Improving Outlook for REITs
Jul 29, 2024
In its latest outlook, PGIM Real Estate highlights trends across global real estate that may bring tailwind opportunities in the next phase of the rate cycle.
In the second quarter of 2024, global real estate investment trusts (REITs) dropped more than 2%, as investors worried about the pace of interest rate cuts in the midst of a relatively strong economy and somewhat sticky inflation. On a U.S. dollar basis, all regions experienced flat to negative nominal returns, with Asia lagging, down approximately 8%.
In the past two years, REITs have had to battle a negative sentiment overhang associated with the uncertainty of the duration of the interest rate cycle. As that uncertainty cloud passes, investors are likely to focus once again on the sector’s stable operating trends and improving growth outlook as supply additions drop to historically low levels and demand remains on a solid footing.
CONSTRUCTIVE REIT OUTLOOK DESPITE SHORT-TERM NOISE
The U.S. REIT market was roughly flat with −0.5% in the second quarter of 2024 after a sizable drop in April followed by consecutive monthly gains in May and June. For the year, REITs are down roughly 1.4%, notably trailing the tech-heavy S&P 500’s 15.5% gain for the year. The REIT market continues to be restrained by interest rate concerns. We expect the short term to remain volatile as equity markets obsess over every inflationary data point, but our overall outlook for REITs in the next 12 to 18 months remains constructive.
We view the modest year-to-date dip in the REIT market as an attractive opportunity because the broader, macroeconomic factors are likely to remain supportive of the REIT market in the next 12 to 18 months. The group’s dramatic underperformance since the beginning of 2022 and discounted valuation leave the sector well positioned for continued gains. Outside the office sector, fundamentals remain steady, with roughly 4% funds from operations per share growth expected in 2024, followed by 6% in 2025. 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 values remains wide, at roughly 10% 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.
From a sector perspective, we continue to favor healthcare and data center as we anticipate seeing strong, multi-year runway of growth based on secular demand trends and limited supply. We also prefer the single-family rental sector given stable fundamentals and reasonable valuation. We see tactical opportunities in the office sector, especially in more defensive areas such as life sciences and New York office, given discounted valuations but significant headwinds.
GRADUAL RECOVERY AS RATE HIKE CYCLE ENDS
The European REIT market suffered a reversal in June after a strong relative performance in the first half of the year up to that point. Europe saw a U.S. dollar gross total return of −4.7% for the month of June as bond yields in the region edged back up and political risk reappeared with upcoming elections in France and the U.K. The European index returned −5.9% in the first half of 2024. France was the worst-performing country for the month by a wide margin, with a −10.6% total return. The calling of the French legislative election caught the market by surprise and caused the yield gap between French and German government bonds to widen significantly. Sweden was the best performer, with 2.25% total return, lifted by the start of central bank rate cuts as inflation moderates.
The interest rate cycle has begun to turn in Europe ahead of the U.S. So far, we have had 25 basis point rate cuts by the Swiss, Swedish, and European central banks. Though markets expect central banks to pause the rate cuts during the remainder of the summer, a U.K. rate cut is expected in September. At least one further 25 basis point cut is expected from all central banks in the European region after that before the end of the year.
European inflation is on track to reach central bank target levels soon—in line with forecasts—and central banks are alert to the risks of economic slowing in the region. The turn in the interest rate cycle should lead to a bottoming out in real estate market values and a gradual return of liquidity in the investment market.
The period of adjustment to higher interest rates and balance sheet restructurings will likely continue throughout 2024 and possibly beyond. However, both equity and bond markets are opening up again, helping ease this period of adjustment. Despite the substantial recovery in the fourth quarter of 2023, the European index is still roughly 33% below its level at the end of 2021; and average share valuations remain at attractive discounts to net asset values that have already been substantially written down and should be nearing trough levels in most sectors.
STRONG FUNDAMENTALS AND AI-DRIVEN DEMAND TO LEAD THE MARKET
The FTSE EPRA NAREIT Asia benchmark declined 8.3% during the second quarter of 2024, due to a combination of an expected delay in Fed’s rate cuts and policy disappointment in Hong Kong/China. The Japanese REIT market fluctuated amid uncertainty around Bank of Japan monetary policy and the timings of interest rate hikes. Residential JREITs outperformed driven by expected improvement in operating profits underpinned by wage growth and rent hikes. Hotel JREITs continued to report robust monthly operating data supported by strong inbound tourism from March to May. Hong Kong was down and extremely volatile after the Chinese central government expressed its intention to digest residential inventory and urged local governments to support the property market. The lack of execution detail on the inventory purchase plan triggered an equity market correction in the second half of the quarter. However, the Chinese regulator had given the green light to Hong Kong/China’s REIT-connect policy, which could be a catalyst. Singapore declined driven by index exclusion events, slowing buybacks and rising caution on the residential market. New private home sales showed signs of slowing down, and developers appeared cautious in recent land tenders.
With the market now pricing in one or two Fed cuts by year-end amid softening U.S. economic data, we expect Asia Pacific real estate equities to perform better in the second half of 2024. We think market sentiment will shift toward being more constructive on sectors with strong real estate fundamentals. In Australia, we are positive on data centers because artificial intelligence and cloud-driven demand should provide structural tailwinds. For Singapore REITs, we like retail and industrial names with solid dividend growth underpinned by strong fundamentals. We are neutral in Hong Kong and prefer nondiscretionary retail REITs that can benefit from upcoming REIT connect fund flow. The U.S. presidential elections in November will also be closely watched for potential volatility in U.S.–China relations, as well as inflationary pressures in the event of a Trump victory.
KEY INVESTMENT OPPORTUNITIES
In today’s environment, REITs continue to trade at a wide disconnect between private real estate pricing and public real estate pricing. Historically, each time we have seen discounts to private real estate of this magnitude in the REIT market, publicly traded REITs have outperformed private real estate on a three-year-forward basis. Additionally, significant M&A and consolidation activity tend to accelerate once capital markets stabilize.
Against this backdrop, we currently see growth opportunities in (1) property companies that can use their cost-of-capital advantage to generate external accretive growth; (2) defensive demand sectors like healthcare, wherein assisted-living occupancy levels remain well below pre-COVID levels; and (3) special situations in select M&A targets. In the second half of the year, we are closely monitoring self-storage and apartments as they cycle through some decelerating fundamentals and head into 2025 with limited supply and accelerating revenue growth opportunities.
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