Rising REIT Optimism as Rates Decline
Nov 15, 2024
In the 4Q24 Outlook, PGIM Real Estate sees a supportive backdrop for global real estate as the global easing cycle continues.
In the third quarter of 2024, real estate investment trusts (REITs) rebounded across all regions, thanks to the long-awaited first Fed rate cut in September. All three regions posted double-digit gains for the quarter. With the market expecting additional cuts for the remainder of 2024 and in 2025, the rate environment has never been better in a while for REIT outperformance. The current rate environment should continue to bode well for REITs.
IMPROVING OUTLOOK FUELED BY SOLID FUNDAMENTALS
The U.S. REIT market posted one of the strongest quarters in recent memory in the third quarter of 2024, up 15.6% compared with the S&P 500’s 5.9% return. The sector benefited from a perfect storm of events that included subdued inflation, moderating rates, and broader equity market rotation out of large-cap technology-focused stocks. In addition, the Fed officially kicked off a new policy easing cycle in September, which should keep the macro backdrop supportive for the near future. Finally, limited new construction and growing demand are likely to keep underlying property fundamentals solid during the next several years.
The top-performing sectors for the quarter were office, storage, and apartments. Some office markets, such as New York, have seen dramatic recoveries in leasing fundamentals and overall returns to office push. Other markets, such as Los Angeles and San Francisco, have been slower to recover but have started to recently show from green shoots. We expect office REITs to remain volatile. While the storage sector is benefiting from improved investor sentiment on a potential recovery in existing home sales, the recent outperformance may warrant some caution due to mixed actual results for storage and reduced revenue guidance on lower rent expectations.
Conversely, the worst-performing sectors were single-family rentals (SFRs) and hotels. For SFRs, the prospect of lower mortgage rates creates a more competitive environment for SFR REITs. The hotel sector is suffering from early signs of macro weakness, with most hotel REITs reducing revenue-per-available-room guidance along with second-quarter earnings.
Despite the recent strength in the U.S. REIT market, we view current valuation as attractive and foresee the sector as well positioned for the remainder of 2024 and into 2025. 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. A mild economic contraction could serve as a positive catalyst for REITs, as rates retrace lower and valuations benefit from their defensive nature.
We continue to focus on a barbell approach, favoring net lease and healthcare sectors due to their defensive attributes and their growth from external acquisitions. We continue to prefer cold storage, given attractive valuation support, defensive demand base (food consumption), and improving operating efficiencies. We also see a strong, multiyear runway of growth in data centers based on secular demand trends and limited supply. We feel cautious about the office sector but see tactical opportunities especially in markets with unique demand dynamics, such as New York.
CONTINUED REBOUND IN AN EASING CYCLE
As rate cutting by central banks in the region accelerated in the third quarter, the European REIT market rebounded strongly and generated a strong 17.1% return. All countries posted positive total returns, led by Germany, France, and Sweden, while Belgium was the weakest performer.
The interest rate cycle has turned in Europe ahead of the U.S. Fed, with interest rate cuts by the Swiss, Swedish, and European central banks and, finally, the Bank of England. The market has rapidly priced in further cuts by central banks in the European region before the end of the year. European inflation is on track to reach target levels, 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, and there is some initial evidence of that in half-year corporate results.
The period of adjustment to higher interest rates and balance sheet restructurings will continue throughout 2024 and beyond. However, both equity and bond markets have been opening up again with high levels of issuance since the beginning of September, thereby helping ease this period of adjustment. The European index is still approximately 28% 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 at or near trough levels in most sectors. We have been taking a less defensive stance for several months as we move into the phase of central bank rate cutting.
FOCUS ON STRONG FUNDAMENTALS AND AI-DRIVEN DEMAND
The third quarter of 2024 proved to be the best for Asia year to date, as the FTSE EPRA Asia Index rose approximately 10% quarter over quarter. Almost every country rose during the quarter, underpinned by the front-loaded Fed cut of 50 bps, which formally ended the rate-hike cycle that began in 2022. With markets expecting additional rate cuts by year-end and in 2025, we believe that REITs will benefit from a strong tailwind in the near future.
The Japan REIT market ended the quarter flat amid market volatility and as concerns about higher interest rates in Japan and appreciation of the yen against the U.S. dollar eased from the end of August after affirmation from the Bank of Japan on the pace of rate hikes. Relatively stable long-term interest rates, alongside improving fundamentals in the office and residential markets, supported the performance of Japan REITs. Office vacancy rates in Tokyo continued to trend down, and residential J-REITs reported strong rent reversion during recent results. Hotel-focused J-REITs, on the other hand, were under pressure as investors assessed concerns about the global economic outlook and the impact of an appreciating yen against the U.S. dollar on demand from inbound tourists.
Australia real estate stocks rose during the quarter, benefitting from the global REIT rally amid the Fed’s rate-cutting cycle. Although Australia’s inflation is stickier than the rest of the world’s, and the market expects that the Reserve Bank of Australia (RBA) won’t start cutting rates until 2025, the August consumer price index cooled down to the RBA’s target range. Real estate transaction activities picked up during the quarter.
Hong Kong had a strong comeback during the quarter, fueled by the Fed’s rate cut and the shift in China’s central government policies. Hong Kong interest rates are closely tied to the Fed’s movements as the Hong Kong dollar is pegged to the U.S. dollar.
Share prices of rate-sensitive Singapore REITs performed strongly as expectation of the Fed’s rate cut came to realization in September. Improving outlook on earnings and dividends amid peaking borrowing costs supported S-REITs’ recovery in performance. S-REITs with data centers exposure rallied on structural and fundamental tailwinds, and hospitality-focused S-REITs recovered in September after lagging in prior months on weak revenue-per-available-room growth and an uncertain global economic outlook.
Going forward, we remain underweight in the Japanese developers and the J-REITs, while favoring hospitality names, given the tourism boost underpinned by the weak yen. In Australia, we are positive on data centers as artificial intelligence (AI) and cloud-driven demand should produce structural tailwinds. Among the traditional real estate sectors, we prefer residential and retail, whose fundamentals are stronger and can benefit from a more favorable rate environment. For S-REITs, we like the industrial names with solid dividend growth supported by strong fundamentals. We also favor fund managers that benefit from the onset of a rate-cut cycle. We moved to overweight in Hong Kong and prefer residential developers that benefit from the rate-cutting environment.
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S&P 500 Index is an unmanaged index of 500 common stocks of large U.S. companies, weighted by market capitalization. It gives a broad look at how U.S. stock prices have performed. The FTSE EPRA/NAREIT Real Estate Index Series reflects the stock performance of companies engaged in specific aspects of the of the major real estate markets/regions of the world - Americas, EMEA (Europe, Middle East and Africa) and Asia. The Index Series is designed to represent general trends in eligible listed real estate companies and REITS worldwide, covering Global, Developed and Emerging indices, as well the U.K.’s AIM market. Relevant real estate activities are defined as the ownership, disposure, and development of income-producing real estate. Dividends, using their ex-dividend dates, are used to calculate the Total Return Indices on the FTSE EPRA/NAREIT Global Real Estate Index Series. Indices are unmanaged and an investment cannot be made directly into an index.
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