For more than a decade following the global financial crisis (GFC), low inflation and supportive central banks encouraged investors to eschew diversification and embrace equity risk and leverage.
More recently, investors have been concerned about allocating money to listed real estate in an environment of ‘higher for longer’ interest rates. In fact, real estate has not been this under-owned since the global financial crisis.
We have been arguing for some time, however, that markets are in the midst of a regime change. Recent market volatility brings the point home.
The rate-cutting cycle has begun following the Federal Reserve’s first rate cut in more than four years at its September meeting. The global economy, which has proven far more resilient than most observers predicted, is slowing – the result of two years of aggressive central bank actions.
In this new regime, diversification will be more important, and we believe investors should carry more fixed income, real assets and cash in their portfolios at the expense of equity risk. In particular, we believe the market cycle is turning in favour of listed real estate investment trusts (REITs).
We see three key proof points of a new regime for REITs. First, a regime shift to lower rates is a favourable backdrop for REITs, in our view.
Interest rates – which dictate the financing costs of real estate – are a key driver for asset values and returns. Lower interest rates reduce borrowing costs, enabling REITs to finance acquisitions and developments more cheaply.
Notably, since 1990, listed REITs have had average annualised monthly total returns of 18.9% when growth and yields were down, which is the environment we are entering. By comparison, listed REITs have had average annualised monthly returns of -11.7% when growth was down but yields were up (the environment we’re moving away from).
Additionally, falling rates typically increase the attractiveness of REIT dividend yields, compared with other fixed income and cash-equivalent securities. This dynamic can drive higher demand for REIT shares, pushing up prices and enhancing total returns for investors.
Second, REITs are attractively valued, particularly relative to equities and private real estate. Stocks have outperformed listed REITs for an extended period, but this is a trend we believe is unsustainable. REITs, which have historically traded at an earnings multiple premium to stocks, are currently at a discount. That rarely happens.
As of August 31, US REITs were trading at a -4.4x earnings multiple spread to equities broadly, compared with the historical average of 0.4x. This is a strong forward indicator for listed REITs. While past performance is not an indicator of future results, REITs have returned 19.2%, on average, in the 12-month periods following REIT multiple discounts of this magnitude. (In the same periods, US equities returned an average of 11%.)
Comparisons with private real estate also look favourable. While many have tried to make the case that US private real estate values have bottomed, we believe that private real estate still has further to fall.
Listed markets typically bottom around a year before private real estate. Listed REITs bottomed in late 2023, and we believe private real estate prices will continue adjusting through 2024 and potentially into 2025.
Third, publicly traded REITs are well positioned to go on acquisition offense. The cost of financing on the unsecured bond market is attractive, credit spreads are tight and, as a result, listed REITs are positioned to be net acquirers in this cycle.
Recent capital market activity further demonstrates listed REITs’ strength and ability to deploy capital.
Most notably, the initial public offering of Lineage, the world’s largest operator of cold storage warehouses, highlights the strength of REIT capital markets. Lineage raised $5.1bn, marking the largest public offering of 2024 and the largest REIT IPO ever.
Other capital markets activity also indicates the strength of listed real estate. Publicly traded Equity Residential agreed to purchase a nearly $1bn apartment portfolio from Blackstone, demonstrating the listed markets’ ability to provide liquidity to private assets. Meanwhile, Welltower has gone on a $5bn acquisition hunt, utilising its lower cost of debt to expand its national footprint of senior housing.
The allocation opportunity
We expect allocations to change. Lineage’s IPO is a powerful indicator of the strength and resilience of REITs in today’s market. With strong fundamentals, attractive valuations, and the potential benefits of a rate-cutting environment, REITs present a compelling investment opportunity.
Markets are beginning to price in the REIT regime shift. Listed REITs returned nearly 17% in the third quarter, raising year-to-date returns to 14.2% as of September 30, 2024.
In September, listed REITs outperformed the S&P 500 by 214 basis points and the Nasdaq by 276 basis points. Real estate is the second best sector of the S&P for the third quarter, following utilities.
Jason Yablon is head of listed real estate at Cohen & Steers. The views expressed above should not be taken as investment advice.