In mid-March, the longest bull market was ended by the sudden outbreak of COVID-19 causing many investors to shift their focus from earnings and risk to balance sheets and safety.

In the very beginnings of the COVID-19 period almost all assets classes and their constituents suffered synchronized drawdowns with the S&P 500, at one point, registering a loss of as much as 30%.

Then, in a couple of weeks’ time, the optimism started to prevail again and in June 8, 2020, the S&P 500 reached a positive YTD return level despite the profound demand shock associated with the strict social distancing measures.

Starting from June 9, 2020, the S&P 500 is down ca. 7.5%. As of now, the economic prospects seem insufficient to justify the further rally in the stock market. Let me give you a couple of short arguments, which, in my opinion, should make you consider defense over offense.

  • The risk of a second wave of COVID-19 (or a severe continuation of the first one) has the potential to force many companies to file for chapter 11 and initiate drastic cost-cutting measures. All this comes with gigantic spillover effects on the overall economy affecting supply chains, investments and consumption.
  • As it can already be seen now, the Fed as well as the Treasury have been pumping loads of liquidity into the system in an attempt to stop the bleeding and reverse the economy back on track as quickly as possible. As a consequence of such actions, the “ammo/reserves are becoming increasingly depleted.” Put differently, each incremental move in the underlying stimulus will experience diminishing outcomes (i.e. become less effective) and weaken the stimulus toolset for any subsequent crisis.
  • The unlimited QE, lowered rates and increased fiscal spending are the perfect pre-requisites for an elevated inflation. Lately, there has been a lot of chatter among the economists about the potential effects on the inflation levels stemming from the enormous amounts of stimulus. If that happens, then depending on the magnitude most of the fixed income instruments and stocks will suffer.
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In my opinion, investors, especially who have a short-time horizon or rely heavily on the investment portfolio to cover essential expenses, should avoid excessive risk-taking in the context of the current economic prospects and where the market is trading at.

The U.S. equity REITs address this issue in providing a safety while also offering more attractive yield than that of Treasuries as well as exposure to steady capital appreciation in the long term.

Source: Ycharts

Looking at the chart above, you might think: “REITs are riskier than the average stock and fall more steeply during market turmoils.”

This is not true, if you exclude the riskiest basket of REITs from the broader REIT indices. If you exclude retail and hotels from your REIT index, you will arrive at significantly higher returns, which, depending how you weight it, have outperformed the S&P 500.

In total retail and hotels account for just over 30% of the total number of publicly traded U.S. equity REITs. Since the GFC and COVID-19 these two sectors have been a huge bottleneck not allowing the broader REIT indices to rise above the S&P 500.

Investors who seek safety and predictable cash flows, should seriously consider avoiding retail and hotels; or at least make sure that the corresponding exposure is not too big.

The following three characteristics are the most vital in terms of safety and protected wealth that make REITs an attractive bet during these market conditions.

Inflation protected REITs

Majority of the REITs have included periodical (usually yearly) rent escalators that tie the level of increases to the overall inflation levels in the economy.

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Given that in many cases REITs carry a notable level of fixed debt, the potential combination of rising rents and unchanged debt service can really set the REIT investors apart from most other investors. The level of inflation pass-through rate for your usual industrial, consumer discretionary or staple company is usually below 1, meaning that there is an underlying stickiness of the previous prices.

So, if you think that there is a reasonable probability of experiencing elevated inflation levels in the economy, REITs with inflation-linked contracts and fixed debt can provide that extra alpha.

Long duration and stable cash flows

The notion of REITs having long contracts and thus relatively stable/predictable cash flows has, on the surface, not played out during this downturn. If this were true, the VNQ should be trading higher or at least close to the S&P 500 levels.

However, as indicated above, you have to sort the sheep from the goats here. Hotels and retail have not only been the most suffering sectors due to the social distancing measures, but also their rent structures are nowhere close to those of other REIT sectors.

The lion’s share of a hotel REIT income is derived from room bookings that are not fixed and for which there is no guaranteed rent provided. For retail a large chunk of the income is associated with the PSF development. Retail landlords tend to stipulate base rents that are fixed and have to be serviced irrespective of the tenant’s sales. Then, the landlords introduce a variable part, which is closely linked to the tenant’s sales performance. The latter part carries much higher risk and is way more unpredictable than the base rent.

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In order to warrant safety in the portfolio, the ex-retail/hotel REIT universe should be considered. This might take away your upside potential in the case of a sharp recovery, but, most importantly, the downside should be somewhat floored.

Balance sheets filled with ample liquidity reserves

During these times, when the sudden demand shock has reduced incomes and caused serious cash burns, it is extremely important to possess access to liquidity and healthy balance sheets.

Most of the REITs have truly restructured their balance sheets since the Great Financial Crisis, and currently have very healthy levels of debt. If you look beyond retail and hotels, you will notice that the liquidity is not a problem for REITs. Even some retail names have accessed loads of it – e.g., Simon Property Group (SPG) and Realty Income (O).

The fact that during the post-GFC, REITs have gone through a massive delivering phase allows REIT investors to not worry about the potential solvency risk. The whole notion of REITs having stronger financials to weather this storm is magnified by the lower interest rate environment, which contributes to even lower debt service costs from the already low debt base.

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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.