Having historically delivered competitive returns, steady income and a low correlation to other assets classes, a period of rate hikes in 2022 and 2023 has been anything but straightforward for real estate investment trusts (Reits) across the globe.
In their simplest form, Reits are a geared play on interest rates. If longer-term bond yields fall, they should do well, while a return of inflation (and bond yields rising) means they will struggle. Rising rates were clearly a headwind on performance for the asset class for the past couple of years (2022-2023), with higher interest rates meaning a higher cost of borrowing for Reits. During that time, global equities returned almost 8% to investors, while the global Reit market fell 12.5%.
However, it should be noted that during this challenging period many Reits continued to show strong fundamentals. As a research note from Fidelity points out: “Commercial real estate supply-and-demand dynamics remained generally favourable in 2023. Moreover, in most parts of the real estate market, Reits’ balance sheets remained well positioned to weather the market environment.”
But the clouds have begun to clear as peak rates have passed, with the majority of the developed world’s central banks now beginning to cut rates. Historical research shows that over the 12 months when a real estate cycle begins to move from trough to recovery, listed real estate securities tend to outperform equities and private real estate. This is because of the correlation between bond yields and real estate valuations.
Cohen & Steers head of listed real estate Jason Yablon says the prospect of falling rates and lower discount rates provides meaningful tailwinds for global Reits. With lower interest rates reducing borrowing costs for Reits, it will enable them to finance acquisitions and developments, supporting asset values.
Yablon cites the fact that since 1990, listed Reits have had average annualised monthly total returns of 18.9% when growth and yields were down. By comparison, listed Reits have had average annualised monthly returns of -11.7% when growth was down but yields were up. Yablon also believes Reits are attractively valued relative to both equities and private real estate. Reits were trading at a -5.8x earning multiple spread to equities at the end of June, compared with an historical average of 0.5x – this has typically been a strong forward indicator for listed Reits.
Euan Anderson, investment director, real assets at abrdn, says Reits are also starting to benefit from a cost of capital advantage relative to the private real estate market, with many having strong balance sheets to raise capital and growth through acquisitions.
He says: “Backed by a stronger financial footing, and buoyed by attractive fundamentals, many Reits have been able to deploy capital at the bottom of the cycle. This has allowed them to grow externally through acquisitions and to benefit from above-market growth. This provides Reits with a distinct competitive advantage versus private-market peers who tend to rely on bank lending which remains challenging to source.”
I also want to touch on some of the longer-term trends impacting the Reit market, many of which are transformative to the sector. For example, the rise of e-commerce and the growing need for industrial and logistic properties (such as data centres). There are also thematic Reits with significant growth potential, such as healthcare, as well as the growing adoption of proptech (property technology) to improve operational efficiency, tenant management and data reviews.
Marcus Phayre-Mudge, who manages the TR Property Trust - which invests in Reits plus shares and securities of property companies and property-related businesses – says his portfolio is currently geared at around 15% (it can go up to 20%), indicating his optimism.
He says: “It comes back to the triple whammy of benefits to the sector. The cost of money is coming down and margins are shrinking. You have to pick very carefully, but the market fundamentals are there and there’s also been a lack of development, meaning we are buying real estate at below rebuild costs, while the equity market is offering us shares in companies at well below rebuild costs.
“The third leg is it’s not just us doing it – private equity will return and that will underpin values in the equity market. We hope to make money either from that consolidation or from companies that are taken private.”
There are caveats investors have to consider. For example, some Reits have greater exposure to the economy, such as offices, industrial warehouses and retail. If rates are cut due to a poor economy, these Reits may struggle as tenants have issues paying rent. As a result, we prefer less cyclical areas of the Reit market, like GP surgeries and supermarkets.
Reits have been badly beaten up after years of struggles when the wider stock market has been reaching new highs. But they now look attractively valued, with high yields and big discounts still on offer, amid an improving macro backdrop.
In addition to the TR Property Trust, investors may also want to consider the CT European Real Estate Securities fund (also managed by Phayre-Mudge) or the Cohen & Steers Global Real Estate Securities fund, a one-stop shop for Reits which is backed by a huge team of analysts covering a universe of around 400 different Reits. Those wanting some Reit exposure via a multi-asset fund might consider the VT Momentum Diversified Income fund, which has the likes of the AEW UK Reit and the PRS Reit among its holdings.
Darius McDermott is managing director at Chelsea Financial Services and FundCalibre. The views expressed above should not be taken as investment advice.