip In The Airlines The Democratization Of Equity Investing The Democratization Of Equity Investing Chart 3Stampeding Into The Cruise Lines The Democratization Of Equity Investing The Democratization Of Equity Investing Chart 4Unafraid Of Falling Knives The Democratization Of Equity Investing The Democratization Of Equity Investing Robinhood customers have also eagerly attempted to rescue ailing mortgage REITs. Mortgage REITs apply several turns of short-term leverage to their mortgage portfolios to fund generous dividend yields that typically range between the high single and low double digits. Mortgage REITs that invest solely in agency mortgage-backed securities (MBS) were stressed when credit spreads blew out in March, but hybrid REITs with sizable concentrations of illiquid non-agency MBS and whole loans faced an existential crisis. Three hybrids – Invesco Mortgage Capital (IVR), MFA Financial (MFA) and AG Mortgage Investment Trust (MITT) – failed to meet margin calls from their repo lenders. MFA and MITT have indefinitely suspended their dividends, while IVR cut its dividend by 96% last week. The companies’ futures were in doubt in late March and early April, but Robinhood customers have poured into the breach. The number of accounts holding the stocks has risen 93-fold, on average, since the S&P 500 peaked in February, with IVR leading the way at 149 times (Chart 4, top panel). Robinhood customer interest began to surge when the three stocks bottomed but increasing numbers of accounts have added them to their portfolios all throughout a turbulent May and June. The stocks are not yet out of the woods and sell-side analysts have panned their recent surges, as it is unclear who else will want to own them when they don’t pay dividends. Stocks from the groups we highlighted all face daunting current predicaments. They might deliver sizable returns if they can emerge mostly unscathed but that is a big if. They have come to account for an outsized share of Robinhood customers’ holdings (Table 1), especially relative to their market capitalizations. Retail treasure hunting may account for some of the recent surges that seemed to spite fundamentals, but we doubt that a community of first-time investors has the heft to move any but the smallest stocks. We suspect that algorithms, hedge-funds and other fast-money pools of capital may be amplifying the momentum that retail activity has set in motion. Retail investors have provided institutions with an opportunity to exit stocks in the three stressed groups. Per weekly data on the level of institutional holdings from Bloomberg, the composition of ownership of all twelve stocks we examined has shifted materially from institutions to individuals (Table 2). In the case of these stocks, retail investors have served as liquidity providers to institutional sellers seeking to exit their holdings. Instead of amplifying volatility, they may have tamped it down, while helping to speed the redeployment of institutional capital. Table 1Searching The Bargain Bin The Democratization Of Equity Investing The Democratization Of Equity Investing Table 2Individuals Have Replaced Institutions The Democratization Of Equity Investing The Democratization Of Equity Investing   Direction Versus Level Many investors lament that the equity rally has occurred without regard for fundamental conditions or in seeming defiance of them. The imposition of rigorous social distancing measures to slow the spread of COVID-19 immediately induced a sharp recession, but the economy has begun to bounce back, and a further rollback of virus containment measures will help it build forward momentum. The latest NAHB survey demonstrated that housing is making rapid strides, with buyer traffic smartly reviving (Chart 5, third panel) and builders’ sales expectations snapping back (Chart 5, bottom panel). May housing starts came in well short of the consensus expectation, but leading building permits indicate that a pickup is just around the corner, and the purchase mortgage applications index hit its highest level in eleven years last week (Chart 6). Chart 5Housing Is Coming Back Fast Housing Is Coming Back Fast Housing Is Coming Back Fast Chart 6Low Rates Help The Real Economy, Too Low Rates Help The Real Economy, Too Low Rates Help The Real Economy, Too The various regional Fed manufacturing surveys all bounced in May, and the June Philly Fed (Chart 7, top panel) and Empire State (Chart 7, second panel) readings extended the trend, zooming far past expectations. Their moves bode well for the Richmond, Kansas City and Dallas Fed readings due out this week and next. They are not all the way back to their pre-pandemic levels, but they’re moving in the right direction and point to a continued pickup in manufacturing activity (Chart 8). Chart 7Gaining Traction Gaining Traction Gaining Traction The economic surprise index hit an all-time high last week (Chart 9), reinforcing the point that the improvement in the direction of economic activity is widespread. Activity has not returned to pre-pandemic levels, and it won’t for a while, but it is beginning to pick up or at least weaken at a slower rate. As states progress through their reopening phases, the direction will continue to improve and the level will get closer to its previous position. Chart 8Weak Level, Improving Direction Weak Level, Improving Direction Weak Level, Improving Direction Chart 9Uncoiling The Spring Uncoiling The Spring Uncoiling The Spring A resurgence in infection rates, or a second wave like the one that appears to be emerging in China, is a threat to ongoing economic improvement. Some states which have moved more rapidly to reopen are experiencing increasing infection rates, but they will only see reversals in economic activity if they revert to strict social distancing measures. It is becoming steadily apparent that most communities, here and abroad, no longer have the stomach for broad lockdowns. It seems that government officials are willing to trade a modest pickup in infections for a pickup in economic growth and individuals are willing to trade an increased risk of infection for a return to some sense of normal life. A severe re-emergence could change the calculus, but for now there is powerful momentum to advance along the path to restarting the economy. Policymakers Versus The Virus A record-high economic surprise index distills the improved direction across a broad sweep of indicators. Our view that Washington will extend fiscal lifelines to households, businesses and state and local governments is still intact. Negotiations over an infrastructure spending initiative are progressing, and we expect a successor to the CARES Act will follow before the end of July. As we’ve discussed before, it is simply too risky politically for Senate Republicans to obstruct aid efforts heading into the homestretch of the campaign. Robust fiscal support, combined with whatever-it-takes monetary support from the Fed, should be enough to see the economy across the pandemic abyss provided that testing bottlenecks are resolved and treatment protocols advance. Investment Implications Wagging a finger at retail investors is not our style. Increased retail participation has probably catalyzed some unexpected equity outcomes but the only outright distortions we’ve seen have occurred in micro-cap stocks and do not have a larger macro resonance. Retail participation in the stock market has always waxed and waned, but major market and economic impacts like the dot-com bubble are rare. We therefore do not believe that equities have become unmoored from reality and that a threatening bubble has formed. The fundamental backdrop has improved. The economy is nowhere near recovering its pre-pandemic levels, but the stock market is a forward-discounting mechanism and direction regularly trumps level. There is surely some froth in the market, and 24 times forward four-quarter earnings is a pricey multiple for the S&P 500, especially when it seems that earnings expectations beyond 2020 are overly optimistic. Retail participation in equities comes and goes, and it rarely proves disruptive at the overall index level. There are also plenty of ways that the virus could spring a nasty surprise, and financial markets seem to be ignoring them. Our geopolitical strategists see scope for turbulence at home, as the administration tries to improve its re-election prospects, and abroad, as any of several hot spots from Iran to North Korea to the South China Sea could flare up. The potential for negative surprises, as well as the furious equity rally, keeps us equal weight equities and overweight cash over the tactical timeframe. We remain constructive on equities over a 12-month horizon, however, as things are moving in the right direction and the alternatives – cash with zero yields and Treasuries with microscopic yields – are so unappealing.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Robinhood announced that it had surpassed the 10-million-customer mark in December.