The Federal Reserve (Fed) unveiled a new framework aimed at allowing inflation to overshoot its 2% long-term average target by keeping the Fed funds rate near zero for an indefinite time period. While it’s not clear how the Fed intends to raise inflation, they are committed to using “the full range of tools” at their disposal including forward guidance and quantitative easing (QE).
What does this mean for REITs?
Strong yields and attractive valuations make real estate investment trusts (REITs) a compelling asset class for investors searching for income. Recovery from the pandemic, rising inflation expectations, and a long future with accommodative monetary policy could all contribute to price appreciation in real estate securities.
What can we learn from Japan’s experience?
The current Fed framework is unprecedented, and as such there is no historical reference to help gauge potential U.S. REIT returns. However, Abenomics is the most comparable policy framework to what the Fed is undertaking. Clear expectations for low rates boosted the overall market in the early years of Abenomics and generated significant flows into REITs as investors sought income. The Japan REIT index increased 84% in the two years following the start of Abenomics and outperformed the Nikkei 225 Index by approximately 10% over the same time period (Figure 1).
Where are current REIT valuations and yields?
Due to challenged REIT fundamentals from the COVID-19 crisis, REIT dividend yields are trading at a spread to BBB-rated corporate bonds not seen since the height of the great recession (Figure 2). REIT yields are also well above the long-term average compared to the US 10-year treasury rate (Figure 3).
How does the new Fed policy approach change the total return outlook for REITs?
Continuous accommodative Fed policy and an improving fundamental backdrop from the pandemic recovery should narrow the REIT yield spread and REITs’ relative valuation. Additionally, secular growth sectors in REITs along with the reinstatement of dividends by short-term-challenged property types should allow dividend growth to return to levels that are at least equal to inflation.
How does inflation affect REIT profits?
A higher tolerance for inflation is historically good for REITs. Real estate lease structures often protect investors from the impact of rising inflation on cash flows, as many leases have CPI-based increases. As a result, REIT dividend growth has consistently outpaced the rate of inflation growth over time (Figure 4).