Green Shoots in REITs
Feb 26, 2024
In its 1Q24 outlook, PGIM Real Estate highlights key opportunities, risk, and the potential for a multi-year recovery in REITs reside across global real estate.
The macroeconomic backdrop for REITs was volatile in 2023, as investors struggled with uncertainty around interest rates, inflation, and economic growth. In the U.S., the REIT market has demonstrated outperformance after the conclusion of past tightening cycles. Fundamentals are likely to remain resilient, even if economic growth softens, given today’s low supply risk and strong secular demand trends. In Europe, the exceptionally strong fourth quarter was enough to put Europe far ahead of other global regions for 2023, while in Asia Pacific, markets were no doubt helped in mid-December by a surprising pivot in the Fed outlook. This decision to cut rather than hike rates going forward has, in our view, become the single-most-important determinant of how APAC real estate equities will perform in 2024.
With the backdrop of a more conducive interest rate environment, market sentiment should shift towards being more constructive in sectors with strong real estate fundamentals.
GOOD BACKDROP FOR REITS AS RATE-HIKE CYCLE ENDS
After a volatile 2023 driven largely by the uncertainty around interest rates and inflation, the U.S. REIT market saw green shoots early in the year as the inflation data began to improve. While the market struggled in the middle of the year due to the rate hikes, it bounced back during the fourth quarter finishing the year in positive territory as the Federal Reserves (Fed) signaled the end of the rate hikes and the potential for cuts in 2024. A moderating interest rate outlook and a resilient labor market should create a good backdrop for REITs.
REITs continue to trade at a significant discount versus private real estate. Historically, when this magnitude of disconnect is seen, publicly traded REITs have outperformed private real estate on a three-year forward basis. We expect M&A and consolidation activities to rise as capital markets stabilize to help close the pricing gap. The rate-hike cycles over the past two years will likely result in significantly lower new commercial real estate supply in 2025 and 2026. This should set REITs up for a strong rental growth potential.
We continue to favor companies that can use their cost of capital advantage to generate external accretive growth, e.g., assisted living in healthcare, special situations in select M&A takeover targets. Self-storage and apartments may see accelerating revenue growth opportunities with supply expecting to drop in the next two years. Additionally, we continue to see growth in data centers, one of the few sectors where investors can get a direct benefit from the artificial intelligence (AI)-related demand.
STRONG REBOUND CONTINUED AS RATES STABILIZED
The fourth quarter saw strong performance across sectors and countries in Europe, with the European REIT market producing a double-digit gain—a continuation of the rebound since the second quarter. Countries that struggled in 2022, namely Germany and Sweden, were outperformers in 2023 as interest rate expectations began to soften.
Inflation figures continued to trend downward since November 2022, despite a recent tick-up in the U.K. While the market may see some consolidation as expectations for rate reductions get extended further, we believe that we’ve entered a new phase of the rate cycle with rates peaking and potentially dropping in 2024, and a different economic cycle that may be positive for REITs.
High leverage remains a key concern in the region as some of the European names have significant volumes of refinancing and a large cashflow impact ahead from higher interest rates moving through their debt book. Given that backdrop, we remain cautious and favor companies that will benefit from interest rate cuts and a better phase of the economic cycle.
UNEVEN RECOVERY WARRANTS SELECTIVITY
The Asian REIT market lagged its counterparts for the quarter and the year primarily due to Hong Kong, where the slowdown in Chinese economic growth continued to be the main detractor. Residential and office REITs in Hong Kong will likely remain challenging given the geopolitical risk and moderating growth in China.
Australia generated strong results driven by a combination of the global interest rate environment and solid performance from data centers–-an area where we see tremendous upside potential as AI cloud-computing-driven demand continues to accelerate. We also favor Australian logistics given strong structural tailwinds driving e-commerce growth.
With many variables (e.g., the Fed’s pivot, ongoing Russia-Ukraine War, the U.S. presidential elections) that may impact the Asian REIT market, market sentiment is expected to shift toward sectors with strong real estate fundamentals. We continue to favor Japanese developers that exhibit strong shareholder returns, with a greater exposure to reopening in Asia given the increase in tourism demand. Outside of Japan and Singapore, we like hospitality and industrial names with solid dividend growth underpinned by strong fundamentals.
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