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The Market Outlook for REITs

by internationalbanker

By Valerie Hernandez, International Banker


Despite the economic chaos inflicted by the COVID-19 pandemic since early 2020, the US real-estate market has proven to be among the most resilient. With buyers keen to capitalise on rock-bottom mortgage rates and housing inventory remaining decidedly tight, prices skyrocketed throughout 2021 and have continued to do so this year. And as the pandemic cooled and businesses opened, office utilisation levels were again on the up. Such bullishness helped real estate investment trusts (REITs) outperform last year. But will they continue to do so in 2022?

A REIT is a legal entity, such as a publicly-traded company, that pools funds to invest in income-generating commercial real estate and was created to replicate mutual funds closely. The REIT typically owns or manages the real estate—such as residential buildings, offices, shopping malls, hospitals and hotels, as well as infrastructure, including fibre cables and energy pipelines—and allows investors to access the dividends generated from the properties without having to buy or operate them themselves. The United States easily accounts for the biggest REIT market, with the National Association of Real Estate Investment Trusts (NAREIT) calculating that REITs in the country collectively own more than $3.5 trillion in gross assets across the country and that US-listed REITs have an equity-market capitalisation of more than $1.6 trillion.

Although REITs suffered early on during the pandemic, along with nearly every other financial market, REIT share prices recovered solidly, as US real estate remained resilient in the face of the economic downturn. And as the wider economy recovered in the final quarter of 2021 as vaccines were rolled out across the country, REITs continued to outperform equity benchmarks. The low interest-rate environment over the last couple of years has also supported REIT market strength by making borrowing for property acquisition more appealing, as well as attracting more investors to the high dividends typically offered by REITs.

According to real-estate firm Jones Lang LaSalle’s (JLL’s) “Capital Markets M&A and Strategic Transactions Monitor” report published in March 2022, 2021 was one of the best years for REITs, as the sector generated a total return of 43 percent and traded at an average premium of 11 percent to net asset value. This was crucial in driving REIT M&A (mergers and acquisitions) volume to $140 billion for 2021, marking it as one of the strongest years on record.

What about this year? Can REITs continue to outperform to the same degree as in 2021? The outlook remains decidedly uncertain. From an economic perspective, 2022 is experiencing an ongoing recovery in gross domestic product (GDP) and employment growth. In the US, job growth averaged 562,000 per month during the first quarter of the year, according to figures from the U.S. Bureau of Labor Statistics (BLS). That said, clear headwinds have emerged this year that may constrain REIT performance, including accelerating inflation, which has now reached 40-year highs; rising interest rates; and geopolitical concerns over the ongoing military conflict in Eastern Europe, all of which cloud the outlook for equity markets.

“While early, this year-to-date has seen broader markets down significantly, as persistently high inflation, an ensuing Fed rate hike and broader geopolitical risks have dominated headlines,” Steve Hentschel, JLL Capital Markets’ head of the M&A and Corporate Advisory Group, noted. “Despite the recent S&P and REIT performance, fundamentals support positive longer-term outlook for REITs, as the vast majority have consistently surpassed their Wall Street research analyst consensus quarterly FFO [fund from operations] estimates over 2021. REITs also posted strong NOI [net operating income] growth and occupancy increases throughout 2021.”

And as several countries around the world have demonstrated in recent weeks, the threat from COVID-19 is far from over. The possibility of new variants of the virus surfacing means that new waves of infection continue to weigh on the global economic outlook, although with increasing vaccination rates and natural immunity gained from prior infections, the overall impact may not be as dramatic.

But despite such potential challenges, a recent analysis from investment research firm CFRA (Center for Financial Research and Analysis) suggests that real-estate stocks can offer a highly suitable hedge against the accelerating inflation that has surfaced this year. REITs are “a strong inflation hedge, with sub-industries that issue short-term leases able to adjust quickly to rising prices,” wrote CFRA’s chief equity strategist, Sam Stovall. REITs can also benefit from price increases for rents and higher real-estate values during hotter inflationary periods, Stovall also noted, although REIT stocks have been volatile this year with US Treasury yields having climbed on the back of investor expectations of further interest-rate hikes to curb inflation. “This volatility has been further amplified recently with the yield curve inversion signalling an increasing likelihood of a recession in 2022 or 2023.”

There has also been growth in commercial real-estate market liquidity. According to Sheheryar Hafeez, managing director of JLL Capital Markets, there is “an increasing sense of urgency among large investors to deploy capital efficiently, especially considering a more uncertain medium-term outlook than at the start of 2022”. Writing in the commercial real-estate publication Commercial Property Executive, Mr. Hafeez also noted the strong appetite for large portfolio deals. “Though interest rates are not expected to reach harmful levels yet, volatility may impact the timing of deals. Improving fundaments and rising net operating income, however, should limit major real estate price declines,” he added.

NAREIT stated that it expects commercial real estate to perform particularly well this year. “Consumers have demonstrated that they still appreciate in-store shopping for certain items, even as they prefer the convenience of online purchases for others. In particular, shoppers often want to check the size and fit and appearance for clothing, shoes, and other fashion items, or they may simply enjoy visiting shops and seeing the displays as a break from mouse-clicks online,” NAREIT wrote in its outlook for 2022. “This consumer preference for ‘more of both’ will likely boost the recovery of the brick-and-mortar retail sector in 2022, and also support the continuing long-term growth of REIT sectors that support the digital economy, including industrial/logistics, data centers, and infrastructure/communications towers.” Whether the longer-term transition toward e-commerce will threaten retail REIT performance anytime soon remains to be seen, however.

Office markets should also keep strengthening as employees continue their return to work on onsite premises rather than from home. NAREIT noted that recent new leases signed by major technology companies confirm that office space remains vital for businesses. That said, greater emphasis should be placed on whether these post-COVID work trends will cause a major decline in the overall office space assigned per worker. “The outlook for office REITs is likely to be uncertain until it becomes clear whether there will be an enduring shift toward remote working—although the recent trend appears to be for most workers to eventually return to the office,” mid-April analysis from Charles Schwab noted. “Nevertheless, increases in office building inventories are likely to weigh on lease prices and potentially property valuations.”

For those wishing to invest in a REIT, one can purchase shares in a REIT trading on a stock exchange, similar to a public stock. Alternatively, investors may look to shares in a REIT mutual fund or exchange-traded fund (ETF), which can offer exposure to several REITs in various property sectors. The Nuveen Short-Term REIT ETF, for instance, seeks to track the performance of the Dow Jones U.S. Select Short-Term REIT Index, which in turn comprises US REITs in property sectors that typically have relatively short-term lease durations.

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