Improving Outlook for REITs
Apr 30, 2024
In its 2Q24 outlook, PGIM Real Estate sees improved sentiment for REITs and highlights property sectors with potential for multi-year expansion.
In the first quarter of 2024, global real estate investment trusts (REITs) gave back a portion of their fourth-quarter 2023 gains as investors worried about the pace of interest rate cuts in the midst of a relatively strong economy and somewhat sticky inflation. On a dollar basis, all regions experienced flat to negative nominal returns, with Europe lagging by being down nearly 5%.
Although both the timing and the magnitude of future rate cuts remain uncertain, we expect the overall path of monetary policy for the next 12 to 18 months to remain constructive to REIT sentiment. In the past two years, REITs have had to battle a negative-sentiment overhang associated with uncertainty about the duration of the interest rate cycle. With the uncertainty cloud now largely passed, investors can once again focus on the sector’s stable operating trends and improving, multi-year growth outlook as supply additions drop to historically low levels and demand remains on a solid footing.
REITS REMAIN ATTRACTIVE DESPITE RECENT SLOWDOWN
The U.S. REIT market took a bit of a breather in the first quarter of 2024 as interest rate crept back weighing on the outlook for rate cuts. The quarter’s best-performing sectors were the mall and lodging sectors. The first quarter represented the second consecutive quarter in which the mall sector outperformed all other U.S. REIT sectors. The lodging sector continues to benefit from an incredibly resilient U.S. consumer and incremental return of business travel. Conversely, the worst-performing sectors for the quarter were the net lease and self-storage sectors. Movement in the 10-year Treasury yield back up toward 4.23% since the end of 2023 created a sentiment headwind for net lease, as the sector relies on external acquisitions to fund earnings growth. We view that recent weakness as temporary because we expect both the cost of debt and the cost of equity to improve for REITs during the course of 2024. The self-storage sector came under some pressure as initial 2024 guidance ranges were somewhat below expectations.
We view the year-to-date dip in the REIT market as an attractive opportunity, as the broader, macroeconomic factors are likely to remain supportive for 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 of the office sector, fundamentals remain steady, with roughly 3% 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. As rates stabilise, 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.
We see strong upside earnings growth in net lease given the improvement in cost of capital and a more active acquisition environment. We continue to favour data centres because the data centre sector represents the only one in REITs to directly benefit from artificial intelligence (AI) related demand. We remain constructive on the mall sector relative to shopping centers given discounted valuation and consistent earnings growth. While we are cautious on office, we view the sector as in only the early stages of a multi-year secular headwind. That said, increased volatility has raised tactical opportunities — especially in more-defensive areas within office, such as life sciences. We see reasonable valuations in multi-family and self-storage, but near-term rental growth is likely limited given challenging comps of record growth in 2021 and 2022, which makes us hesitant to fully embrace these sectors today.
NEW PHASE OF RATE CYCLE FUELS RECOVERY
After a strong fourth quarter of 2023, the European REIT market corrected during the first quarter as investors readjusted for interest rate cuts. All European markets posted negative returns from the start of the year to the end of March. Finland and Belgium were the weakest major markets as residential, healthcare, self-storage and industrial names in those countries underperformed. The best-performing major countries for the quarter were the U.K. and France on an improving inflation outlook.
The period of adjustment to higher interest rates and balance sheet restructurings will likely continue throughout 2024 and possibly beyond. Inflation figures have been falling in Europe since November 2022, with the pace of declines picking up in second-half 2023 after slow initial progress. Though the level of inflation moderation in Europe lagged other global regions significantly for some time due primarily to external inflationary factors related to the Russia–Ukraine war, expectations for the interest rate outlook throughout Europe have improved considerably. We believe that we will soon be entering a new phase of the interest rate cycle and, potentially, the economic cycle as well, which should lead to a bottoming out in real estate market values and a return of liquidity in the investment market.
FOCUS ON STRONG FUNDAMENTALS AND AI-DRIVEN DEMAND
Faced with a backdrop of persistent inflationary pressures in the U.S. and a repricing of Fed cuts for this year, the Asian REIT market marginally outperformed the other regions in the first quarter. The drivers of that were extremely varied, with Japanese developers and Australia REITs leading the charge while Hong Kong continued its persistent underperformance. Singaporean developers and REITs also lagged during the quarter. J-REITs reinforced the trend of REIT underperformance as the Bank of Japan finally hiked rates for the first time since 2007.
Australia REITs outperformed as the market grew increasingly confident that the Reserve Bank of Australia would stay put as inflation measures subside. The market was also captivated by the global data centre theme, witnessing strong demand from both hyperscalers and enterprises. We are positive on Australian data centres as AI and cloud-driven demand should provide the sector with structural tailwinds.
The Fed’s pivot has become an important determinant of how Asia Pacific real estate equities will perform in 2024. Recent U.S. data suggests a repricing of fewer rate cuts than first envisaged at the start of the year. However, with increasing expectation of rate cuts rather than rate hikes, market sentiment will at least shift toward being more constructive on sectors with strong real estate fundamentals. As such, we continue to favour Japanese developers and names that exhibit strong shareholder returns with greater reopening exposure, as well as hospitality names that benefit from pent-up tourism demand. In Singapore, we prefer fund manager and landlord plays, and hospitality and industrial S-REITs with solid dividend growth underpinned by strong fundamentals.
References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in the portfolio at the time of publication and, if such securities are held, no representation is being made that such securities will continue to be held.
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