14 minute read
July 2022Download Report
Despite the prospect of near-term volatility, REITs are well positioned to help mitigate higher interest rates, sticky inflation and challenging economic conditions, in our opinion.
- REITs have historically delivered strong performance following interest-rate increases.
- Listed real estate securities are well positioned to withstand elevated inflation as well as stagflation.
- REITs have solid dividend growth prospects and cash flow growth estimates above their historical average.
Rising yields historically not a challenge for REITs
With supply-chain disruptions and high commodity prices likely to keep inflation elevated for a prolonged period of time, the Fed is expected to continue raising rates at least through 2022. This rising-rate environment is posing significant questions for investors on how to be positioned.
For instance, some investors think they should avoid REITs when interest rates are rising. History shows us differently.
Although sharp increases in interest rates may unsettle markets in the near term, history shows that the direction of the economy and job growth tends to have a greater impact on REIT returns than rising rates do. In other words, the environment that may be pushing the Fed to raise rates is one that can benefit REITs in the form of higher rents while REITs’ characteristics can make them an inflation buffer.
To put REIT performance into perspective, we analyzed the 12 largest one-month increases in the 10-year U.S. Treasury yield dating back to 2000. The data showed that while REITs have underperformed equities in the immediate aftermath of significant yield increases, they have historically outperformed 3, 6 and 12 months after such increases (Exhibit 1).
U.S. REIT performance during and after significant increases in the 10-year Treasury yield(1)(2)
At April 30, 2022. Source: Bloomberg, Morningstar, CNS proprietary system.
Data quoted represents past performance, which is no guarantee of future results. The information presented above does not represent the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance listed above. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin. (1) Rising-yield periods are the 12 largest 1-month increases in the yield of the U.S. 10-Year Treasury since 2000 and through March 30, 2018. These rising-yield periods are 4/10/00-5/8/00; 11/7/01-12/7/01; 10/9/02-10/22/02; 6/13/03-7/15/03; 3/24/044/23/04; 9/15/08-10/14/08; 12/30/08-1/29/09; 5/14/09-6/10/09; 11/11/10-12/10/10; 5/27/13-6/25/13; 11/6/16-12/3/16; and 12/29/17- 2/21/18. Note the most recent meaningful yield increase (greater than 0.50%) has occurred in longer than a 30-day period. Average is calculated as the simple average of relative returns of REITs and equities over the time periods shown. (2) Returns shown during subsequent periods are calculated as an average cumulative return from the ending dates of the 12 rising-yield periods shown above, over the subsequent 3, 6 and 12 months. See page 4 for index associations and additional disclosures.
In the current cycle, inflation remains above trend, growth expectations are slowing and Treasury yields are rising. At the same time, consumer savings remains solid even though off the peak levels of 2021, and unemployment is holding at historically low levels, with more job openings than unemployed people (Exhibit 2).
Within this backdrop, REIT fundamentals, in our opinion, are above trend but decelerating. Though slackening, favorable supply/demand dynamics are supporting healthy estimated earnings growth. Durable and predictable cash flows may provide defensiveness relative to other asset classes.
This environment is one in which we think active management can become more important as demand slackens and financing costs rise, widening the differences between healthy and weak businesses. In a higher rate environment, we believe investors should focus on sectors such as self storage or single-family rentals that will retain pricing power, which can help offset higher financing costs.
Excess savings have risen above pre-COVID savings amounts but are softening with negative real wage growth(1)
U.S. total unemployment is close to its lowest level in 20 years
At May 31, 2022, unless otherwise noted. Source: Bloomberg, Bureau of Economic Analysis, Bureau of Labor Statistics.
There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin.
(1) Excess savings are the difference between total savings and implied level of total savings assuming pre-Covid trend savings rate. Excess savings have risen as savings rates exceeded pre-Covid trend savings rates through most of the pandemic and early recovery. Latest available data is through February 2022.
REITs can be a potential inflation buffer
Even as the Fed and other central banks raises rates to combat rising prices, we believe inflation is likely to remain higher than it was over the last economic cycle.
Listed real estate has distinct characteristics that can help provide a buffer to inflation. For example, sectors with shorter lease durations (such as self storage) have the ability to reset rents promptly as conditions change. In case of slow growth—or even recession—longer inflation-linked rental contracts offer relatively strong and steady income growth potential.
Furthermore, though inflation hurts company profits when costs rise faster than revenues, REITs typically enjoy operating margins of around 60%, reducing the effect of higher costs. In addition, higher costs for land, materials and labor can reduce the potential profits of development, raising the economic barriers to new supply and reducing potential competition for existing properties.
Traditional asset allocations may provide less safety to defend against a prolonged environment of higher inflation than real estate assets, which have historically performed well in elevated inflationary periods (Exhibit 3).
Real estate has historically delivered when inflation is high
Returns during varying periods of inflation (%)(1)
At December 31, 2021. Source: NCREIF, Bureau of Labor Statistics and Cohen & Steers proprietary analysis.
Data quoted represents past performance, which is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend will begin. This chart is for illustrative purposes only and is not intended to represent the returns of any specific security.
(1) Returns represented by simple average returns of apartment, hotel, industrial, office and retail sectors in the NCREIF Property Index (NPI), which is a quarterly, unleveraged composite total return index for U.S. private commercial real estate properties held for investment purposes only. Sectors are based on NCREIF classifications. Inflation is represented by the consumer price index (CPI), which measures changes in the prices paid by urban consumers for a representative basket of goods and services. (2) Low inflation characterized as years when inflation was less than 2.0% (11 periods). (3) Moderate inflation characterized as years when inflation was between 2.0% and 4.5% (25 periods). (4) High inflation characterized as years when inflation was greater than 4.5% (8 periods). See page 4 for index associations and definitions, and additional disclosures.
REITs have the potential to deliver high and growing income
U.S. REITs currently offer dividend yields above those of 10-year Treasuries, global and U.S. stocks, and competitive with yields of global and U.S. bonds (Exhibit 4). Beyond 2022, we expect that dividend growth will remain attractive, thanks to the cash flow-focused nature of REIT business models and their tax advantaged distributions.
What’s more, cash flow growth for U.S. REITs, as measured by funds from operations (FFO), is expected to reach 17% this year and 7.9% in 2023, well above its historical average of 5.6% (Exhibit 4). Cash flow could become increasingly important as the economy transitions into a period of potentially slower growth and higher inflation.
Real estate offers the potential for attractive and growing yields
U.S. REITs’ competitive dividend yields (%)(1)
U.S. REITs cash flow growth estimates (%)(2) are above their historical average
At June 30, 2022. Source: Cohen & Steers, Bloomberg and Citi.
Data quoted represents past performance, which is no guarantee of future results. The information presented above does not represent the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance listed above. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend will begin. There is no guarantee that any market forecast set forth in this presentation will be realized.
(1) Yield-to-maturity used for fixed income indexes. 12-month dividend yield used for equity indexes. (2) Historical cash flow growth shows the weighted average funds from operations (FFO) growth by year of Citi’s REIT universe, which is composed of 160 companies. Data from 2021 onwards is from Cohen & Steers. U.S bonds represented by the ICE BofA Corporate Master Index (Credit quality: A-) tracks the performance of U.S. dollar-denominated investment-grade corporate debt publicly issued in the U.S. domestic market. Global bonds represented by the ICE BofA Global Corporate Index which tracks the performance of investment grade corporate debt publicly issued in the major U.S. domestic and Eurobond markets. Global stocks represented by MSCI World Index. See below for index associations and definitions and additional disclosures.
A strong combination
We believe that while interest rates may continue to rise and inflation may remain elevated in the near future, REITs represent a compelling investment opportunity, particularly given their historical ability to withstand inflation and their potential to deliver solid cash flow and dividend growth. And with economic growth slowing, we believe active management can play an important role in determining which sectors are better positioned to weather any slowdown.
Index Definitions / Important Disclosures
An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes. Index comparisons have limitations as volatility and other characteristics may differ from a particular investment. U.S. bonds: The Bloomberg U.S. Aggregate Bond Index is a broad-based index that measures the investment-grade U.S. dollar-denominated fixed-rate taxable bond market. U.S. REITs: FTSE Nareit All Equity REITs Index contains all tax-qualified REITs with more than 50% of total assets in qualifying real estate assets other than mortgages secured by real property that also meet minimum size and liquidity criteria. U.S. stocks: S&P 500 Index is an unmanaged index of 500 large-capitalization stocks that is frequently used as a general measure of U.S. stock market performance. 10-year U.S. Treasury: The 10-year Treasury note is a debt obligation issued by the United States government that matures in 10 years.
Data quoted represents past performance, which is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated herein will be repeated in the future, and there is no way to predict precisely when such a trend will begin. There is no guarantee that any market forecast made in this document will be realized. The views and opinions presented in this document are as of the date of publication and are subject to change without notice. This material represents an assessment of the market environment at a specific point in time and should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment, and is not
intended to predict or depict performance of any investment. This material is not being provided in a fiduciary capacity and is not intended to recommend any investment policy or investment strategy or to account for the specific objectives or circumstances of any investor. We consider the information to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of appropriateness for investment. Cohen & Steers does not provide investment, tax or legal advice. Please consult with your investment, tax or legal professional regarding your individual circumstances prior to investing.
Risks of investing in real estate securities. Risks of investing in real estate securities are similar to those associated with direct investments in real estate, including falling property values due to increasing vacancies or declining rents resulting from economic, legal, political or technological developments, lack of liquidity, limited diversification and sensitivity to certain economic factors such as interest-rate changes and market recessions. Foreign securities involve special risks, including currency fluctuations, lower liquidity, political and economic uncertainties, and differences in accounting standards. Some international securities may represent small- and medium-sized companies, which may be more susceptible to price volatility and may be less liquid than larger companies. No representation or warranty is made as to the efficacy of any particular strategy or fund or the actual returns that may be achieved.
Cohen & Steers Capital Management, Inc. (Cohen & Steers) is a U.S.-registered investment advisory firm that provides investment management services to corporate retirement, public and union retirement plans, endowments, foundations and mutual funds. Cohen & Steers U.S. registered open-end funds are distributed by Cohen & Steers Securities, LLC, and are available only to U.S. residents.