Todd Kellenberger

Rising interest rates have posed challenges for REIT stock prices over the last two years, leading to historically large discounts relative to broader equity markets. However, yields peaking has typically been a catalyst for strong REIT market outperformance, and when combined with attractive valuations, the stage looks set for a bounce-back year for REITs.

The past two years have been tough for public REIT stock prices, both on an absolute basis and relative to other equities, as rising interest rates created headwinds for real estate. However, with interest rates having peaked, prospects for future outperformance in the REIT market appear more favourable.

REITs are trading at historically significant discounts relative to broader equity markets, thanks mainly to the interest rate sensitivity of the REIT market. While rising yields are a headwind for real estate values, the peaking of long-term real yields has historically been a significant catalyst for REIT market total returns and their relative performance to broader equity indices. As yields declined in late 2023, REITs did indeed rally but are still presenting investors with pronounced valuation discounts.

REIT relative valuations also reflect investor concerns about real estate’s challenges—rising financing costs, lower capital availability, outsized debt maturities, and office market struggles. However, these concerns are largely misplaced as balance sheet leverage is, on average, below 30%, REIT debt maturities are quite manageable, multiple capital sources, such as equity or unsecured debt, are open, and exposure to U.S. traditional office is below 4%.

The combination of peaking yields and attractive relative valuations could deliver a bounce-back year for REITs in 2024, and the durable, long-duration nature of REIT cash flows should provide defensiveness as economic growth slows.

By Todd Kellenberger, REIT Client Portfolio Manager

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Todd Kellenberger

Throughout last month’s persistent volatility and the continued uncertainty of COVID-19, the defensive attributes of REITs could help them stand up over the long term, according to Principal Real Estate Investors.

Speaking on a call to investors, Shern-Ling Koh, CFA and Todd Kellenberger, CFA from Principal Real Estate Investors, provided a Global REIT market update, the team’s current outlook, as well as the investment opportunities and risks they believe investors should focus on.

According to  Shern-Ling Koh, portfolio manager, real estate securities, Asia generally, has held up relatively well, but  Australia has been hit harder than most.

“Asia has held up quite well in this bear market, with REITs displaying their typical defensive characteristics going into a period of uncertainty, until a week or two ago when there was a sharp collapse.

“This sharp drop was in line with people selling bonds, forced deleveraging on many fronts. This selling off had a material impact on REITs. Australia was impacted hardest in the region, down almost 50% in US dollar terms year to date, while Hong Kong has held up the best down 23%,” said Mr Koh.

Mr Koh said the predominance of retail has been a factor in Australia’s performance.

“Almost 50% of the AREIT benchmark is comprised of retail REITs. Retail has been under pressure in Australia for quite a while, just like retail in many other developed markets. As Australia’s has a commodity-based economy and as demand collapses globally, that’s not great for the market.

“Australian REITs are stapled securities and in times of uncertainty, people start worrying about the earnings from the development component.”

Todd Kellenberger, client portfolio manager, real estate securities told investors that COVID-19 is a human and economic crisis, but not another GFC:

“In the REIT market, we are seeing a differentiation in return between sectors, rather than an across-the-board fall as seen in the GFC. This time around we are dealing with a much healthier banking system; we are dealing with a credit market situation that overall has not, especially in real estate, taken unnecessary risks and engaged in over-leveraging, and it’s worth noting is that the average REIT leverage ratios were meaningfully higher pre-GFC than they are today,” Todd added in reference to the fall from >40% to 30-35% on average.

According to Mr Kellenberger, the effect of social distancing has hit the property sector hard, causing a decline in retail foot traffic, and high hotel and office vacancies.

“The impact on the office sector will vary by country, depending on the length of average lease periods and how long the lock-downs continue. There will be tenants that don’t survive this, it’s just a question of how many. On a macro level there are the logistical challenges of completing due diligence, tenants are pausing leases and lenders can’t underwrite loans without accessing the property,” said Mr Kellenberger.

In conclusion, Mr Kellenberger said he thought REITs could perform over the long-term.

“Going into 2020 we had a medium to long term view, focusing on structural growers and unique offerings. The duration of the virus is uncertain, and the future is murky. However, there’s many areas in REITs where things can turn out much better than in the GFC.”

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