Wells Fargo: 4 Red Flags on U.S. REITs
U.S. REITs Are Now Overvalued
Real estate investment trusts, or REITs, have long been a go-to choice for some income investors. However, one of the major banks in the U.S. recently raised some red flags about the sector.
In a report published on Thursday, August 11, Wells Fargo Investment Institute said that it would keep its tactical overweight on U.S. REITs. However, it also pointed out that domestic REITs are now overvalued. (Source: “REITs: Still Overweight—But We Have Concerns,” Wells Fargo Advisors, August 11, 2016.)
REITs have been one of the top-performing major asset classes over the past 12 months. John LaForge, head of real asset strategy at Wells Fargo Investment Institute, pointed out that the sector’s strong performance has brought questions on valuation.
“Are U.S. REITs now overvalued? Our answer is yes; most angles show that domestic REITs are now overvalued. But most angles that show REITs as overvalued are not so extreme that we are ready to pull the plug on our REIT tactical overweight,” he wrote. “Further, there are important views that still highlight REITs as cheap, such as REITs vs. bonds.” (Source: Ibid.)
However, valuation is not really a major concern at this point. LaForge said that, “as long as U.S. REITs continue to perform well relative to most asset groups, as they are doing today, overvaluation is of secondary concern to us.”
Other than valuation, the analyst also pointed out three other issues with domestic REITs.
The first one is the slowing of commercial real estate prices. LaForge looked at three commercial real estate indexes and noticed that while the year-over-year price gains are still positive for each index, the magnitude of those gains is declining. “We would not classify this angle as a true REIT negative today, but it is a worry of ours should the slower real estate price gains transition to negative ones,” he wrote.
The second one is that banks and capital markets are tightening real estate lending. LaForge noted that bank lending standards in 2016 have tightened to levels not seen since the financial crisis in 2008. Moreover, the tightening is happening across multiple types of commercial real estate loans.
The third concern is that investors are losing confidence in real estate conditions. In particular, polls from the Real Estate Roundtable showed sentiment on real estate conditions have dropped to levels last seen during the financial crisis eight years ago.
Still, LaForge said that, “U.S. REITs have continued to perform well, even in the face of mounting fundamental concerns.” The conclusion: “Until the positive performance trends turn negative, we believe it is prudent to keep our tactical overweight to U.S. REITs.” (Source: Ibid.)
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