Signs Point to Opportunities in Global Real Estate

Few market sectors have suffered as much from steep interest rate hikes as real estate.

Publicly listed real estate investment trusts (REITs) performed relatively well in 2021 as the fog of the COVID-19 pandemic started to dissipate. But inflation triggered a swift series of rate hikes — the Federal Reserve (Fed) increased rates 11 times in 17 months, beginning in March 2022 — that shocked the REIT market.

REITs started 2024 down 1% for the first quarter, with returns slightly positive for the trailing three- and five-year periods. That’s a far cry from the long-term returns of 8% and 13% produced during the 10- and 15-year periods, respectively.

We’ve spotted conditions in the market that point to REITs potentially outperforming from this point forward:

• Strong fundamentals and attractive valuations.

• Stabilization of interest rates.

• Supply and demand imbalances.

Real Estate Fundamentals and Attractive Valuations

Global REITs have traded relative to general equities at levels unseen since the Great Financial Crisis (GFC). This time, REITs are enjoying strong balance sheets and underlying fundamentals. In addition, Figure 1 shows that interest rates have pressured real estate’s relative multiples to GFC levels with wide discounts to equities and private markets.

History has shown REITs outperformed after periods of trading at extreme discounts. Also, publicly listed REITs were up 18% in the fourth quarter of 2023 compared to private REITs, which were down 4.8%. We believe public REITs had priced in a recession while private REITs were slow to mark down their assets. See Figures 2 and 3.

REITs offer an attractive yield and could grow dividends, creating a compelling total return for investors.

There has also been an uptick in mergers and acquisitions in the real estate market, which supports the notion of relatively cheap valuations in publicly listed REITs. Blackstone agreed to buy multifamily REIT AIR Communities for $10 billion, representing a 25% premium to its share price when the deal was announced in April. Blackstone also announced in January that it will take Canadian residential REIT Tricon private in a deal valued at $3.5 billion. We think these types of deals will continue as investors spot steep discounts for listed REITs.

Impact of Stabilizing Interest Rates on REITs

Interest rate increases generally don’t favor real estate. From 2022 to 2023, several short-term interest rate hikes were by far the biggest headwinds to listed REITs.

While we believe the Fed stopped increasing rates last year, inflation has proved more challenging to tame to the Fed’s liking. Even with the likelihood of rate cuts being pushed out until late 2024 or even 2025, we still believe that the total returns for REITs are poised to improve.

We developed our view from examining 30 years of data showing that listed REITs returned an average of 23.42% over the 12 months following the peak of an interest rate cycle, compared to just 10.27% for the S&P 500^® Index. See Figure 4.

We saw this play out recently as the U.S. 10-year Treasury declines benefited real estate stocks during the fourth quarter of 2023. The 10-year Treasury peaked at 4.99% on October 19, 2023, and fell to 3.89% by the end of the year. Real estate stocks performed well during this time. Rates shot back up to 4.65% earlier this year, creating a headache for real estate. Still, we think moderation in inflation and interest rates should help global REITs. While stabilizing interest rates should provide a catalyst for listed REITs, the asset class isn’t simply relying on Fed rate cuts.

Real Estate Supply and Demand Dynamics

Several economic conditions, some brought on by interest rates and inflation, have diminished new real estate development. Banks and lenders are less willing to extend debt for real estate projects on terms developers and builders would like if they’re extending debt. Labor and material costs have also increased, leading to fewer construction starts across asset classes and geographic locations.

The confluence of these factors has constrained real estate supply. However, it has also created opportunities in certain sectors. Take data centers, for example. Pinched supply chains, cost inflation and lack of available power have slowed the development of new data centers. The lack of supply, set against the extraordinary excitement and investment in artificial intelligence, has resulted in strong pricing power for data center REITs.

A similar situation has played out in residential real estate. Homebuilders have been slow to add new supply to certain markets, leading to higher home prices. When coupled with elevated mortgage rates, this has caused families to rent single-family homes for the space and convenience they provide compared to multifamily housing.

Construction starts, in aggregate, are down 30% from their peak in 2022. In addition, aggregate construction starts as a percent of total inventory now below long-term averages. We believe this fundamentally plants the seed for increased pricing power, all else equal.

This has created a favorable dynamic for REITs that own single-family homes, particularly in suburban markets.

REITs Outlook: Identifying Investment Opportunities

We are looking to other sectors with strong pricing power, including data centers and single-family housing. These include senior living facilities, class-A shopping malls and lodging.

Senior living has bounced back from pandemic-related challenges.

Strong demand has been met with a significant decline in supply, leading to significantly higher pricing power, returns on invested capital and earnings potential.

Hardly any new supply of class-A shopping malls has come online in recent years, resulting in existing locations producing higher occupancy levels and rent rates for owners. Shopping mall fundamentals are also supported by high employment, increasing personal net worth for consumers and online retailers expanding to store formats.

Like senior housing and malls, demand for hotels has been strong as the worst effects of the pandemic have lifted. Business travel has resumed, and revenge spending has continued while very little new supply has opened. One exception is resorts, where we think supply will grow and upper price points will be relatively modest over the next two years.

We have found attractive lodging opportunities in Japan, where continued negative real rates have supported higher asset values across several property types for property companies. We also believe management teams have improved their corporate governance by focusing more on investment returns.

The pandemic and subsequent efforts by central banks to shore up economies worldwide have been particularly challenging for real estate. However, we believe a shift in the market could ultimately benefit listed REITs as 2024 progresses.