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It Ain’t Over Till It’s Over: 4 Trends Driving REIT Valuations

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It has been an eight-year run for equity real estate investment trusts, returning almost 450% to investors, or roughly 20% per year. The broader equity market has also been on a tear, returning roughly 350% during the same period. Relatively easy monetary policy persists, credit spreads remain tight and the U.S. economic expansion is almost 100 months old — the third longest in history.

Advisors now find themselves at a crossroads. On one hand, one could argue that not only are REIT valuations stretched, but the fundamental cycle for commercial real estate has generally peaked. For example:

  • Supply has trended higher in the multifamily sector, eroding rental rate growth, while a shift toward a service-based economy has disadvantaged self-storage demand and depressed market rents.
  • Traditionally stalwart property types, such as regional malls and shopping centers, have succumbed to e-commerce pressures, softening productivity and sales trends.
  • Even trophy office assets located in major cities are facing slower leasing, as tenants rationalize space needs to enhance efficiency and promote collaboration among employees.

Aggravating these real estate trends is an uncertain environment for the equity market. Geopolitical anxiety stemming from North Korea’s nuclear ambitions, Russian election-tampering allegations, central bank tightening and uncertainty regarding U.S. tax reform, have left advisors questioning the sustainability of the U.S. economy and the future direction of equity returns.

Yet the old Yogi Berra aphorism — “It ain’t over till it’s over” — could apply to present-day markets.

Commercial real estate evolved from an alternative asset allocation into a mainstream investment classification when S&P Dow Jones Indices created a new real estate sector in 2016. This promoted REITs to a sector all their own, providing enhanced liquidity and exposure.

Modern-day REITs generally provide investors with professional management, institutional asset quality, strong balance sheets and an increasing palette of property sectors to choose from. When making allocations to real estate, advisors are not constrained by traditional property types, but can now allocate among prisons, farmland/timber, single-family homes, infrastructure, movie theaters, data centers and cellular towers.

As a result, we see four emerging trends that may help support REIT valuations, and thus provide investors with attractive risk-adjusted total returns:

  • Technological advancement/disruption — a double-edged sword. Amazon has disrupted retailing channels and negatively impacted the shopping center and mall real estate sectors. However, emerging from this disruption are industrial real estate, data centers and cell towers. More distribution centers are needed to meet the logistic demands stemming from a growing service sector and e-commerce economy. Further, rapid growth in cloud computing, 5G networks, and emerging trends in virtual reality and artificial intelligence are driving demand for data centers and cell towers. Finally, advances in medicine and biotechnology are helping to increase demand for outpatient medical facilities, life science campuses and even emergency-care facilities, which can now be found in your local shopping center.
  • Lower correlations and growing number of property types. An expanding universe of emerging real estate property types may change the narrative describing real estate cycles, which has been traditionally focused on supply and demand. New and evolving real estate sectors have different fundamental demand drivers, which may result in lower correlations and provide an increasing opportunity set from which REIT investors can choose from.

  • Glacial demographic movements. Baby boomers, Generation X, millennials and Gen Z are each impacting real estate fundamentals in different ways. Boomers are living longer, increasing the need for senior housing and assisted living facilities in both rural and urban metro areas. The millennial and Gen Z cohorts are renting apartments longer and delaying home purchases, either due to affordability constraints or mobility preferences. At the same time, younger empty-nesters are migrating back into cities and renting. Finally, urbanization preferences among the Gen X cohort are causing employers to relocate their headquarters into cities, creating more live, work and play communities. This not only helps office and multifamily absorption but supports retail demand.
  • Interconnected global capital markets. REITs are gaining popularity across the globe, and several domestic U.S. REITs own assets in foreign countries, financed with local currency. Capital markets are becoming more and more interconnected, despite the rise of national populism around the world. Further, sovereign wealth funds continue to increase allocations to real estate, as the search for yield is not only a U.S. phenomenon. As a result, real estate equity capital, both listed and private, may continue to flow across borders in search of the best risk-adjusted returns, arbitraging exchange rates and interest rates, as well as economic and real estate cycles.

It remains unclear what inning REITs are in. However, the evolution of new property sectors, some born from disruption, are helping change the fundamental landscape for commercial real estate and the valuation backdrop for listed REIT securities. We believe REITs will continue to offer an attractive risk-adjusted total return over the next 18-24 months, help diversify portfolio risk and provide investors with an attractive income solution.