ICF: Heavy Exposure To CRE Structural Headwinds, Reversal Difficult To Vision

Investment brief

The U.S. commercial real estate ("CRE") sector has been hit with a firestorm of systematic headwinds over the last 18 months or so. The sector as a whole, including listed equities, REITs, and real estate ETFs has compressed to multi-year lows in terms of public market value. Arguably, the market has done an efficient job at discounting the foreseeable risks involved with the sector, related to the broader macroeconomic picture.

The iShares Cohen & Steers REIT ETF (BATS:ICF) is one such name. The fund has an interesting structure, investing in a diversified suite of REITs, rather than individual listed equities—a fund of funds of sorts. It tracks the Cohen & Steers Realty Majors Index but has a 10.5% 3-year tracking error from its benchmark. The fund's distributions have been lumpy over the years, and it currently pays a 3.25% trailing distribution yield, with $1.77Bn of AUM and an expense ratio of 0.33% of AUM at the time of publication.

Figure 1. ICF long-term price evolution, now testing 200DMA and trading below 50DMA, broke key levels of September '20 and January '19.

After extensive analysis, my judgment is that the broader economics cannot be ignored for ICF and that the probability of a reversal to the upside is highly unlikely in the near future. For investors across all time horizons, the scope for ICF to catch a strong bid at its current levels appears muted, and one must not ignore the travel of the overall market. In that vein, my recommendations across all 3 investment horizons are the following:

Fundamental—

• Short-term (next 12 months)— Neutral — Value is not supported, as 1) multiples remain elevated above adjacent sectors + the broad market, and technical setups are weak. Look to sell rallies and avoid long positioning.
• Medium-term (18 months–3 years)— Neutral — Earnings, FFO + NOI growth heavily dependent on the path of rates, the inflation/rates axis, and emerging trends in the economics of CRE. Avoid allocating on further weakness.
• Long-term (3+ years) — Neutral — Future cap rates, returns on invested capital, and capital flows are difficult to ascertain. That in itself reduces predictability of long-term cash flows. Consider more selective opportunities within more predictable sectors that are finding buyer support in the current business cycle.

Technical—

• Neutral to bearish across all-time horizons. Range trade not supported, potential for additional downsides in next 3–6 months.
• Key levels + price target: Look to $47–$48 for continued range trade, with scope for additional short-term travel to $45.00.

Net-net, aside from the contrarian review required to buy CRE at the moment, investors will be served better elsewhere in my opinion. Rate hold.

Talking points

• Macroeconomic backdrop

Consilient investors will undoubtedly have picked up on the pressures facing CRE in the coming period. A total of $2.6 Trillion in CRE loans are set to mature in the coming 5 years, sparking a large unwinding process of deleveraging and recapitalization. With the paradigm shift in policy rates, this is a significant downside risk.

Figure 2.

Multiple research sources corroborate that office spaces/buildings are to be hurt the most. This is related to (i) the higher rates environment, (ii) the financing structure on these assets, and (iii) changing trends in work 'environments' (a la ' work from home'). Per Goldman Sachs (GS) macro research, office properties have seen added supply on the market, with negative absorption of 54mm sq. ft. in the last 4 quarters.

ICF is diversified across multiple REIT types, with <4% of the fund's exposure weighted to office REITs. This may or may not be a saving grace; nonetheless, these exogenous risks are ubiquitous to the entire CRE sector.

• Financing costs, economic returns are key headwinds

The Fed's hiking cycle has diminished CRE transaction volumes since it began in Q1 '22. Volumes have reduced by 64% YoY and sit at their lowest levels since 2012, at a c.$70Bn quarterly rate, per GS research. The firm notes the "surge in rates and pullback in bank lending following this year’s regional banking crisis has led to substantial stress in US CRE...". It continues:

The CRE market is also a rates-sensitive asset class. Most CRE acquisitions are financed with mortgages, often involving a lump sum payment (“balloon” payments) when the loan matures. A key valuation metric for CRE investors is the “cap rate”—the ratio of a property’s net operating income (NOI) to its sale price. When mortgage rates exceed cap rates, the economics of purchasing CRE becomes challenging, which weighs on transaction volumes and pushes prices lower (and cap rates higher) to adequately compensate investors.

These patterns have started to play out in recent months."

As a result, the spread of US CRE capitalization rates over 10-year yields has compressed to levels seen around the GFC, and the 1980's before that (Figure 3).

Figure 3.

• Next 12 months returns unattractive

Starting multiples to buy ICF today are 26.5x earnings, nearly double the broad universe, and well ahead of FactSet's segment avg. of ~15x. It sells at 2.3x book value with a 7% cash flow yield and 3.1% trailing distribution yield, getting you to 10% in blended cash yield. In my opinion, this isn't enough premium to overcome the broader set of risks. Next 12-month returns are heavily impacted by starting multiples.

Despite this, fund flows into the ETF had been relatively strong across the bulk of '23. But they were equally heavy throughout September and October with the broad selloff in equities.

Figure 4. Money flows into/out of IFC equity, '23

Technical factors for consideration

Both range trade and upside bias appear limited by multiple data points gleaned from the technical studies below.

1. Regarding Momentum

IFC just completed a 5-waves down move with momentum clearly biased to the downside. MACD crossed in July as an early sell signal and has since crossed 2x subsequent to this, whilst trending lower.

Figure 5.

2. Regarding skew + directional bias of price distribution

IFC's price distribution across Q1–Q3 shows multiple data points.

• Observations: Underdeveloped bell curve with high volume node at $54 forming wide ledge. Significant area of low usage between $48—$52, showing the lack of time spent in this region. An inferior ledge is forming at ~$48, which could continue to be formed to match the ledge at $54. In my opinion, it could continue to fill out this ledge at or below $47.00 going forward. Prices have already extended to this level. The high usage area is $54–$58.00s. Markets tend to move from areas of high usage to pockets of low usage. I'd advocate observing where the ledges are being filled (i.e., at and below the $47–$48s) where it could fill the lower-most distribution. I'd also note, the quality of the lower mode (POC) has shown to be a magnet of price in the past month. Distribution is negatively skewed, further supporting the notion of further incremental losses going forward.
• Key levels: Investors should closely monitor the $47–$48 region as a key resistance area forming at the lower ledge. If prices break this level, it would confirm further bearish strength. On the upside, $54 remains the major magnet for any reversal. However, the combination of the negatively skewed distribution, flat momentum, and trend action (discussed later) suggests the path of least resistance is to the downside.
• Actionable strategy: Avoid longs above $54, sell into rallies extending from $45–$54.

Figure 6. High volume node at $54, ledge forming around $47–$48 region.

As confirmation, we have downside targets of $44 on the continued downtrend, which supports the notion IFC could continue to fill around this zone. With unwinding fundamentals + selloffs in the broad indices, this shouldn't be overlooked.

Figure 7.

3. Regarding directional bias of trends

A bullish view is equally unsupported on trends analysis of multiple time frames.

Figure 8. Short-term (60-minute chart, looking to coming days)—

Observations + key levels:

1. Reversal off lows would need to find buyers at $48.20 then $48.80, looking to a retracement to the $49s. That's if we have bottomed here in the short term.
2. Currently testing the marubozu line of last week's large green candle, so if it breaks this mark, this would be remarkable (red line).
3. This would push us into the cloud but the lagging line would need to break $49.00 at least to confirm the signal.
4. Breadth of the cloud is narrowing, but we are still neutral beneath the cloud.

Figure 9. Medium-term (daily chart, looking to the coming weeks)—

Observations:

1. Bullish marubozu engulfing back in July at A still hasn't been retaken. This is around the high-volume node from the market profile.
2. 2x tests of the cloud at B failed after crossing in August, with 2x gaps down at C yet to be retaken either.
3. Bearish cross of baseline on turning line hasn't been reversed either, and we are neutral beneath the cloud.
4. Gap down at point D hasn't been retaken, this is at $49.60. Note the high volume buying in October is unable to send us higher, with high volume selling pushing units lower.

Key levels:

• Gap down at $49 then $50.50, look to $44-$45 with break lower.
• Long-term upside at $53-$54.

Figure 10. Long-term (weekly chart, looking to coming months)—

Observations:

1. Shooting star from February at 1) marked the beginning of downtrend. Range from bearish marubozu candle at 2) wasn't retaken until 3), where it tested the cloud but failed with a reverse hammer and subsequent bearish confirmation.
2. Bullish marubozu line at 4) then captured by bears, with large bearish engulfing in September.
3. Bearish cross of turning line over base line remains in situ as such no change in short-term momentum.
4. Another bearish engulfing candle at 5) with marubozu line of this candle yet to be recaptured.
5. We've now had 2 large volume weeks of selling and 2x doji candles showing the battle bulls have had in capturing the market.
6. Alas, neutral beneath the cloud.

Key levels:

• $49 at the marubozu line of the October engulfing candle is the next key level that needs to be retaken on the bullish side.
• Otherwise, we're looking at a potential selloff to the $45 zone.

Discussion summary

Fundamentals are breaking down in the CRE space leading to an unwinding of the immense capital gains produced over the last decade. ETFs like IFC no longer have the Fed's liquidity/rates support and it certainly shows in the economics of the sector's performance in '22—'23. One cannot overlook these structural, potentially systematic risks. Emerging risks in occupancy are also to be noted. IFC's starting valuations have potentially capped coming 12-month returns as well. Moreover, there is weak technical support to suggest IFC could trade higher over the coming 3-6 months. As a reiteration:

Fundamental bias— Neutral over coming 1–3 years; avoid allocating on further downside,

Technical bias— neutral on all time frames.

In that vein, I rate IFC a hold, eyeing a range of $45–$48 in the coming months.