INSIGHTS

On August 05, 2022

Rising rents matter more to REITs than rising rates

Despite the prospect of near-term volatility, REITs are well positioned to help mitigate higher interest rates, sticky inflation and challenging economic conditions, in our opinion.

KEY TAKEAWAYS

1. REITs have historically delivered strong performance following interest-rate increases.
2. Listed real estate securities are well positioned to withstand elevated inflation.
3. REITs have solid dividend growth prospects and cash flow growth estimates above their historical average.

Rising yields historically not a challenge for REITs

With supply-chain disruptions and high commodity prices likely to keep inflation elevated for a prolonged period of time, the Fed is expected to continue raising rates at least through 2022. This rising-rate environment is posing significant questions for investors on how to be positioned.

For instance, some investors think they should avoid REITs when interest rates are rising. History shows us differently.

Although sharp increases in interest rates may unsettle markets in the near term, history shows that the direction of the economy and job growth tends to have a greater impact on REIT returns than rising rates do. In other words, the environment that may be pushing the Fed to raise rates is one that can benefit REITs in the form of higher rents while REITs’ characteristics can make them an inflation buffer.

To put REIT performance into perspective, we analyzed the 12 largest one-month increases in the 10-year U.S. Treasury yield dating back to 2000. The data showed that while REITs have underperformed equities in the immediate aftermath of significant yield increases, they have historically outperformed 3, 6 and 12 months after such increases (Exhibit 1).

In the current cycle, inflation remains above trend, growth expectations are slowing and Treasury yields are rising. At the same time, consumer savings remains solid even though off the peak levels of 2021, and unemployment is holding at historically low levels, with more job openings than unemployed people (Exhibit 2).

Within this backdrop, REIT fundamentals, in our opinion, are above trend but decelerating. Though slackening, favorable supply/demand dynamics are supporting healthy estimated earnings growth. Durable and predictable cash flows may provide defensiveness relative to other asset classes.

This environment is one in which we think active management can become more important as demand slackens and financing costs rise, widening the differences between healthy and weak businesses. In a higher rate environment, we believe investors should focus on sectors such as self storage or single-family rentals that could retain pricing power, which can help offset higher financing costs.

REITs can be a potential inflation buffer

Even as the Fed and other central banks raises rates to combat rising prices, we believe inflation is likely to remain higher than it was over the last economic cycle.

Listed real estate has distinct characteristics that can help provide a buffer to inflation. For example, sectors with shorter lease durations (such as self storage) have the ability to reset rents promptly as conditions change. In case of slow growth — or even recession — longer inflation-linked rental contracts offer relatively strong and steady income growth potential.

Furthermore, though inflation hurts company profits when costs rise faster than revenues, REITs typically enjoy operating margins of around 60%, reducing the effect of higher costs. In addition, higher costs for land, materials and labor can reduce the potential profits of development, raising the economic barriers to new supply and reducing potential competition for existing properties.

Traditional asset allocations may provide less safety to defend against a prolonged environment of higher inflation than real estate assets, which have historically performed well in elevated inflationary periods (Exhibit 3).

REITs have the potential to deliver high and growing income

U.S. REITs currently offer dividend yields above those of 10-year Treasuries, global and U.S. stocks, and competitive with yields of global and U.S. bonds (Exhibit 4). Beyond 2022, we expect that dividend growth will remain attractive, thanks to the cash flow-focused nature of REIT business models and their tax- advantaged distributions.

What’s more, cash flow growth for U.S. REITs, as measured by funds from operations (FFO), is expected to reach 17% this year and 7.9% in 2023, well above its historical average of 5.6% (Exhibit 4). Cash flow could become increasingly important as the economy transitions into a period of potentially slower growth and higher inflation.

A strong combination

We believe that while interest rates may continue to rise and inflation may remain elevated in the near future, REITs represent a compelling investment opportunity, particularly given their historical ability to withstand inflation and their potential to deliver solid cash flow and dividend growth. And with economic growth slowing, we believe active management can play an important role in determining which sectors are better positioned to weather any slowdown.

CRN: 2022-0805-10239 R

Opinions in this piece are those of Cohen & Steers and are not necessarily that of AAM.