Hedging REITs Against a Bear Market
Hedging with REIT Inverse ETFs
REITs have become very popular investments over the last few years because of the higher income they pay out to investors.
With an average yield of about 4.22%, the income produced is roughly double that of the broader stock market yield and that of U.S. Treasuries.1
Other benefits of REITs are capital appreciation and diversification.
This ability to generate extra income comes from the way REITs are structured by the tax code. They must pay out at least 90% of their cash flow to their unit holders.
They are also attractive to individual investors because some REITs pay out their distributions on a monthly basis, instead of the typical quarterly payment style.
But now might be the time to consider hedging any REITs you own with REIT inverse ETFs.
The Feds zero-interest rate policy has forced investors further out on the risk spectrum (whether they realize it or not). Interest rates have been low for a long-time now so the extra yield of REITs was attractive to many.
When we talk about REITs we must make the distinction between housing (residential) and the commercial real estate markets. Let’s look at each real estate market.
What are the Risks for REITs?
The housing market has had a remarkable rebound-almost all the way back to the 2006, pre-financial crisis levels. But the same characteristics that enabled the first housing bubble have reappeared for potentially another one.
Mortgage rates are even lower than they were in the mid 2000’s for a conventional 30 year fixed loan. Home prices have skyrocketed again and real estate is once again expensive.
This is due to a few factors including a construction labor shortage, low rates and the return of low-money down loans. The National Association of Realtors shows that the affordability index in October, 2015 is the lowest since June 2006.
Many ‘investors’ bought real estate this time around not for flipping but for rental income, desperate for yield. These homes could end up coming back onto the market in droves if the institutional investors (private equity firms) get into trouble and need to raise cash or if the economy gets so bad that rents plummet.
As we’ve seen in the past, there are few environments more illiquid than an over-supplied housing market. Interest rates can’t stay low indefinitely without consequences.
Real Estate Investment Trusts
Many investors have invested in REITs over the last few years looking for higher yields, diversification benefits and capital appreciation. Of course, when the economy and real estate market is in recovery, they outperform.
But on the cusp of rates rising, they’ll see problems.
Retail REITs like (shopping malls, etc) are tied to consumer credit, the demand for which may dry up. Student housing REITs are dangerous. The preferential tax benefit could be an overlooked threat in the future. If 1-public sentiment turns negative towards any entity that may be “unfairly” avoiding taxation or 2- a poor economy could stress tax receipts of our already indebted government and force legislation to remove various tax status they enjoy.
These are real threats as we see companies like Apple being targeted for not paying taxes on overseas profits, tax inversion scrutiny and political candidates already talking about going after hedge funds and their carried interest.
Many yield-starved investors have purchased mortgage REITs (known as “m-REITs”) for their unusually high yields, often in the double-digit realm.
The Fed’s unprecedented purchasing of mortgage-backed securities (MBS) has kept the market functioning seemingly well. But now that quantitative easing has ended, its sink or swim time for the housing market and associated mortgage loans and securities.
M-REITs make their money on the spread between interest rates or the “spread”. They then leverage this bet by multiples. Mortgage REITs are highly leveraged investments. The debt to equity ratio for mortgage REITs is around four times as high as for traditional REITs.
So there is plenty of risk for m-REITs including:
- Mortgage defaults
- Yield Curve Movements
If short term borrowing costs spike they can lose money just as fast.
How to Hedge with REIT Inverse ETFs
There are a couple leveraged REIT inverse ETFs out there.
With -2x exposure, ProShares UltraShort Real Estate Shares, SRS, which aims to return the double inverse return of the Dow Jones US Real estate index on a daily basis.
For more aggressive traders, there is Direxion’s Daily Real Estate Bear 3x Shares, DRV, which tracks the MSCI REIT index.
There are other ways real estate exposure may be hedged with inverse ETFs or alternative ETFs. The engine of the housing market are the home builders.
Home building stocks tend to be a leading indicator for real estate in many cases. ProShares offers the ‘UltraShort Home builders & Supplies’ (HBZ), a double-leveraged inverse ETF (-2X) on the Dow Jones U.S. Select Home Construction Index.
The last housing crisis almost put many financials out of business. A repeat could do similar damage.
Another ProShares fund is the UltraShort Financials (SKF) which is a 2X leveraged inverse financials ETF that aims to deliver the opposite return of the Dow Jones U.S. Financials Index.
The largest holding in the index, as of August 2015, is Wells Fargo, the nation’s largest mortgage lender. The fund has decent size at over $50 million in assets and over 26,000 shares normally traded. There are also 8 counterparties, the largest of which is Goldman Sachs (as of September, 2015).
Lastly, nothing will harm the housing market or securitized products tied to the real estate market (whether residential or commercial) like rising interest rates.
Because the next interest rate cycle will be the detonator that starts the real problem-credit contraction. If this contraction in credit outweighs the results of quantitative easing and the velocity of money keeps falling, we’ll get deflation.
You won’t want to be anywhere near the highly levered sectors if that occurs and real estate is near the top of that list. The result will be low occupancy rates, foreclosures and defaults.
The mortgage rate is most often associated with the U.S. 10-year Treasury so inverse interest rate ETF TBX could produce a nice hedge. TBX is the “Short 7-10 Year U.S. Treasury” ETF from ProShares which aims to deliver the opposite return of the Barclays Capital U.S. 7-10 Year Treasury Bond Index.
The only downside is only 4 counterparties and low relative trading volume (which should pick up if rates rise substantially).
Inverse ETFs mentioned: