Solid property-level performance, conservative debt ratios and attractive pricing have been driving some investors who have traditionally focused on private real estate to consider funds that invest in publicly-traded REITs in recent months.
REITs have historically outperformed private real estate during recessions and during subsequent economic recoveries, according to Nareit research. And as real estate continues to be viewed as an attractive alternative investment option in spite of recent market volatility, publicly-traded REITs are benefitting from rising investor interest.
In fact, the amount of interest in REITs is probably the greatest it’s been in a decade or longer, according to Corrado Russo, managing partner and head of global securities at Hazelview Investments, a Toronto-based investment management firm that invests in both public and private real estate. “I think it’s just a function of people looking at the discounts that REITs possess today relative to private market valuations,” Russo said. “And the discounts are bigger than they’ve ever been.”
Research firm Morningstar counted 97 U.S.-based open-end funds and ETFs that invest primarily in REITs. At the end of the fourth quarter, these funds had close to $156 billion in total net assets, after a steady, year-long decline from the $236 billion mark reached in December 2021.
Some sector analysts calculate that REITs have traded at a discount to their calculated net asset values (NAVs) for much of 2022 and into 2023. Currently, the average discount to NAV for REITs of all property types is 9.9%, according to research firm Green Street Advisors.
When it comes to returns, year-to-date through April, the most recent months for which data is available, the FTSE NAREIT All-REIT Index posted a return of 1.49%. However, for the three-year period through April, the Index posted a return of 10.31% and for the five-year period it posted a return of 5.66%.
In the current climate, with the private real estate market trailing publicly-traded REITs in adjusting its valuations and various challenges facing the industry, sources WMRE interviewed noted more cycling out of private real estate investments and into the REITs. That interest has spanned from pension funds to insurance companies to high-net-worth individuals, according to Russo. They are looking at the discounts and saying: “Is now an opportunity to get in and get some real estate that’s on sale in the public markets?” he noted.
Representatives at New York-based investment management firm Cohen & Steers report the same trend. The firm manages assets for both institutional investors and for a variety of retail-oriented constituencies. And listed real estate has been getting more attention from both institutions and, increasingly, “constituencies of the wider wealth management world," according to Evan Serton, senior portfolio specialist with the firm.
Todd Kellenberger, client portfolio manager of real estate securities for Principal Asset Management, an investment management firm headquartered in Des Moines, Iowa, said his firm has been talking to clients about potentially shifting their money into publicly-traded REITs for the past three quarters as they expect REITs will outperform private real estate over the next two to three years. Given the price dislocation in the market, the firm ranks public real estate at the top of its list of attractive investment opportunities right now.
However, in Kellenberger’s experience, the shift in investor preference from private to public real estate hasn’t been particularly sizeable over the last six to nine months. One of the reasons that might be holding investors back from making the switch is that private real estate tends to be highly illiquid and a number of non-traded REITs limited redemptions in recent months, he noted. Another segment of investors might also be “choosing to ride out the storm” in the private markets, hoping conditions won’t get too bad, Kellenberger added.
Last year marked the worst performance year for publicly-traded REITs since 2008, with the FTSE All Equity REIT Index falling 24.95%. Going forward, however, investment managers feel it will be private real estate that will feel the pinch.
“When you look at the performance across those two markets last year and you see the positive returns that private real estate delivered, combined with the materially negative returns that listed real estate delivered, there's an opportunity, I think, to seek more attractive valuations in the listed market,” said Serton.
While rising interest rates and the possibility of an impending recession remain at the forefront of many investors’ minds, investment management professionals said they believe those concerns have already been priced into REIT stocks. So, while it is possible that REIT stock prices will fall further, now still appears to be a good time to invest in the sector.
“Right now, I think the biggest opportunities in real estate are REITs and debt,” said Scott Crowe, president and chief investment strategist at Pennsylvania-based real asset manager CenterSquare Investment Management. “REITs because they've priced [a recession] in and debt because you can generate mid-teen returns with very low risk relative to where asset values are going to end up.”
In general, REIT fundamentals simply look good, industry observers said. That’s particularly true when it comes to debt and worries about a potential credit crunch on the horizon. Much of the conversation about challenges facing commercial real estate owners today centers around turmoil in the regional bank sector, which holds close to 40% of the $4.5 trillion in outstanding commercial real estate debt. But over the past real estate cycle, REITs have already moved away from using secured debt supplied by banks and started relying much more on the unsecured bond market, according to a May 2023 REIT report from CenterSquare. Unsecured loans make up more than 75% of current outstanding U.S. REIT debt, and that figure has been rising steadily since roughly 2010.
In addition, in the U.S., REIT leverage has tended to be lower since the Global Financial Crisis (GFC), averaging slightly higher than 30%, CenterSquare reported. In contrast, the leverage used by a typical closed-end fund will be more than twice that level, around 65%.
Post-GFC, REIT management teams focused on issuing equity, selling underperforming assets, raising capital, shoring up balance sheets and staggering their debt maturities, said Serton. “And the result of all of that work 15 years later is that REIT balance sheets are in excellent health relative to where they used to be. The same can’t be said for a lot of private market investors in real estate.”
Which REITs are in favor
When it comes to specific REIT sectors, it’s no surprise that office continues to struggle—returns for publicly-traded office REITs were down 2.4% in April. However, office REITs makes up less than 5% of the overall REIT market capitalization, investment executives noted.
Another potential trouble spot are retail REITs, according to Kellenberger. “Where we sit today, we are looking at the cyclical challenge of a recession, and that is likely to create headwinds for consumer spending and overall retail sales activity,” he said. “You also have the structural headwind that's still in place of e-commerce taking share, and the consumer preference shift to online purchases. The convenience of it all—that’s not going away.”
On the brighter side, residential and healthcare REITs are among those standing strong, performing the best in April, according to Nareit data. In addition to those sectors, data center and seniors housing REITs are also enjoying healthy supply and demand dynamics in their property portfolios, said Serton.
As for multifamily REITs, the affordability issues in the U.S. when it comes to for-sale housing and the lack of supply in that sector will continue to push individuals into apartment rentals, he added.
“The ability of those landlords to continue to raise rents is also material and, combined with generally much more attractive valuations in those listed markets, I think that’s what’s driving the rotation out of private into listed [REITs].”
What’s also notable is that interest in publicly-traded REITs is spreading outside companies based in the U.S.—it’s particularly strong for REITs based in Asia. “Asia opened post-Covid much later than the rest of the world, so it never really ended up with the same inflation problem,” said CenterSquare’s Crowe.
However, REITs based in Europe may be facing more challenges and a less rosy outlook. They have to contend with more troubled economies and tend to be over-levered compared to U.S. REITs, Crowe noted. European REITs, as a group, have not been as disciplined about managing their leverage in recent years, he said. “And I think given what's happening in the banking system, that's going to be a problem for the real estate market and the REIT market in Europe.”
Meanwhile, Kellenberger cautioned that while REITs tend to be a good investment hold for investors during recessions, it’s hard to know exactly what any given downturn can bring. Because of market volatility, it’s impossible to say whether REITs have bottomed out, he noted.
"But what we are saying is throughout that environment and potentially coming back out of it, REITs have … potentially a great opportunity to outperform. And they're the kind of thing you would want to own throughout it.”
