The Real Estate Reel: What’s actually driving listed REIT returns

Let’s take a closer look at real rates, credit spreads as well as net operating income growth, and quarterly changes in private commercial real estate valuations. Or, in other words, critical drivers of listed REIT returns.

First, we think real rates, which are interest rates adjusted for inflation, are driving listed REITs performance so far this year.

Year-to-date total returns for listed REITs stand at -4.3% through the end of May 2024. It’s the only sector of the S&P 500 that’s down this year, but REITs are still up almost 20% from their trough that occurred in October of 2023.

At the same time, real rates have risen 52 basis points since the end of 2023 to around 2.2%.

And there is a strong directional correlation between year-over-year total returns for listed REITs and real rates over the first five months of this year (Exhibit 1).

The rise in real rates is a function of the market now pricing in one to two interest rate cuts this year compared to seven to eight at the end of last year given sticky inflation.

At May 31, 2024. Source: Bloomberg, Cohen & Steers. U.S. REITs represented by FTSE NAREIT All Equity REITs Total Return Index.
Data quoted represents past performance, which is no guarantee of future results.

We think the market has become preoccupied with the timing and magnitude of interest rate cuts. Listed REITs are more than just a play on interest rates, especially over the medium to long term.

Instead of just a short-term focus on rate cuts, I’m watching investment grade corporate credit spreads and net operating income growth.

In contrast to real rates, investment grade corporate credit spreads are 13 basis points tighter year-to-date. REIT debt spreads are 26 basis points tighter over the same period.

This is important because it indicates that listed REITs have access to cheaper sources of debt than the broader commercial real estate market.

Listed REITs should be able to take advantage of acquisition opportunities given their favorable access to cheaper financing.

Indeed, there has been almost $13 billion of REIT senior unsecured bond issuance in the first quarter of 2024, which is more than $51 billion annualized.

This compares to average annual issuance from 2010 to 2023 of almost $37 billion, ranging from a minimum of almost $13 billion in 2022 to a maximum of over $73 billion in 2020.

At March 31, 2024. Source: Bloomberg. 2024 projection based on annualized results from 1/1/24-3/31/24.

It’s also worth noting that fewer banks are tightening lending standards for commercial real estate, as indicated by the Senior Loan Officer Opinion Survey just published by the Federal Reserve for the first quarter of 2024.

Under 30% of banks tightened CRE lending standards last quarter compared to almost 41% the prior quarter and a peak of approximately 68% of banks tightening in the second quarter of 2023. We think this is a signal that the worst might be behind the CRE market, which may be a tailwind for listed REIT valuations.

Meanwhile, net operating income growth remains above the historical average of 2.5% to 3%. Typically, you’d expect negative NOI growth when CRE valuations are under pressure like they are today.

We think there are two primary reasons why net operating income growth remains on solid footing.

First, there’s been relatively muted supply of new properties, absent a few sectors like multifamily. This is evidenced by vacancy rates remaining well below historical averages (Exhibit 3).

At March 31, 2024. Source: NCREIF, Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results.

Second, we think listed REITs have become less cyclical over the past two decades as subsectors like data centers, cell towers, single-family rentals and seniors housing have become more prominent.

Finally, we’ve long argued that listed REITs are a leading indicator for private CRE valuations in both downturns and recoveries.

It’s therefore not surprising that next-twelve-month listed REIT returns have been positive in 18 out of the 19 quarters since 1978 when private CRE valuations as measured by the NCREIF ODCE index were negative (Exhibit 4).

Investors have historically been rewarded for investing in listed REITs when private CRE valuations are declining.

Next 12-month returns

At May 31, 2024. Source: Bloomberg, Cohen & Steers. U.S. REITs represented by FTSE NAREIT All Equity REITs Total Return Index. Private real estate returns represented by NCREIF ODCE index.

Bottom line, there are a host of factors that drive listed REIT total returns over the medium to long term. And investors should widen their aperture beyond hyper focus on the Fed.

When we review these factors in combination, we expect positive returns over the next 12 months for listed REITs across economic scenarios.

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Watch May 2024 The Real Estate Reel: What recent listed vs. private returns mean for allocations

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