Morgan Stanley trigger PLUS on Real Estate Select Sector SPDR offer ‘reasonable’ terms

By Emma Trincal

New York, Feb. 24 – Morgan Stanley Finance LLC’s upcoming 0% trigger PLUS due March 7, 2028 linked to the Real Estate Select Sector SPDR fund offer exposure to real estate assets under attractive terms given its cap level and downside protection amount, advisers said.

If the ETF return is positive, the payout at maturity will be par plus 200% of the fund’s gain up to a maximum return of 250%, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the index return is negative but ends at or above the 70% trigger and will lose 1% for every 1% decline if it ends below the trigger level.

Fund of REITs

The underlying fund replicates the performance of the Real Estate Select Sector index, which consists of S&P 500 companies that are directly involved in real estate activities. The stocks are real estate investment rrusts (REITs) whose main purpose is to generate and distribute income by owning and renting real estate. The fund excludes mortgage REITs, which do not own real estate.

“This is a reasonable investment in this environment,” said Joe Solan, managing partner at 4Sight Advisors LLC.

The share price of the Real Estate Select Sector SPDR closed at 38.13 on Friday, or 25% off its April high.

“Can it go down another 30% on top of that in five years? It’s possible but unlikely.”

Mortgage rates trend

One stumbling block for investors in REITs or real estate assets has been the rise of mortgage rates, which may add thousands of dollars to the monthly cost of homeownership. But Solan’s view remained optimistic.

“Mortgage rates have dropped since the Fed decreased the magnitude of its rate hikes from 50 basis points to 25 bps,” he said.

The Federal Open Market Committee raised the Federal Funds rate by 25 bps during its Jan. 31-Feb.1 meeting, its first 25 bps increase since it began raising rates in March. In between, the Fed has raised the rates by 75 bps four times and by 50 bps twice.

The current 30-year fixed mortgage rate is at 6.88%.

“It’s creeping back up, but it’s considerably below the 7.5% level it was at last fall,” he said.

“Obviously higher mortgage rates are putting pressure on the REITs market. A lot of that depends on what the Fed does,” he said.

One positive factor, he noted, was a relatively low inventory in the residential market.

“It helps keep prices fairly high,” he said.

“The low supply doesn’t entirely offset the high mortgage rates factor, but it tampers its negative impact.”

Call spread

The notes offered attractive terms on the upside.

“The issuer was able to price the relatively appealing cap because people expect real estate to go up modestly if it goes up at all,” he said.

“That significantly lowers the cost of the call options, which you need to buy in order to price the upside leverage.”

Investors are long at-the-money calls and short 250% out-of-the money calls. The at-the-money call strike is the equivalent of the underlying’s initial price. The 250% strike is the cap level. The selling of the calls helps finance the long call position. This setup is known as a “call spread.” If the cost of the calls is lower and with some premium collected from writing the calls, issuers have more pricing power.

“The call spread represents the cost of pricing the upside,” he said.

High dividend

For some investors, giving up the dividend payments in a long-dated note can be a deal breaker. It’s especially true with high-yielding underlying assets such as REITs.

The Real Estate Select Sector SPDR ETF yields 3.16%. Over the five-year period, investors give up the equivalent of approximately 16%.

Solan did not believe such opportunity cost would be a deterrent.

“Most people investing in this note would not be concerned by this. You’re doing it for the price appreciation. You’re willing to give up the dividend,” he said.

Diversification benefit

“The upside is attractive if you want to put money in real estate,” he concluded.

Solan said his firm does allocate to real estate within a stand-alone bucket.

“We do have exposure to this asset class. We like it as a diversification tool. We diversify across equities, short-term bonds, real estate and commodities.”

Overall, Solan said the notes “made sense” for investors seeking exposure to real estate.

“You’re probably not likely to go down 30% and you have five years to go up, which should be enough time for the Fed to stop raising rates and for the market and the economy to recover,” he said.

Bullish cap

Steve Doucette, financial adviser with Proctor Financial, also had a favorable view on the note and its structure.

“You typically should have some real estate and REITs as part of your asset allocation. We used to. Right now, we don’t. It wasn’t doing its job,” he said.

“That said, it’s an interesting deal. The terms are good and so is the share price. You’re probably getting a good entry point.”

The cap was appropriately priced given the growth potential of the underlying for the period.

“Real estate is usually up over long periods of time. It’s an asset class that has historically done very well,” he said.

“If you’re capped out at 250% over five years you still get a more than decent rate of return.”

The 250% maximum return over five years is the equivalent of a compounded return of 28.5% per year.

“This cap is pretty bullish. It gives you a lot of upside,” he said.

Some risks

The notes however involved some risks, such as the rise in interest rates, he said.

“It can add up to your monthly bill when mortgage rates go up that much. So that’s definitely something to consider,” he said.

Timing the market cycle can also be a challenge.

“The catch here is you tend to see real estate move within 15-year cycles. And we hit a peak last year. So, after five years, we may be in a downturn,” he said.

“Another thing to look at is what type of REITs are we investing in? Warehouse REITs are fine. But office buildings are not that exciting. Since Covid, people are working from home much more than before. Even with the reopening, many offices are now vacant.”

“As always, you have to know what you’re getting into. You’ve got to do some research.”

Overall, Doucette had a favorable opinion on the product.

“I think demand is only going up and supply remains limited; so, over the long-term, you should be doing well. This is a pretty nice note,” he said.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes will price on March 2 and settle on March 7.

The Cusip number is 61774TS37.

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