Recent market events add conviction to the argument that favourable entry points are emerging for REITs
Late last year, we wrote a report arguing an attractive entry point was emerging for real estate investment trusts (REITs). Recent market developments have added further conviction to this view, with four key factors underscoring our analysis.
First, commercial real estate fundamentals look to be on a strong footing; and, second, recessions tend to create strong entry points for REITs, with historical returns on a next-12-month basis of greater than 10%. That said, the best entry points for REITs tend to come early-cycle, when next-12-month REIT returns have historically been greater than 20%.
Third, we look to be transitioning from a stagflationary environment to a stagnationary environment, which has historically been much more accommodative for REITs. And, finally, the US Federal Reserve’s medicine is beginning to work. With inflation backing off, the Fed should stop hiking interest rates sooner rather than later. This is typically a very good environment for REITs – in fact, they have historically produced returns above 15% over the six months following the end of a Fed hiking cycle.
Leading private-market indicator
There are additional market developments that are important to understand. First and foremost, we have long argued that listed REITs are a leading indicator for the private market. What has played out over the past two quarters is in line with this view – listed REITs were up for both the last quarter of 2022 and the first three months of this year – while the NCREIF ODCE benchmark, which is a widely followed index of open-ended mutual funds that own core assets, was actually down over the same periods.
Over those two quarters, listed REITs outperformed the NCREIF ODCE index by more than 10 percentage points. This is noteworthy as it is unusual for REITs to rise two quarters straight while the NCREIF ODCE index declines. Still, it is not just the timing of the ODCE index decline that is significant – it is also the magnitude. The 4Q22 return of around -5% was the fifth-greatest quarterly decline since 1978. The return in 1Q23 of around -3% was the eighth-greatest decline since 1978.
Our analysis of the previous 10 largest declines in the NCREIF ODCE index shows that REITs have never been down on a next-12-month basis – they have been up anywhere from 15% to more than 100%. While it is not reasonable to expect returns in the higher end of this range, we do believe this is a strong market signal that we may be at an attractive entry point for REITs.
Nevertheless, investors may be wondering: if this is such an attractive environment, why are REITs underperforming the S&P 500? For one thing, the recent banking headlines will have created concerns that are weighing on REITs. In particular, there is now increased focus on tightening lending conditions – especially in the office sector. Contrary to common misconception, however, office exposure within listed REITs is only around 3.5% of the index’s market cap.
Further, there is a view that commercial real estate is a highly levered asset class yet, in the case of REITs, this simply is not true. On average, REITs have less than 35% loan-to-value ratios, and loans are 86% fixed (for an average term of around six years). These attributes, which appear not to be well understood among the general investor population, may help insulate REITs against looming market pressures.
Given continued healthy REIT fundamentals and our view of recent market developments, historical precedent points to the possibility of a strong rebound for the asset class – lending further conviction to the assessment that 2023 may offer a favourable entry point for the sector.
Richard Hill is head of real estate strategy & research at Cohen & Steers