Are REITs Turning the Corner?
The real estate sector is starting to turn the corner after being unloved for the last few years. The Dow Jones U.S. Select REIT Index (the benchmark for our Real Estate Income & Growth portfolio) peaked at the end of 2021. Once interest rates started increasing in early 2022, the index declined and has been in a slump ever since. Higher interest rates have a greater impact on real estate than most businesses since they decrease the asset/property valuations and increase the cost of debt. Over the last few years, the sector has seen some rallies, but they have been short-lived as macroeconomic conditions keep delaying the first interest rate cut.
On July 11th, the most recent Consumer Price Index (CPI) was released showing a 0.1% decline in inflation. This reading has increased the confidence that the Federal Reserve will begin cutting interest rates this year; the current consensus is September. From the release through July 22nd, the benchmark increased 3.43%, providing most of the year-to-date return of 3.85%. According to Strategas, 87.1% of companies are currently trading above their 50-day and 200-day moving averages, demonstrating the wide breadth and strength of the recent move on a technical trading basis.
Despite the weak performance, we continue to believe in an allocation to REITs. The sector underperformed as rates increased and stayed elevated, but those headwinds seem to be fading. While interest rate declines are likely to be slow, the market could start its true recovery and many areas of real estate are already at or near their bottom. Office properties may remain depressed due to work-from-home and migration, but their potential drag on the entire real estate market is likely limited by its relatively small size; office REITS comprise only 4.1% of the benchmark index.
An allocation to REITs has several benefits. Since REITs are required to distribute at least 90% of their income, distributions are high and increase over time as rents rise. The sector often behaves differently to large-cap companies, adding an attractive diversification element. According to JP Morgan, REITs have been the best-performing asset type six times (2010, 2011, 2012, 2014, 2015, and 2021) since the financial crisis, whereas large-cap has only led twice (2019 and 2023). Over the last fifteen years, large-cap stocks have returned 14.0% on an annualized basis while REITs returned 10.9%.
REITs have been underperforming, but it appears the worst may be in the rearview mirror. The market conditions and interest rate environment are turning the corner, and the sector has had a strong response over the last few weeks. Also, the sector’s history of healthy and increasing distributions and capital appreciation should be appealing to long-term investors.