Global REITs - As the cycle turns, opportunities abound
Article10 mins18 April 2024
Every cycle has a life of its own. Only in hindsight do we see a pattern. After many years of falling interest rates, the sudden and rapid rise that began in early 2022 felt ground-breaking and unique.
We are now in the interregnum, or transition period, a place where inflation is abating but rates have yet to fall. Whether rising rates—the first upheaval—are matched in their import by the second—if and when they fall—remains to be seen. Either way, real estate investment trust (REIT) investors may eventually come to view this period as just another (accelerated) cycle.
In the meantime, the share prices of select global REITs appear to inhabit the old world and are yet to anticipate the new. This transition period of market re-calibration is the opportunity where history has often shown that investments made at such point often prove fortuitous over the long term.
As persistent inflation shows signs of moderating, the recent interest rate tightening cycle that appeared so threatening is likely to turn from headwind to tailwind. Two years ago, developed market central bankers set out to tame the post-pandemic inflation with the brute force of interest rate increases. It was the singular theme driving returns across the global REIT sector.
It is likely to be so again, in the opposite direction. Recent macroeconomic data suggests that while the pathway forward may have some bumps, inflation’s direction is likely to be down:
Monthly annualised run-rate of global headline inflation
Of course, there are local variations, with Australia a case in point. In December 2022, inflation was running at 7.8%. A year later, that figure had fallen to 4.1%, still well above the Reserve Bank’s target range. The corresponding figures for the United States were 6.45% and 3.35%.
Across the globe inflation is falling. Perhaps it was transitory after all. Evidence of moderating price pressures and sustained falls in the rate of inflation is what “data-dependant” central banks have been waiting for.
By association, so have investors in commercial real estate. The announcement last December by the Federal Open Markets Committee that it expected a total 75 basis point cut to rates in 2024 suggests the tightening cycle is now over. The question now is “when” rates will fall rather than “if”.
The answer has substantial implications for the global REIT sector. As the interest rate cycle moves past its peak, finance costs will moderate as will excess inflationary-era expense cost growth in real estate operations, taxation and insurance segments.
This is a likely to lead to a greater focus by global REIT investors on fundamental operating performance in the underlying portfolios. This is our bid to help you prepare by looking at the current market through three different but connected lenses.
1. Solid operating fundamentals
Operating fundamentals remain firm across most commercial real estate sectors. Tenant demand is robust and market rents are generally either stable or growing. Together with annual rent indexation in leases, there is further support for top-line revenue growth. As cost pressures subside, bottom line earnings and distribution growth in the medium term should also be favourable.
Operating fundamentals were one of the most encouraging features of the recent half-year reporting period (see Five key takeaways). As rates start to fall, we’d expect them to improve further.
2. Constrained supply
Whilst demand is holding up in commercial real estate, supply is seriously constrained and is likely to drop precipitously towards 2025. This is the delayed impact of higher rates, which over the last few years have made capital for development more expensive and constrained supply.
New commercial developments have long lead times, which is a boon for incumbent owners. The scarcity of future supply within select sectors should benefit existing asset owners in the medium and longer term.
3. Increasing transaction activity
As real estate fundamentals remain robust and the cost of capital either remains stable or falls, we expect direct and corporate transaction activity to increase. Those REITs able to play offence will use their existing platforms and the relatively attractive cost of capital to invest in future growth. These are the ones to watch.
As for corporate and direct market transaction activity, it’s showing signs of thawing. While activity levels vary across sub-sectors—office, for example, is struggling to attract capital and a closing of the bid-ask spread—industrial and logistics and retail have experienced greater capital formation. As the cost of capital stabilises, transactions should increase.
What this means for REIT investors
From their trough in October 2023, global REITs delivered a respectable total return of 12%1. This wasn’t enough to outperform global equities, which delivered 20% over the same period. The performance difference between global REITs and equities is even more stark from the start of 2023 to the current period; global equities have outperformed REITs by a significant 31%. This disparity is unlikely to last. We believe a reversal in interest rate policy will be the trigger for change.
In the meantime, selected REITs are trading at discounts to fair value. Market observers got a taste of what can happen to prices towards the end of 2023 when central bank commentary moved away from hawkish messaging. The result was a surging REIT sector to finish off the year.
The impact of falling rates is likely to be equally powerful, if not more so. This is the time to get set beforehand. As an active manager, we are currently capitalising on the discounts implied by select AREIT share prices compared to our assessment of fair value and believe long-term investors will benefit accordingly.
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