Publicly-traded REITs had a rough go of things during the Fed’s regime of rising interest rates. Total returns on the FTSE Nareit All Equity index were down 24.95% in 2022 and in negative territory for most of 2023. But when the tenor on monetary policy changed, REITs rebounded and ended 2023 with the index up 11.36%. REITs still trailed the broader equity market, with the S&P 500 up 26.3%.
The trend started to reverse in late 2023, with the REITs posting a 17.9% return for the fourth quarter. And it will likely continue in 2024 as multiple factors converge to create a favorable environment for the sector, according to REIT fund managers. But as of Dec. 29, publicly-traded equity REITs were trading at a median 10.7% discount to their consensus NAV per share, according to S&P Global Market Intelligence, indicating further room for recovery.
“It’s the interest rate stabilization piece, it is the attractive valuation piece and it’s the fact that we will see growth in this sector, especially in those sectors that are more defensively postured or have strong secular growth underpinning their demand,” said Laurel Durkay, managing director and head of global listed real estate assets with Morgan Stanley Investment Management.
As the global asset management firm Nuveen completed its investment outlook for 2024, “the REIT sector was one of our top picks,” noted Saira Malik, chief investment officer with the firm.
Solid Fundamentals
When it comes to portfolio fundamentals—occupancy levels, rental income growth, debt ratios—many publicly-traded REITs were already in a healthy place in 2023, according to an outlook published last month by Steve Buller and Sam Ward, real estate investment portfolio managers with Fidelity. Yet all the news headlines about a “crisis in commercial real estate,” driven largely by troubles in the office sector, made investors nervous about putting their money into REITs.
“An issue with REITs has been, in a sense, that the baby has been thrown out with the bath water,” said Malik. “Many are worried about the office sector and so people feel, ‘Why do I want to own anything associated with real estate, public or private?’ But if you look at REIT benchmarks, the office sector tends to be less than 5% of benchmarks.”
When it comes to issues that might threaten the performance of U.S. commercial real estate—which include concerns about liquidity, a slow investment sales market, the higher cost of capital and a potential recession—publicly-traded REIT shares already have those factors priced in, noted Richard Hill, senior vice president and head of real estate strategy and research with Cohen & Steers, a global investment manager specializing in real assets.
“You now have a situation in which real estate securities are very attractively valued,” said Durkay. “REITs are screening cheap vs. themselves and vs. private real estate.”
That creates an attractive entry point for investors, especially since public REITs tend to deliver their highest returns during early stages of the real estate recovery cycle, said Hill—sometimes hitting above the 20% mark, according to previous Cohen & Steers research. In spite of REITs’ fourth quarter rally, their total returns remain approximately 16% below previous peaks, Hill noted. Cohen & Steers estimates that if the Fed manages to achieve a soft landing for the U.S. economy this year, the sector will deliver returns in the 10% to 13% range. AEW Capital Management forecasts total REIT returns of approximately 25% over the next two years, which also roughly translates to low double digits in 2024, according to Gina Szymanski, managing director and portfolio manager, real estate securities group for North America, with the firm. That’s based on a current dividend yield of 4% and growth of 6%. The forecast will rise if the Fed ends up cutting interest rates later this year, as it indicated it might during its December meeting.
Typically, REITs deliver returns that are between those of a bond and an equity—somewhere in between 4% and 10%, Szymanski noted. “I would say we are on the higher end of what a REIT usually does for our outlook this year,” she said. “And then that would increase even more if we had a [Fed] pivot.”
Good Omens
At the moment, most of the investment managers WealthManagement.com spoke to consider the probability of an interest rate cut at the Fed’s March meeting to be low since the U.S. economy continues to show resilience. What they do anticipate is rate stabilization in the first half of the year, followed by some moderate rate cuts later in 2024—likely three or four of them as the Fed will attempt to keep real rates stable, according to Malik. Both rate pauses and rate cuts tend to create a favorable environment for publicly-traded REITs, Szymanski noted. Interest rate stability limits volatility of REIT valuations, while lower cost of debt would allow REITs to take advantage of new acquisition opportunities at the same time as private market prices come down. (Hill estimates that private real estate valuations are about 50% of the way through to where they will ultimately end up). That is how similar situations played out during the early 2000s and in the aftermath of the Great Financial Crisis, from 2010 through 2014, Hill noted.
Even a recession would not necessarily disrupt the positive outlook for publicly-traded REITs, in his view. In that scenario, while REITs would deliver returns that would be close to 0, “we think they would outperform the S&P 500 significantly on a relative basis,” he noted.
In addition, while a recession would put a dent in REITs’ property fundamentals, it would also force the Fed to cut interest rates faster, said Szymanski. “So, you kind of come right back to a positive outlook.”
Winners and Losers
Of course, the REIT industry has more than a dozen property sub-sectors and financial advisors should keep in mind that not all of them will do well even in a favorable environment. Factors to consider include whether leasing and rental rates for the types of properties a REIT owns are likely to experience steady, long-term growth and whether demand for these properties is currently outstripping supply.
Data center REITs, for example, seem to be on every investment manager’s recommendation list because growth in new technologies is likely to fuel greater demand for data centers for years. At the same time, issues with power availability previously limited the amount of new supply that could be added to that market. That means REITs will not only have opportunities to grow their portfolios by adding new data centers going forward—they will be able to aggressively push rental rates for the first time “in a decade,” noted Durkay.
Seniors housing REITs were another popular pick due to favorable demographic trends. The youngest baby boomers are reaching an age when many people begin to move into seniors housing and the deliveries of supply to the sector had been significantly curtailed in the wake of the Covid pandemic. In addition, seniors housing has grown more upscale in recent years, with “more activities, more amenities. It is making them more attractive for people at earlier ages,” according to Malik.
REITs that own and operate single-family rentals (SFR) should benefit from a shortage of single-family homes for sale, higher mortgage rates and the run-up in prices for those homes. Today, buying a home is almost 50% more expensive than renting one, Durkay noted, which should drive demand for SFR units well past 2024.
A sector that is poised to benefit greatly from interest rate cuts are net lease REITs, according to both Hill and Durkay. Total returns within the sector tend to be highly negatively correlated with increases in interest rates, Durkay noted. Given that most net lease REIT portfolios tend to be almost fully occupied and rely on credit-rated tenants, interest rate cuts would allow for strong return growth going forward.
The near-term outlook is less favorable for two sectors that have been investor favorites over the past few years—apartment and industrial REITs. While both property sectors will continue to benefit from long-term demand drivers, this year new supply deliveries are so far outpacing demand. For the industrial sector, in particular, potential short-term underperformance would have more to do with overly exuberant growth expectations than any property-level challenges, according to Hill. “If growth turns out to be really good, just not great, then we think the multiple can be pressured,” he noted.
In addition, in spite of their recent rally (total returns were up 19.6% in December), office REITs continue to flash warning signs to investment managers. There is the issue of lingering vacancies and the fact that office utilization rates remain at roughly 50% of their pre-pandemic levels, noted Durkay. There is concern that the same advancements in technology that will prop up data centers will make remote work easier. Plus, office REITs might also run into problems with their loans as valuations in the sector drop.
“When you are looking at office demand, I think it is going to be negative, that will impair the overall level of occupancy, it will impair the overall level of rents and what that ultimately does is impair the overall value of this real estate,” said Durkay. “When loans are coming due, you will see in a lot of cases the value of the debt will be in excess of the value of the that property. It is not only a demand problem, a fundamentals problem, I also believe it is a balance sheet and value problem. So, the outlook that I have for offices specifically in the U.S. is not favorable over the long term.”
