Overview
Global REITs have significantly outperformed broader equity markets in the last few days by nearly 200 basis points as a perfect storm of events conspired to spike global volatility. REITs are proving to be a relative outperformer in this uncertain environment. The U.S. unemployment rate rose last week, increasing the odds of a recession, the yen strengthened significantly as the yen carry trade continues to unwind, and escalation risk has elevated in the Middle East war.
The 10-year U.S. Treasury bond yield has dropped approximately 50 basis points from July 26, 2024 (4.24%) through August 4, 2024 (3.75%). The Fed is expected to begin a rate-lowering cycle in September, if not sooner. This declining rate backdrop is favorable for REITs as their cost of capital decreases, providing upward pressure on real estate pricing. Importantly, we are seeing no cracks in demand for real estate property types at this point. Many of the larger property types within REITs have defensive demand characteristics, like healthcare and housing-related real estate that will be insulated if there is in fact a recession. Additionally, property types like net lease, with long-term leases and diversified high credit tenants, will continue to grow dividends in a recession. Lastly, areas of high growth backed by limited supply and resilient demand like data centers should continue to deliver relatively strong earnings.
United States
In recent days, the U.S. REIT sector has been one of the best performing GICS sub-sector of the S&P 500.
In our opinion, renewed focus on REITs has been driven by:
- A significant reduction in future rate increases along with an expectation of a more aggressive easy approach.
- Growing economic uncertainty increasing the attractiveness of REITs' inherently defense business models.
- Lower rates globally increasing the relative attractiveness of REITs' dividend yields.
- Market rotation from overvalued tech-based equities to more discounted equity subsectors.
The recent string of weaker than expected economic data points (sub-50 ISM and 4.3% unemployment report) has led to a spike in market volatility and increased the risk of an economic recession in the United States. While difficult to predict the ultimate path of the U.S. economy from here, REIT investors should take some added comfort in the fundamental outlook, even if the recent slowdown fears materialize. For starters, the REIT sector today is much more concentrated in defensive sectors with secular demand support, such as data centers and healthcare. Meanwhile, sectors with more sensitivity to economic cycles such as office, lodging and malls, have witnessed a considerable drop in market cap within the REIT benchmarks. In addition, higher rates and tighter lending standards have significantly limited construction starts in recent years, which should serve to cushion fundamentals even if demand does start to contract from current levels in more cyclical sectors.
We utilize a barbell approach to our sector allocation within the U.S. REIT market, seeking to minimize unintended factor exposure and maximize stock selection based alpha regardless of the macro outlook.
That said, some of our highest conviction overweights, data centers and healthcare, are very well-positioned to navigate a slowing economy. For healthcare, demand for needs-based senior housing is largely demographic driven and poised to remain above-average for years to come. In addition, a loosening labor market could provide more relief on expense pressures for operators and serve as a net positive for NOI growth. For data centers, the spike in leasing demand from new AI-based products is unlikely to slow regardless of the macro environment. Even if tech weakness hurts relative sentiment, the fundamentals are likely to remain very supportive. Within the past month we have been increasing our exposure to the net lease sector, which is poised to outperform in the current environment given a highly defensive lease structure and improving external growth potential. We have also added to our cold storage sector positioning through a recent IPO in addition to adding to existing weights. In addition, we have trimmed some of our office positioning after recognizing significant gains since we added to this sector in mid-2023.
Asia Pacific
The Topix was down 12% on Monday, down 20% the last 3-days and was worse than the 2011 tsunami (-18%) and Black Friday in 1987 (-17%). To put it in perspective, the move was bigger than Lehman '08 & Covid. 20% of stocks in JPX were stop limit with volumes the highest on record. Circuit breakers were triggered, and seemingly random and unconnected asset moves were the order of the day. It speaks to a flight to safety, and a massive deleveraging event for the ages. The yen has appreciated 7% from last week. However, risk aversion has spread across the region: Singapore REITs were down 3% and Australia REITs were down 4.6%, with Hong Kong being the sole bright spot with developers/landlords up 2%. Again, the dichotomy with bonds (showing super stability) is there, but REITs may stabilize more after this initial bout of dumping.
Problems began last week with the Bank of Japan (BoJ) sacrificing the Japanese equity market for the yen. By sounding hawkish in the post meeting conference, Governor Ueda probably saved the Ministry of Finance hundreds of billions of dollars in protecting the currency. He also torpedoed Japan's equity bull market by raising the expected cost of debt by not just 25 basis points but somewhere in the region of 50-75 basis points for the statement he made that "0.5% should not be viewed as an upper limit for the short rate."
The negative U.S. unemployment data on Thursday created the perfect storm of U.S. recession fears and higher Japanese rates. It has led to two things: first, considerable unwinding of the yen carry trade, and secondly, a flight to safety - encapsulated by global sovereign bond yields that are down 5%-27% in the last five days. This rate decrease in itself is a great story for REITs - the 10-year USD yield at 3.75%, the 10-year Japan Government Bonds (JGB) at 0.8%. Assuming we avert a deep recession, a slowdown in borrowing costs and lesser cap rate pressure is a dramatically different picture from six months back and helps the REIT narrative enormously.
With the market now pricing in about five rate cuts by the Fed come year-end, and the yen already jumping to 143.9, this severely curtails the room to hike further for the BoJ. That 10% move in currency alone has probably mitigated most of its imported inflation risk. What is left now is to prevent a currency-induced export crunch that would jeopardize Japan's 2024 GDP growth. There's now considerable risk that Ueda could have overdone it, hurting both exports and tourism.
The Japanese real estate selloff presents an opportunity for select Japanese developers where fundamentals remain strong and earnings multiples have compressed. In addition, JREIT dividend yield spreads have widened about 50 basis points, providing investors with a more attractive alternative to 10-year JGB.
Conclusion
As a reminder, PGIM Real Estate's Portfolio Management team monitors the portfolio's risk-factor exposure on a daily basis with a more formal monthly risk meeting with the entire global analyst team. In heightened periods of volatility, we are granularly focused on how every trade and position impacts our portfolio's exposure to beta, momentum, volatility, etc.
More often than not, such volatile times create opportunities to add to attractive REIT names and discounted valuations not offered otherwise.
