Revisiting REITs

Bottom line up top:

• U.S. public REITs have taken their share of lumps in 2022, lagging both their private-market counterparts and most broad U.S. equity indexes.?Like other asset classes, REITs have been laid low this year amid white-hot inflation that has the Federal Reserve pursuing an aggressively hawkish rate hike cycle. REITs have typically fared well in rising rate environments, but a combination of factors has conspired with the unprecedented Fed backdrop to thwart this advantage: lofty valuations following last year’s record return for the asset class (+41%), a relative high correlation to broader equity markets and growing fears of a recession. The result: REITS are down nearly 28% as of 30 September, as measured by the FTSE Nareit All Equity REITs Index — on pace for their worst calendar year return since 2008.
• Industrial, mall and office REITs (three of the four core property sectors in commercial real estate) have suffered some of this year’s biggest declines,?substantially underperforming the FTSE Nareit All Equity REITs Index as a whole (Figure 1). Apartment REITs, the fourth core property type, bucked the trend by finishing slightly ahead of the index. Demand for apartments remained elevated, translating into strong rental rates and occupancy throughout the year.
• REIT returns have declined far more than the market value of private commercial properties themselves,?as depicted in Figure 1. But supported by continued strength in their underlying fundamentals and fairly wide discounts to net asset values, we see compelling upside to several REIT property sectors once investors are confident that inflation has been tamed and the current rate hike cycle is complete.

Portfolio considerations

It might be time to consider taking some real estate allocations public.?Both public and private real estate investments have provided healthy returns during past rate hike cycles. While public REITS have tended to do better while rates are going up, private real estate has outperformed in the 12-month periods immediately following the end of those cycles (Figure 2). This year, private real estate looks poised to repeat its history of strength in rising rate environments. Meanwhile, the historic decline in publicly listed REITs in 2022 so far could position the asset class for a brighter post-hiking future. Investors who believe we’re closer to the end of the rate hike cycle may find public REITS an area worth examining for future real estate allocations.?

We don’t recommend buying sight unseen.?While value may be found in several REITs sectors, we don’t expect all property types (or individual REIT companies) to recover equally. Increases in real estate stock prices over time are tied to the growth in their earnings, as well as the value of the underlying real estate owned by the REIT. This means an emphasis on selectivity is paramount.?In our view,?investors may be best served by seeking out high-quality, well-capitalized REITs with superior assets located in supply constrained markets.?These assets tend to benefit from lower construction rates, higher occupancy rates and high barriers to entry. On a sector basis, as with their private counterparts,?we currently favor publicly traded REITs in the apartment and industrials sectors,?thanks in large part to strong absorption rates and historically low vacancy levels in both sectors.?The retail property sector may present a compelling opportunity?as well, as store openings have outpaced closings for the first time in several years, due in part to a notable shift in consumer preference for brick-and-mortar retail in the post-pandemic environment.

For further reading, click here.