Think Small to Bet On Big Trends

The building recovery in residential REITs is still invisible from 30,000 feet up.

First, I’d like to wish everyone a very happy Memorial Day weekend. The holiday is a great opportunity to relax with family and friends—as well as honor Americans who put their lives on the line for freedom, a cause infinitely bigger than all of us.

In contrast, investing is like your health—not a big picture cause but a game best played by focusing on what’s in front of you. You can make a lot of money by betting correctly on big picture trends. But chances are you won’t notice them until it’s too late, unless you keep your feet on the ground.

What I’m talking about is focusing on what the private sector and specifically leading individual companies are actually doing—rather general statements of government officials, professional economists and media personalities who always want to give you their view from 30,000 feet up.

I fully realize that’s not what the talking heads say on investment television and other popular media. And the big marketing machines like Blackrock and Vanguard continue to suck in trillions of dollars precisely by telling people not to make their own decisions, or heaven forbid consult investment professionals.

Had a look at your very limited options in a typical pension plan or 529 college savings plan lately? It’s no exaggeration to say only the most intrepid (or stubborn) will even bother trying to make a move anymore. Rather, most opt for so-called “Target” funds, which only require you to decide what year you want to reach your investment goal.

The theory behind Target funds is they automatically shift your money from “riskier” to “safer” investments as their target date approaches, which means basically between exchange-traded funds the fund company sponsors. For example, Vanguard’s Target funds allocate between Vanguard ETFs, so Vanguard gets to keep all the money. The shifts between ETFs are managed algorithms. So is the composition of the ETFs, so firms like Vanguard don’t have to pay anyone but the IT Department.

The problem, of course, is that markets change. And such automated systems are always last to notice. In the case of the Target funds, bonds have been considered “safer” than stocks. So as Target dates approach, portfolios shift more into bonds. And that’s created big losses at precisely the wrong time for Target funds with dates in the 2020s.

Bottom line: Target funds are fatally flawed. And so are all investment options where investors don’t have control of—or in the case of most ETFs—even know what their money is invested in. The obvious solution is to take control, first by finding out what you actually own and then by doing something about it.

It should be clear to anyone who’s been reading this column that I’m a staunch advocate of picking your own stocks. And after several decades of cutthroat competition to reduce fees and commissions, I can say with assurance it’s literally never been easier or cheaper to do that, if you’re willing to spend even an hour a month of your time.

And here’s another reason to pick your own stocks: Digging into what the companies you own are actually doing is the best way to identify investment trends in progress.

Fewer people than ever consult trusted advisors, let alone do their own stock research. Even the rapidly shrinking ranks of Wall Street professionals tend to focus on just a handful of companies.

That means if you look hard enough you can identify ongoing trends in progress, well before they’re all over the popular investment media. In fact, I’ll wager pretty much all of us have discovered one way or the other that by the time Jim Cramer or some other personality starts talking about a trend or opportunity, it’s pretty much run its course.

Let me give you an example of a yet to be acknowledged trend in progress: The ongoing recovery of residential real estate investment trusts. Since the beginning of 2022, the MSCI US Residential REIT Index (RMSRD) has lost more than -30 percent of its value and the S&P 500 Residential REITs Index (S5RERE) is off -25 percent including dividends.

One reason is the Federal Reserve’s upward push on interest rates, which has hurt the REIT sector three main ways. First, raising borrowing costs has forced REITs to pull the plug on multiple development projects as well as acquisitions. Second, higher interest rates have squeezed profits by raising the cost of borrowings used to fund previous development and acquisitions, other than what’s under long-term mortgages. And third, higher debt service costs have eroded tenants’ ability to stay current on rents, raising default and vacancy rates.

Residential REITs’ share prices have languished under an additional burden: The widely held belief that a flood of new residential housing supply in 2024 will severely depress rents and occupancy, especially in the Sunbelt.

Sounds like a good reason to avoid residential REITs, if not REITs entirely. But since the largest residential REITs started reporting Q1 results and updating guidance in mid-April, the S&P Residential REIT Index is up nearly 10 percent. That’s nearly three times the return on iShares US Real Estate ETF (IYR), which holds a broad basket of US REITs. And it’s even twice the return on the S&P 500, which has lately gotten a big boost from resurgent artificial intelligence stocks.

One month does not a long-term trend make. But in this case, as I highlighted to readers of my REIT Sheet advisory last week, residential REITs’ recent outperformance really does look like just the beginning. The reason: The view from 30,000 feet up that a flood of new supply is about to wash out residential REITs is not confirmed on the ground.

Don’t just take it from me. AvalonBay Communities (NYSE: AVB) CEO Benjamin Schall has already meaningfully increased 2024 guidance, which he credits to being “able to build occupancy earlier than expected.” He says the REIT’s “suburban coastal” regions are seeing “significantly less supply.” And while he believes the Sunbelt faces “pressure on rents and occupancy (that) would last through the end of 2025, if not into 2026,” AvalonBay is starting to commit significant capital to the region, a tacit acknowledgement that the worst is over even there.

Also consider what Mid-America Apartment Communities (NYSE: MAA) CEO H. Eric Bolton had to say at his REIT’s Q1 earnings call: “Leasing conditions will remain pressured by new supply deliveries through the year,” but also the REIT will be able to “absorb the new supply in a steady manner that will enable continued stable occupancy, strong renewable pricing, strong collections and overall revenue results that are aligned with the outlook that we provided in prior guidance.”

CEOs are paid to promote their companies. But that also means not setting guidance they can’t deliver on. So here’s the view from the ground: The residential REIT business still faces challenges, but the trajectory has clearly turned upwards. And that means the bottom for sector stocks was almost certainly last October. Bottom line: It’s time to place your bets if you haven’t yet.