Real estate investment trusts (REITs) are thought to be sensitive instruments This sensitivity stems from the fact that REITs are high-yield instruments, in that most of their total return stems from dividends rather than price appreciation. Dividends are fueled by rents and property sales, both of which are affected by interest rates and the business cycles. Stable earnings growth along with low volatility and low correlation to the equities resulted in REITs outperforming both equities and the bond market over the past business cycle.
Recent market sell-off, particularly spike in the yields, have had their impact on REITs, just like practically on all other asset classes. Most of the fears and analysis was centered around the rising yields, particularly spike in yields, and its negative implications on REITs. The arguments made in defense of the REITs were that investors often view REITs as bond proxies and reduce exposure to them in favor of stocks, while higher rates are often an indication of economic growth – which may help increase real estate demand, drive occupancies higher and improve REIT cash flows.
The relationship between rising yields and REITs is by all means complicated and does not have to be positive. However this relationship is not the cause – it is the effect. The real cause is the bigger picture – where are we in the business cycle curve and how do REITs fare forward looking from that point in the business cycle?
If we believe that we are past the peak and in the late expansion phase of the business cycle, REITs tend to be in mid-range of the relative performance compared with other sectors (chart #1). However, looking forward as markets always do, moving into contraction phase and approaching an eventual recession, REITS significantly underperform and are the worst relative performer compared to other sectors (Chart #2) .
Chart #1 – Annualized sector performance in the late expansion phase of the Business Cycle – Courtesy of Fidelity Investment
Chart #2 – Annualized sector performance in the recession phase of the Business Cycle – Courtesy of Fidelity Investment
Analyzing the long term cycle on a monthly chart (chart #3) of iShares U.S. Real Estate ETF (:NYSE), we are looking at the short term price support and target at around 70 and the longer term support line and target around 60 – both being singled out as strong support lines based on price patterns and Fibonacci retracements. The one and colossal resistance level is at 78, making today’s close at 77.61 the best entry point for a Short.
The main arguments for selling IYR is summarized below:
- The long-term cycle is a very consistent parabolic shape which confirms the top of the cycle.
- The cycle patterns and timing is also very similar to the current (late phase) business cycle.
- Speculative (blue line below in mid-part of Chart #3) and Institutional (purple line below in mid-part of Chart #3) money-flows have been deteriorating and diverging from the price since the start of 2016, suggesting serious and permanent money outflows.
- Momentum has been deteriorating and cycles have moved in negative territory, suggesting weakness and follow-through in price.
Chart #3 – IYR ( iShares U.S. Real Estate ETF ) – Courtesy of TD Ameritrade ThinkorSwim
We are using IYR – ISHARES US REAL ESTATE ETF as a proxy and relatively liquid REIT ETF. The iShares U.S. Real Estate ETF seeks investment results that correspond generally to the price and yield performance of Dow Jones U.S. Real Estate Index.
There are two ways in my view to play this scenario with IYR – simple and complex.
Simple – I am keen buying long terms options LEAPS because of sheer leverage and relatively low long-term volatility, so we can get leveraged benefit of price falling and implied volatility rising – playing the long-term cycle outcome around the 60 price support and target.
- Sell short outright IYR @ 77.36
- Buy IYR LEAPS – Buy Jan-2020 60 Puts @ 1.24 mid-point
Complex – I am keen on buying calendar put spreads because of unusual and large time implied volatility skew (very expensive and high shorter duration implied volatility and relatively cheap and low longer duration implied volatility) – playing the shorter-term bearish/range cycle outcome around the 75 and current price support in near-term and penetration of the 70 price support in the mid-term.
- IYR Options Calendar Spreads – Sell Nov-02-2018 77 puts / Buy Jan-30-2018 77 Puts @ 1.07 mid-point
As the charts (Chart #4, Chart #5) illustrate below, in route to November-02-2018 options expiration, we are somewhat bearish with the price breakeven points between 75 and 79 and 1-standard deviation price range between 74 and 80.5 (now trading @ 77.36) – with only about 14 calendar days to expiration and an option to leave the November-30-2018 77 puts outright long after the November-02-2018 option expiration makes this trade appealing and a high probability of success.
Chart #4 – Risk Profile for IYR Calendar Option Spreads – Sell Nov-02-2018 77 puts / Buy Nov-30-2018 75 Puts @ 0.53 mid-pointdebit – Courtesy of TD Ameritrade ThinkorSwim
Chart #5 – Breakeven points for IYR Calendar Option Spreads – Sell Nov-02-2018 77 puts / Buy Nov-30-2018 77 Puts @ 0.53 mid-point debit – Courtesy of TD Ameritrade ThinkorSwim
Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Yields rising are not the reason for the recent REITs sell-off. The real reason is the fact that we are in the late phase of the business cycle curve.
The longer-term cycle reversal, and shorter-term deterioration of (institutional and speculative) money-flows and momentum are signaling a bear market, or at least continuation of a correction.
There are three preferred bearish trading strategies we are looking at, using IYR as the trading proxy: sell short, buy LEAPS puts and buy calendar spreads.