Don’t Abandon REITs
Investor appetite for REITs has declined with the COVID-19 pandemic and unlike the broader stock market, the asset class has yet to approach pre-COVID levels. While various sectors of the real estate industry face divergent outlooks, it is worth remembering the evolution of REITs and the long-term benefits of having them in a diversified portfolio. Among US REITs, certain sectors/sub-sectors look poised to benefit from a recovery. From a portfolio perspective, real estate offers meaningful diversification and income generation benefits with US REITs tending to play a “hybrid” role between equities and bonds.
In the first half of 2020 and most significantly in March and April, the negative effects of the global pandemic began to manifest within the real estate industry. In the first quarter, US Real Estate Investment Trusts (REITs) declined by 28% although in the following period they rebounded by 10.8%. The retail, hospitality and food services industries especially remained under extreme duress as lockdowns resulted in the closure of many businesses and rising unemployment and social distancing guidelines dented demand. As many small businesses have put up the shutters for good and a good number of them have closed down temporarily, investors have rightly become concerned about rent and mortgage payments. This combined with an ever-growing shift in consumer demand from traditional brick-and-mortar stores to online shopping has raised pertinent questions regarding the nature of cash flows and dividends for US REITs in 2020 and beyond.
Opportunities Within a Shifting Landscape
By the second quarter of 2020, policy makers responded with massive, broad-based fiscal and monetary stimulus to support affected workers and businesses in record time. Economic data for May showed that these interventions helped mitigate the negative effects of the steep economic decline. This proved to be beneficial for US REITs as well with many sectors recording gains and the severely affected ones, such as regional malls and shopping centers, coming off their lows.
Among sectors, Industrials appears to have weathered the crisis better than others and continues to benefit from the economic recovery and the rise in e-commerce. Although office space and apartments have been affected, companies are continuing to adjust their operational needs and renters are expected to continue to seek out places to live as the disruption passes.
From a historical perspective, REITs could be considered as much more diversified today than ten years ago. Also, evolution wise, what we choose to call here as “focused” REITs (cell towers, data/distribution centers and eldercare facilities)1 along with the Residential, Industrial and Diversified sectors have expanded at the expense of the Retail, Office and Hotel & Resort sectors. This also means that the broad array of companies now available as part of REITs generates a more diversified stream of income for investors than before (Figure 1).
Going forward, investors may be inclined to favor US REITs that have quality properties – those that are designated as prime and are geographically desirable. The industry is optimistic about its future with the Real Estate Roundtable’s Future Conditions Index increasing at a record spread relative to the Current Conditions Index. Additionally, supply should continue to decline over the course of 2020 even as demand should pick up slowly as the American Institute of Architects’ indices have only just begun to rebound from their spring lows.
Fundamental Characteristics of Real Estate
One of the fundamental characteristics of REITs is the diversification benefit that it offers in the context of a total portfolio. Over the past 10 years, the US REITs to equities correlation has maintained its historical levels, hitting a nadir in 2015 relative to equities. At the same time, the correlation of REITs to US corporate bonds has increased, while its correlation to US government bonds has declined (Figure 2).
In comparison to the recessionary period of 2007-2009, US REITs’ balance sheets are stronger and less leveraged now, thereby better positioning themselves to potentially deliver stable future earnings growth. As the economy further reopens, demand across sectors should increase, too, leading to improved cash flows and payments.
US REITs are also required to distribute much of their taxable income as dividends, which is an attractive option for investors looking for periodic incomes. Furthermore, due to the substantial current sell-off, there may be areas of sectoral opportunities among REITs. For instance, many US REITs are now trading below their net asset value and certain undervalued properties have upside potential not least in terms of merger and acquisition activities post the pandemic crisis (Figure 3).
With the current low interest rate environment projected to continue into 2022, US REITs may outperform investment grade bonds as well, which should further improve their potential in terms of portfolio diversification. It should be noted that US REITs do not necessarily sell-off when interest rates rise as the correlation to the US 10-year Treasury yield going back to 1988 is 0.10.
REITs that are more sensitive to growth tend to favor modestly rising rates, reflecting prospects of a robust economy, while income-dependent REITs may thrive in lower-rate environments. Also, in a lower-interest regime, the divided streams from REITs have higher value.
Closing Thoughts
The incorporation of US REITs in a total portfolio provides investors with core exposure to a wide range of commercial and industrial real estate properties. This hybrid asset’s potential diversification benefits, income yields and growth prospects may shine brighter as capital markets exit the lows reached in March 2020 and the economy continues to recover from the global pandemic.
Appendix
Institutional investors use US REITs to gain exposure to the broad commercial and industrial property marketplace. Most US REITs own and operate income-producing real estate properties and structures and are characterized as hybrid assets on account of their equity and bond like features.
The basic legal structure of US REITs could provide stable current income to investors as they are required to distribute at least 90% of their taxable net income to shareholders. In addition, US REITs participate in long-term growth internally through occupancy and rent increases, tenant upgrades and redevelopment of existing properties and externally through accretive acquisitions, ground-up development and joint-ventures or fund management investments.
They are considered as highly liquid and transparent investment vehicles and are actively managed by experienced and professional management teams. REITs are diverse with exposures spanning across multiple sub-sectors, ranging from traditional office, industrial, healthcare and residential sectors to retail, hotels and specialized segments such as self-storage, data centers, and cell phone towers.
The author would like to acknowledge the contributions made by Katherine Winson to the article.