Jason A. Yablon
Head of U.S. Real EstateMore by this author
Head of Real Estate Strategy & ResearchMore by this author
18 minute read
Listed REITs have likely priced in a recession; Our analysis points to a recovery next.
- A new market regime
We believe we are entering a more favorable environment for REIT investing after a year that has been particularly challenging for listed real estate as it repriced quickly to the new interest rate regime and the anticipated recession.
- Fundamentals are resilient
Though financing costs are higher, and growth will be slower, REITs enter this recessionary period in a relative position of strength, buoyed by tight supply and subsequent healthy cash flows.
- Setting up REIT entry points
REITs have historically performed well in the environments we are now anticipating in succession: when both growth and real yields are down; the end of the rate hiking cycle; and the transition to an early cycle environment.
Analysis of similar historical environments may suggest favorable entry points for REITs emerging
Investors have priced in a negative, forward-looking view of listed real estate. Slowing growth and higher inflation have created a stagflationary backdrop that has been especially challenging for REITs.
The result is that there has been a dramatic performance difference between listed and private real estate in 2022. While REITs, as measured by the FTSE Nareit All Equity REITs Index, are down -27.9% through September and down -21% through November, the NCREIF ODCE index, a measure of private real estate that is calculated quarterly, is up 13% through September on a total return basis.
Based on history, we believe that gap in performance will not persist. Indeed, private real estate returns are just beginning to slow as expected. Private real estate typically lags listed real estate due to its slower-moving price discovery and transactions. The NCREIF ODCE Index returned just 0.5% in the third quarter, representing a substantial and sequential deceleration from its 7.4% return in Q1 and a 4.8% return in Q2. That’s the second-greatest deceleration since 1978 (Exhibit 1).
We have advised investors to have strategic allocations to both private and listed real estate. This is not an either-or proposition. Yet, we see the current market conditions as a reason to overweight listed REITs compared to private. In fact, we see the emergence of a backdrop that supports a REIT recovery over the next 12 months.
First, real estate fundamentals are historically strong. Real estate supply vs. demand is tight, as indicated by data such as high occupancy rates. We anticipate a deceleration in REIT earnings to reflect a possible recession, but we expect REIT cash flows to be resilient, particularly compared to other asset classes.
2022 Private Real Estate returns are decelerating
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. Private real estate returns represented by NCREIF ODCE Index.
Second, listed real estate has historically outperformed in the type of more supportive inflationary backdrop we can now see on the horizon. That is when the end of the rate-hiking cycle occurs and also when both real yields and growth are down.
While the best returns have been earned during the early cycle, the market still generated 10.8% forward average 12 month returns following a recession (Exhibit 6). And for this cycle we have likely already experienced a majority of this recessionary decline.
Healthy REIT fundamentals
REIT fundamentals are decelerating but will remain resilient. In fact, we have lowered our 2023 growth expectations for REITs amid the slowing economic backdrop. But REITs have entered the economic slowdown in relatively healthy positions due to favorable supply-demand dynamics amid tight supply.
A key difference between this cycle and previous downturns is that real estate supply is likely to remain lower for longer. We expect inflation to decline but to remain elevated until at least the end of 2023. Higher costs for land, materials and labor have increased replacement costs, reducing the potential profits of development and raising the economic barriers to new supply and reducing potential competition for existing properties (Exhibit 2).
Higher construction costs may slow real estate supply growth
Real estate supply may remain lower for longer as construction costs have continued to see significant increases.
Current forward-looking estimates for 2022 show supply growth may trend even lower.
At September 30, 2022, unless otherwise noted. Source: Greenstreet, Cohen & Steers, and Turner.
Data quoted represents past performance, which is no guarantee of future results. 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. There is no guarantee that any market forecast or investment objective will be realized.
(a) Construction costs represented by YoY change in constructions costs by the Turner Building Cost Index. Turner’s Building Cost Index is determined by the following factors considered on a nationwide basis: labor rates and productivity, material prices and the competitive condition of the marketplace. (b) Real estate supply growth is represented by the average annual supply growth of all REIT sectors in Greenstreet’s coverage universe. (c) Long-term average represents the average of annual supply growth of all REIT sectors in Greenstreet’s coverage universe from 1996-2021.
Durable and predictable cash flows may also provide defensiveness relative to other asset classes. REITs offer the potential for relative stable earnings, especially compared to equities, due to limited supply, in-place leases, high operating margins, and low labor intensity.
Moving past peak inflation
The Fed is engaged in one of its most aggressive rate-hiking cycles ever to tackle inflation. It appears to be having the intended effect.
Labor markets remain tight and resources are constrained. This could keep inflation elevated, but leading indicators offer evidence that inflation peaked in June. Listed rental prices and housing starts are both falling, while lending standards are tightening. Manufacturing inventories have shifted from excess demand to excess supply. And corporate profit margins are falling.
The futures market indicates the overnight lending rate will reach a terminal point close to 5% by June 2023. Moreover, the five-year breakeven inflation rate (derived from five-year Treasury inflation-protected securities) implies that market participants expect the Fed will succeed sooner rather than later (Exhibit 3). We believe this supports a more favorable backdrop for REITs for two primary reasons.
Inflation is up, but forward expectations suggest moderation
January 2010–December 2022
At December 14, 2022. Source: Bloomberg.
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.
First, moving towards lower real yields. Low growth but higher yields, generally indicating stagflation, presents a headwind to real estate. Periods when both growth and yields are down, indicating a more stagnationary environment, have represented a significant tailwind to REITs. REITs, on average, have declined –8.8% in periods when growth is down but yields are up. By contrast, they have climbed 18.0%, on average, during periods when both growth and yields are down (Exhibit 4). That represented a 27% swing, on average, when the transition occurred.
REITs outperformed when real yields moved downward
Average annualized monthly total returns January 1990–September 2022
At September 30, 2022. Source: Bloomberg, Morningstar, and Cohen & Steers.
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. There is no guarantee that any market forecast set forth in this presentation will be realized. U.S. REITs represented by the FTSE Nareit All Equity REITs Index. U.S. equities represented by the S&P 500.
Listed real estate has historically outperformed in the type of more supportive inflationary backdrop we can now see on the horizon.
Second, REITs have performed remarkably well when rate-hiking cycles have ended. The pace of Fed hikes has moderated, and the point at which the Fed stops raising rates has historically been a critical inflection point; on average, REITs have returned 15.8% in the first six months after the Fed has stopped raising rates (Exhibit 5).
Investors may already be anticipating these two dynamics playing out. REITs gained in October—up 3.4% for the month, as measured by the FTSE Nareit All Equity REITs Index. Since then, REITs rallied more than 7% in one day (November 10th) on the news that inflation, as measured by the Consumer Price Index, had fallen to 7.7% in October. They rallied again 1.4% on December 13th after inflation fell again to 7.1% YOY in November. Just prior to finalizing this publication REITs were up 9.6% for Q4 through December 13th.
One risk to our base case, however, is the possibility that the Fed overshoots, choosing to err on the side of continuing more aggressive 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.
REITs have climbed in the six months after end of hikes(a)
At September 30, 2022. Source: Cohen & Steers calculations, Bloomberg, and Federal Reserve.
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 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 might begin.
(a) Returns represent average of hiking period cycles covering February 1994-March 1995, July 1999-June 2000, July 2004-August 2006, and December 2016-February 2019. (b) U.S. REITs are represented by the FTSE Nareit All Equity REITs Index. (c) U.S. equities are represented by the S&P 500 Index.
REITs and early cycle recoveries
Debate continues over whether we are in a recession. We think, however, that the market has priced in a worse recession than we expect.
Against this backdrop, and while past performance is not an indicator of future results, we believe the current downturn could present a similar arc to recessionary precedent. REITs have performed remarkably well after periods of downturns.
We analyzed recessionary periods dating back to 1990. This analysis shows that the best returns for REITs have been generated investing during the early cycle. However investing during the recession has generated forward returns on average of 10.8% which is above long term averages (Exhibit 6).
The forward REIT return of 10.8% outperforms the returns of the equity market of 4.5%. This outperformance continues as we move into the early cycle.
We see even stronger relative outperformance in early cycle recovery periods when comparing private and listed real estate. Private real estate had negative 12-month forward returns of -11.8% post-recessions and then positive returns of 9.2% post early cycle periods.
By understanding the leading and lagging behaviors of listed and private markets, real estate investors can tactically allocate at different times across the two asset classes.
REIT forward returns turn positive in a recession
Average 12-month forward total returns based on U.S. conference board indicator(a)
January 1990–December 2021
At September 30, 2022. Source: Thomson Reuters Datastream, Cohen & Steers, and Bloomberg.
Data quoted represents past performance, which is no guarantee of future results. Index comparisons have limitations as volatility and other characteristics may differ from a particular investment. Analysis based on U.S. business cycles as determined by the U.S. Conference Board Coincident Indicator.
(a) The Composite Index of Coincident Indicators is an index published by the Conference Board that is a broad-based measurement of current economic conditions, helping economists and investors to determine which phase of the business cycle the economy is currently experiencing. Months from January 1991-December 2020 have been categorized as early, mid, late cycle, or recession. Above returns show the average annualized return during these periods. (b) U.S. REITs represented by the FTSE Nareit Equity REITs Index which contains all tax-qualified REITs except timber and infrastructure 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. (c) U.S. Equities represented by the S&P 500 Index which is an unmanaged index of 500 large-capitalization stocks that is frequently used as a general measure of U.S. stock market performance. (d) U.S. Private Real Estate is represented by NCREIF Fund Index – Open End Diversified Core Equity (NFI-ODCE).
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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.
Data quoted represents past performance, which is no guarantee of future results. The views and opinions presented in this document are as of the date of publication and are subject to change. There is no guarantee that any market forecast set forth in this document will be realized. 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.
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