In brief

• Historically, real estate investment trusts (REITs) have done well when bond yields are falling and monetary policy shifts towards an easing cycle. However, they are quick to reprice for this outlook.
• Surveys suggest that the positioning in REITs remains light, which would be supportive for returns, but also reflects the uncertainty of an economic soft landing.
• Investors should consider both public and private real estate, given the differences in sector composition and volatility.
• Private real estate offers a steady income stream with a broader portfolio diversification benefit and potentially higher long-run returns. 

A slower growth environment and continued progress towards inflation targets has kick-started the policy easing cycle in many parts of the world. This backdrop of diminishing inflation and falling rates should be beneficial for income generating assets such as real estate. The expected decline in interest rates and bond yields should create a favorable backdrop for both listed and unlisted real estate, offering income, and in the unlisted real estate market an opportunity to diversify portfolio and lower volatility.

Rate cuts are good for REITs

The global REITs index has returned 7.4% year-to-date, underperforming the MSCI AC World (12.3%). Asian Pacific REITs have fared worse, with a 1.2% returned compared to the 10.9% for the MSCI Asia Pacific index. However, expectations have shifted with the outlook for rate cuts and falling bond yields. Since July, when a soft U.S. inflation report led to a repricing for the start of the U.S. Federal Reserve’s rate cutting cycle, both global and APAC regional REITs have outperformed their respective equity benchmarks.

Historically, REITs have thrived as rates cycles peak and bond yields rollover. During the post-pandemic period, the elevated volatility in the bond market has weakened this relationship (see Exhibit 1). However, it may re-assert itself given the expected asymmetric profile of yields and the global synchronisation in monetary policy easing. Lower interest rates would reduce debt costs and lower the risk-free rate, positively impacting valuations.

While central banks’ policy easing is now more certain, there is still uncertainty on how far yields will fall in the current easing cycle and reflect views on whether a downshift to slower growth will become an eventual slide into recession. This uncertainty may be contributing to the relatively light positioning in the REITs market. The August Fund Manager Survey from Bank of America showed that month-on-month, fund managers had increased their exposure to REITs, but that absolute positioning was well below historical averages.
 

Source: FactSet, FTSE NAREIT, MSCI, NCREIF, J.P. Morgan Asset Management. (Left) Excess return is the 3-month moving average of the 6-month change in REITs index less the relative equity benchmark. Data reflect most recently available as of 06/09/24.

Sector composition also matters. The global REITs index has a 32% weight towards the residential and retail sectors. These sectors may be more sensitive to a fall in cash rate given the pass through to mortgage costs or spending habits. Meanwhile, sectors such as industrials may be less sensitive to policy rate changes and more so the longer dated yields used for deriving discount rates and valuation metrics.

Compared to the global REITs index, the majority (69%) of the Asia Pacific REITs index is in diversified REITs. These REITs have exposure to a mix of property types and the higher share is a function of changes in the Asian REIT market where mergers are more common to increase size and investor attention. Diversified REITs can avoid the discounts applied to out-of-favor sectors, but limit being able to target in-favor sectors.

Private real estate: Knowing where to look

Higher interest rates have weighed on the private real estate market and impacted valuations. The rise in bond yields has narrowed the cap rate spread, pushing the income premium on real estate down relative to a risk-free asset like a U.S. Treasury bond. However, transaction-based cap rates in the U.S. have risen in the past few years as prices on the underlying assets have fallen (Exhibit 2). The still low price suggests a potential future return if prices normalize.

Beyond valuation and price concerns in real estate, the fundamentals are starting to improve. In the U.S., vacancy rates in the office sector remain elevated and delinquencies are rising. However, the aggregate figures do not capture the nuances. Vacancies are concentrated in a relatively small share of the market, with 72% of all vacant office spaces being within just 15% of total office inventory. Meanwhile, net absorption rates of newer buildings (those built after 2015) are far outstripping anything older.

There are signs of improvement across other real estate sectors. Vacancy rates in retail and apartments have been relatively steady, while vacancies in the industrial space are rising from a very low rate.

Across Asia, the private real estate market is just as diverse and offers its own source of diversification, as well as avoiding some of the “work-from-home” trends that have beset the U.S. and European off sector.

Multi-family housing in Japan retains its long-term appeal, given the demographic shifts and a rise in household formation in some gateway cities. Meanwhile, purpose-built student accommodation is becoming popular in Australia for investors wanting more residential exposure away from the traditional sources.

In contrast to the U.S., where an increase in the delivery of industrial real estate is impacting valuations, the strength of manufacturing across Asia supports the industrial and logistics real estate sectors.

Investment Implications

Declining bond yields on expectations of an easing monetary policy cycle and relatively light positioning should support the outlook for REITs. However, being liquid REITs, they can reprice quickly, and while they may continue to have positive returns, may not outperform the broader equity market.

The private real estate market should also benefit from the fall in rates. However, valuations have been slower to adjust, suggesting that the long-term potential return may be much higher.

Both listed and unlisted real estate offer steady income, which may be a wise defensive strategy in a weaker growth environment. However, REITs will experience higher equity-like volatility compared to the private side of the market.

The U.S. REITs index has a long run correlation of 0.6 to the wider S&P 500. Meanwhile, the correlation of unlisted U.S. real estate is -0.1.

The private real estate market can offer investors both steady income and bolster portfolio diversification given the low correlation to equity markets.

For most, a core strategy that seeks to diversify assets across investment themes and markets will maximize this benefit.

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