Commentary: Entry points for listed REITs are emerging

With the Federal Reserve slowing the pace of interest rate hikes and non-traded REITs limiting redemptions, investors are interested in future listed and private real estate market performance.

Despite a significant sell-off in listed REITs in 2022, real estate fundamentals remain strong, and we view this as an attractive entry point for the asset class.

Historically, REITs have performed well in the environment we anticipate: when both growth and real yields are down; the end of the rate hiking cycle; and the transition to an early cycle environment as the economy covers from a recession.

Investors have priced in a negative, forward-looking view of listed real estate. Slowing growth and higher inflation created a stagflationary backdrop that's especially challenging for REITs. The result was a significant performance disparity between listed and private real estate in 2022.

REITs, as measured by the FTSE Nareit All Equity REITs index, were down 27.9% through the third quarter 2022 and -24.9% through December. In contrast, the NCREIF ODCE index, a quarterly measure of private real estate, was up 7.5% in 2022.

While these return metrics are anticipated, the gap is unlikely to persist as listed real estate is a leading indicator for private valuations. Indeed, private real estate returns are beginning to slow. The NCREIF ODCE index posted fourth quarter 2022 total returns of -4.97%, its biggest quarterly decline since 2009 and the fifth greatest since 1978. This follows the 0.5% gain in the third quarter of 2022, representing a deceleration from its 7.4% return in the first quarter and a 4.8% return in the second quarter. Listed REITs, on the other hand, were up 4.1% in the fourth quarter of 2022 and up 10.1% last month, one of the best starts to the year since 1995. Bottom line, at the end of January 2023, listed REITs stood more than 21% above their 2022 lows just as private valuations are just starting to reset lower.

This is a key reason why non-traded REITs, or NTRs, have been in the news lately; investors are rebalancing their private real estate holdings, leading NTRs to limit redemptions. By understanding this lead versus lag relationship, investors can tactically allocate at different times across the two asset classes.

We advise investors to have strategic allocations to both private and listed real estate throughout the market cycle. This isn't an either/or proposition. Yet, current market conditions make the case for overweighting listed REITs for three reasons.

First, listed REITs have priced in a worse recession than we expect. Real estate fundamentals are historically strong as supply vs. demand is tight, evidenced by high occupancy rates. We anticipate a deceleration in REIT earnings given a possible recession, but we expect REIT cash flows to be resilient, particularly compared to other asset classes.

Second, listed real estate historically outperforms in the more supportive inflationary backdrop we see on the horizon. That backdrop is when the end of the rate-hiking cycle occurs and when both real yields and growth are down.

Third, while the best returns of 20% or more have been earned during the early cycle, the market still generated 10.8% forward average 12-month returns following recessions from January 1990 to December 2021. And for this cycle we believe we have likely already experienced most of this recessionary decline for listed REITs.

One risk to our base case, however, is the possibility that the Fed overshoots, choosing to err on the side of continuing more aggressive rate hikes as it seeks to win back credibility amid criticism it was slow to react to inflation. If that were to happen, it would push back the end of the rate-hiking cycle and the magnitude of the slowdown could be worse.

When it comes to sectors we favor, we prefer those with shorter lease durations and strong pricing power, as landlords may reset rents and offset higher financing costs; these include sectors such as single family for rent and self-storage.

We also believe companies that provide information and logistics infrastructure, especially data centers and industrial warehouses, may continue to benefit from strong secular demand in the shift toward an "e-everything" economy.

In a reversal of the retail apocalypse we've observed for the last few years, regional malls and shopping centers reported strong leasing trends in November. Companies expect positive net store openings in 2023 despite the challenging macro backdrop, which is supported by healthy consumers and a growing preference for "buy online, pick-up in store."

REITs, in our view, are well-positioned to have a strong 2023 and already are off to a promising start. We believe investors can enter the market at attractive valuations relative to private market valuations; for instance, listed REITs were valued at a 5.8% implied cap rate at the end of 2022 compared to a 3.9% applied cap rate for the NCREIF ODCE index. As such, investors have the opportunity to potentially reap strong returns historically associated with investing in REITs in the early cycle.

Rich Hill is head of real estate strategy and research at Cohen & Steers Capital Management Inc., based in New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.