Backdrop Improving for Resilient REITs
Sep 4, 2023
In its 3Q23 outlook, PGIM Real Estate highlights areas of growth and secular trends driving global real estate as the global economy softens.
In its 3Q23 outlook, PGIM Real Estate highlights areas of growth and secular trends driving global real estate as the global economy softens.
Solid REIT Fundamentals with Improved Sentiment
The U.S. real estate investment trust (REIT) market gained 2.2%1 in the second quarter of 2023, lagging the S&P 500’s 8.7% return. Year-to-date REITs are up 4.6%, well behind the broader market’s 15.9% return. We continue to view the REIT market as overly discounting a likely slowdown in the U.S. economy. A more resilient labor market, combined with softening inflation data, bodes well for a near-term end of the Federal Reserve’s current rate-tightening cycle and improved REIT sentiment. Outside the office sector, fundamentals remain steady, with roughly 4% funds from operations per share growth expected in 2023, followed by 7% in 2024. Barring a major economic contraction, we expect REIT fundamentals to remain steady for most property types given long lease durations, low supply risk and defensive and secular-based demand.
The current spread between REIT implied valuations and private real estate appraised values is at a historically wide spread: roughly 15% on an equally weighed basis. As rates stabilize, that valuation discrepancy is likely to lead to increased M&A opportunities for private-equity players looking to deploy capital toward the discounted REIT sector. We would also expect large institutional investors to rotate their real estate allocations from private to public to take advantage of this arbitrage opportunity. The liquidity benefit of the publicly traded REIT structure has become abundantly clear in recent months, and that benefit will likely have long-term implications for real estate allocations.
Public REIT-to-REIT M&A has also increased in recent months. The current environment is rewarding REITs with better balance sheets and superior platforms with premium valuation. As such, many REITs are taking advantage of the valuation spread to consolidate attractive, smaller-cap peers. We’ve witnessed hostile REIT-to-REIT M&A activity during the past 12 months. Without a dramatic change in the current macro backdrop, we see that trend as likely to continue.
Elevated Inflation with Looming Macro Risks
Europe saw a slightly positive return of 0.9% (U.S. dollar gross total return) in June, just edging Asia Pacific but still lagging well behind North America’s positive, 4.7% return for the month. In both the second quarter (–3.2%) and the first half (–6.1%), Europe trailed well behind North America. Stubborn inflation data and longer central bank tightening cycles have been the main factors behind Europe’s continued underperformance this year.
Inflation figures have been on the decline in the region since November 2022, but the level of inflation still remains high throughout Europe. That elevated level is especially true in the U.K. Headline inflation is coming down only slowly, and core inflation has so far resisted the pressure of higher interest rates. Companies with weak balance sheets remain on near-record discounts to net and gross asset values because they are still exposed to refinancing risk and falling cash flows. Cap rates moved up quickly in the second half of 2022 in response to major upward moves in bond yields last year and have moved out further this year, but share prices are still implying further moves in private market cap rates. Our focus remains on companies better equipped to withstand the risk of further corrections as macroeconomic and geopolitical risks remain prevalent in the region.
Central Bank Policy in Focus
The Asian real estate equity market ended the second quarter weaker, delivering a –3.3% return2. Hong Kong declined the most (–9.6%) for the quarter, followed by Singapore (–4.9%) and Japan (–1.2%). Australia was the only exception, delivering a 0.2% return for the quarter.
The current situation presents an interesting dilemma wherein bad macroeconomic news could benefit real estate equities as long as interest rate hikes slow while net operating income is maintained. In Asia Pacific, attention would center on how the Fed, the Bank of Japan and the Chinese government move in the coming months. With continued evidence of sustained inflation in the core services sector in the U.S., the Fed recently telegraphed two further 25-bps hikes in the Fed funds rate. This was largely contrary to prior market expectations of rate cuts in the latter half of 2023. The possibility of rate cuts has been further delayed on the back of persistent, sticky core inflation in the U.S. With 2024 as an election year, it remains to be seen how forceful the Fed would be in pushing rates higher, which could inadvertently engineer a recession in the U.S. In China, expectations remain that the government would have to stimulate its economy in the coming weeks albeit in a more controlled fashion. The Bank of Japan is widely expected to adjust monetary policy at its upcoming meeting due to stronger wage and inflation data.
We remain positive on Australian self-storage and manufactured housing as demographic and market consolidation trends provide structural tailwinds for those sectors. As Hong Kong’s reopening remains on track, we favor the retail and residential sectors. Given rising interest rate pressure, we prefer Japanese developers that exhibit strong shareholder returns with greater reopening exposure. We also favor hospitality names that would benefit from tourism reopening and logistic JREITs given their strong fundamentals leading to growth in distribution per unit. In Singapore, we prefer the fund manager/landlord plays. For SREITs, we like hospitality and industrial names with solid dividend growth underpinned by strong fundamentals.
For Financial Professional Use Only. Not for use with the public.
- Represents the U.S. portion of the FTSE EPRA NAREIT Developed Index as of June 30, 2023
- FTSE EPRA NAREIT Developed, Asia Pacific. As of June 30, 2023.
S&P 500 Index is an unmanaged index of 500 common stocks of large U.S. companies, weighted by market capitalization. Indices are unmanaged and are provided for informational purposes only. Investors cannot directly invest in an index. Past performance does not guarantee future results.
Risks—Investing in real estate poses certain risks related to overall and specific economic conditions, as well as risks related to individual property, credit, and interest rate fluctuations. Nondiversified investments may be subject to greater volatility or loss resulting from a particular security or sector which would have a greater impact on the return. Foreign securities are subject to currency fluctuation and political uncertainty. Real estate investment trusts (REITs) may not be appropriate for all investors. There is no guarantee a REIT will pay distributions given the inherent risks associated with the market. A REIT may fail to qualify as a REIT as defined in the Tax Code, which could affect operations and negatively impact the ability to make distributions. There is no guarantee a REIT’s investment objectives will be achieved.
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