As 2021 comes to a close, real estate investment trusts (REITs) have posted significant outperformance year-to-date relative to broad stock market indices, stimulating debate towards the sector’s prospects through 2022.
Generally, Vision maintains a constructive outlook for publicly traded North American REITs into the new year. The winners and losers amongst REITs will be determined by balancing the increasing macroeconomic risks that may exert near-term price pressure on stock valuations, and evolving supply-demand fundamentals that delineates a bifurcated property market of performers and laggards.
Recently, rhetoric from central banks and policymakers has subtly shifted in appreciation of market forces that are threatening persistent price appreciation over an extended timeline. Statistics Canada reported a 4.7 per cent annual growth rate in the consumer price index in October, representing an 18-year high. Over the same period, inclusive of food and energy prices, the U.S. core personal consumption expenditures (PCE) price index increased more than 5 per cent. Federal Reserve Chairman Jerome Powell has since abandoned the term “transitory” in the wake of ongoing labour shortages fueling stickier wage growth, combined with supply chain disruptions.
Goldman Sachs now anticipates core U.S. PCE to remain above 3 per cent into 2022, until the tapering of asset purchases is reduced to nil, and a probable interest rate-hike cycle begins mid-year.
Investors have long espoused the REIT asset class as an effective inflation hedge as REITs benefit twofold: i) from growing cash flows as REITs mark rents to market; and, ii) valuations of REITs’ underlying properties rising to reflect increasing replacement costs of new developments.
However, applying this assessment to the broad REIT market may prove misleading. Property types experiencing challenged fundamentals, such as select retail and office assets are not in a position to raise rents due to either record vacancy levels which will worsen with significant new supply under construction and/or longer-term lease arrangements that may not incorporate annual rent increases to reflect inflation. Conversely, property types with favourable supply and demand conditions, for example, single-family rental homes and industrial logistics assets are well positioned to ride the tailwind and realize outsized rent growth.
REITs should benefit from improved consumer purchasing power underpinning rent growth, prolonged lower borrowing costs and a continued secular compression of capitalization rates.
In the present economic landscape, REITs are generally well positioned to outpace rising interest rates with earnings growth, as interest expense represented only 21.6 per cent of net operating income in Q1 2021, which was near historic lows and back to pre-pandemic levels, by taking advantage of an attractive borrowing environment to lock-in fixed-rate debt at a lengthened average term to maturity exceeding 7.25 years.
A nuanced look at REITs by property type is an important next step. For example, industrial and logistic properties are benefiting from the tailwinds of e-commerce growth as a percentage of total retail sales and the reversal of multi-decade trends with, the emergence of reshoring and replacement of “just in time” inventory management with “just in case” redundancy in supply chains. In the third quarter, the National Association of Industrial and Office Property (NAIOP) Research Foundation reported an upward revision to projected net absorption in 2022 totalling 334.6 million square feet, improving on a record 2021 as demand continues to outpace supply.
Conversely, office assets continue to be challenged by the structural shift to work-from-home. Green Street, a leading independent real estate research and advisory firm, forecasts an estimated 15 per cent long-term net reduction in demand for office space due to the secular shifts emanating from the global pandemic. In an environment where demand is greatly reduced, it will be difficult to realize earnings growth through lease renewals, especially in a sector that requires a significant level of capital expenditure in the form of tenant inducements to drive occupancy.
A key factor lends confidence to the current pricing of publicly traded REITs over the next 12-months. This is that institutional investors have targeted increasing investments in real estate to benefit from predictable annual cash flow, augmented by growth as well as inflation protection. This has contributed to a near record US$379.4 billion wall of capital from pension fund, institutional and private equity dry powder earmarked for direct property investments. This demand for real estate property investments is a solid backdrop to underpin REIT valuations.
We expect elevated volatility to create pockets of opportunity to buy select publicly traded REITs at a significant discount to where they would transact in the property market. This arbitrage is a unique factor inherent to the real estate sector and for example, has resulted in 19 takeovers of the Vision Opportunity Fund’s portfolio holdings since inception 13 years ago. Finally, another unique aspect of investing in the real estate sector through publicly traded securities is if property market fundamentals deteriorate or valuations get stretched, one can benefit from shorting select securities, whereas investors cannot short real estate properties directly.
– Jeff Olin is CEO and portfolio manager at Vision Capital Corporation, based in Toronto. Visit Visioncap.ca