Rogier Quirijns
There is a popular investor assumption that REITs, like other yield-based assets, underperform wider equity markets in periods of interest rate increases. However, this is largely a myth.
REITs have a two-fold relationship with rates: firstly, as REITs are required to distribute 90% of earnings as dividends, these companies often need to raise capital from markets to grow.
Secondly, as income assets, REITs actively compete with bonds for investor capital. As rates go up, cost of capital increases and bonds typically display higher yields – supposedly compounding the challenge for the REITs market.
Since the Federal Reserve first raised rates in 2016, global real estate securities have lagged the broader global equity markets by around 9% – seemingly reinforcing this underperformance assumption.
However, this is an historic anomaly. In previous rate rise cycles, such as in the US between 2004 and 2006 – when the Federal Reserve raised its benchmark rate 17 times against a backdrop of an accelerating economy and strong job growth – US REITs returned 99.3% compared to just 34.7% for the S&P 500.
As long as real estate fundamentals are improving, these returns highlight the ability of REITs to perform even if rates are rising. As for the recent underperformance of global REITS, we believe this has largely been driven by sentiment and misconception around rates rather than economic reality.
The fundamentals surrounding real estate remain compelling, in our view. With demand continuing to outpace supply – and as rates move higher on improving economic fundamentals – this dynamic is unlikely to reverse.
This should provide significant pricing power for landlords, counteracting the impact of higher rates. We believe that the upside of the recent underperformance in REITs is a meaningful relative value opportunity for investors in real estate.
Global REITs are currently trading on a PE of 17.9x, a five-year low for the asset class – while global equities are trading on a PE of 21x, a five-year high. A similar story is evident in the US, where REITs are trading on a PE of 18.2x, while equities are at 23x. However, we think investors must be selective with this opportunity – economics and valuations differ between regions. For example, US REITs are trading at a 6% premium.
However, the US is at an advanced stage in its economic cycle, with slower growth than the global average and a faster expected rate hike path. At the same time, REITs within the index in Australia, the UK and Japan are trading at discounts of between 6% and 9%, while these economies are on a lower-for-longer interest rate stance.
Within our global REITs portfolio, our US allocation is line with the index, but we are overweight Europe. In the UK, we are attracted to niche areas, such as industrials, student accommodation and healthcare.
We are also overweight Germany, which is enjoying strong economic, population and job growth – thanks to a vibrant exports sector and attractive migration policies.
Rogier Quirijns is a senior vice president and portfolio manager at Cohen & Steers
