Increased volatility has swept across major asset classes in recent weeks and this means more opportunities for active investors. The CBOE Volatility Index (VIX) was recently trading above 20, at the high-end of its 52-week range. In addition to a sell-off in stocks, there have also been major gyrations in bonds, commodities, and currencies. In particular, precious metals have plunged and interest rates have been rising sharply.
Making the atmosphere even more attractive for nimble investors is the fact that trading volumes and market liquidity are up substantially as large institutions react to news that the Federal Reserve is likely to begin tapering its quantitative easing program at the September FOMC meeting. It would seem that the market is in the midst of a major shift, particularly on the interest rate front. As the Fed prepares to exit the Treasury market by the middle of next year, the long-term cycle of lower interest rates is coming to an end.
Rising rates could trigger further sell-off in REITs
As this potentially seismic market shift unfolds, investors should consider looking for short opportunities in the REIT sector, which has historically moved inversely to interest rates. Over the last month alone, both the SPDR Dow Jones REIT ETF and Vanguard REIT ETF are down around 12%. Among the individual names that investors are betting against are DDR Corp (NYSE:DDR), EPR Properties (NYSE:EPR), Digital Realty Trust, Inc. (NYSE:DLR) and National Retail Properties, Inc. (NYSE:NNN).
All of these REITs currently have short interests above 10% and are in steep near-term downtrends. The potential for more panic selling in these names is high as downside momentum in the bond market continues to accelerate, pushing interest rates upward. Higher rates increase the cost of financing for Real Estate Investment Trusts, which pay out most of their earnings as dividends. As a result, the largest cash cost for most REITs is interest expense. Also, rising rates make fixed income investments more attractive relative to alternatives such as REITs — hence the recent heavy selling in the sector.
“This sector is going to woefully underperform in a rising rate environment,” Jonathan Pong, an analyst at Robert W. Baird & Co. in New York, said in a Bloomberg interview. “History proves that out.” Greg Guttenplan, a REIT analyst at CreditSights Inc., told Bloomberg that “relative value is gone” for the asset class. “There’s really not much more room to run for the REIT sector,” he added.
Operational metrics remain weak at DDR
Among the least favored names is DDR Corp (NYSE:DDR), a $5 billion shopping center REIT. Despite the dire outlook for the sector, DDR Corp (NYSE:DDR) was still positive on the year as of Monday, June 24, having gained around 2%. Nevertheless, the shares had fallen almost 15% in the last month alone and more than 16% of its float had been sold short. Despite the recent losses, DDR is still yielding a relatively paltry 3.40%, suggesting that there is more room for downside. Consider, for example that the 10-Year Note is currently yielding 2.54% and the 30-Year Treasury Bond is yielding 3.56%.
This company was devastated in the wake of the financial crisis and DDR Corp (NYSE:DDR) has never fully recovered. In 2007, the shares traded above $60, which compares to a current price in the mid-teens. Although the REIT has only missed one dividend payment over the last 5 years, its payout has fallen substantially from pre-crash levels. In 2008, the REIT’s quarterly dividend payment was $0.69 versus $0.14 in the most recent quarter.
Investors should also be very concerned about DDR Corp (NYSE:DDR)’s lack of profitability. The company has posted net losses for five consecutive fiscal years. While revenue has risen for the last three years, the gains have been very modest. On a positive note, analysts are estimating that funds from operations (FFO) will be positive in both fiscal 2013 and 2014, but it remains unclear if DDR Corp (NYSE:DDR) will be able to successfully navigate a rising interest rate landscape given its historical operational weakness.
Cyclical exposure could weigh on Entertainment Properties
Another name that is in plunge-mode is Entertainment Properties Trust. Investors piled into this REIT for much of 2013, but now they cannot get out fast enough. A little more than a month ago Entertainment Properties was trading above $60.00 as yield hungry investors snapped up shares. While EPR Properties (NYSE:EPR) was still up around 3% on the year, it has lost roughly 16% over the last month, pushing its yield well over 6%. Investors continue to bet against the company, with around 11% of its float sold short. Earlier this month, analysts at KeyBanc downgraded EPR Properties (NYSE:EPR) from Hold to Underweight.
Unlike DDR, Entertainment Properties Trust’s operational metrics are relatively healthy, although one concern may be that net margins have been flat to down over the last several years. For fiscal 2013, FFO is expected to grow around 11% on a roughly 14% increase in revenue. Analysts anticipate that this will be followed by a better than 5% gain in FFO in fiscal 2014 along with a 11.40% bump in revenue.
In addition to the headwinds created by rising interest rates, Entertainment Properties may be vulnerable to a downturn in the economy. The majority of the REIT’s properties (around 76%) consist of mega-plex theatres and entertainment recreation centers. As a result, EPR Properties (NYSE:EPR)’s tenants are exposed to cyclical changes in the economy and consumer spending patterns. In a recession, these tenants could experience financial difficulties which would in turn weigh on EPR Properties (NYSE:EPR)’s business.
Hedge fund says short Digital Realty
Digital Realty Trust, Inc. (NYSE:DLR) is one of the most heavily shorted names in the sector, with around 21% of its float sold short. Investors have been doing very well betting against Digital Realty Trust, Inc. (NYSE:DLR), which has lost almost 15% so far in 2013. The REIT is focused on data centers. As such, DLR is exposed to capital expenditure trends in the technology industry as well as interest rate risk.