Long before the COVID-19 crisis, the manner in which we live, work and play was already shifting in meaningful ways. Driven by demographics, technology and evolving preferences over the past decade, the built environment has also evolved, and continues to do so. As a result of these changing demand patterns, alternative property types have arisen and today represent what we believe to be an increasingly important component of the future real estate market. Assets such as data centers, cell towers, single-family rentals, life sciences labs and cold-storage facilities are poised to benefit from secular tailwinds. Yet, these properties often require more sophisticated management platforms, with a heavier focus on specialized development, operations, and human capital. In response, the REIT market has embraced these complexities at a pace that is years ahead of traditional “core” private real estate strategies, thus becoming the optimal gateway for investors to access the alternatives in an efficient manner.
PREPARING FOR ACCELERATING DEMAND
One does not need to search long to find examples of these alternative platforms. Institutional single-family rental properties emerged out of the global financial crisis as distressed mortgages and provided opportunities to gradually amass large portfolios. This asset class differs from its multifamily peers, consisting of geographically distributed portfolios and individually unique properties, all of which present an operational challenge to the manager. Here, REITs bring the value of a platform with robust revenue management, customer acquisition, and operational expertise to a national portfolio. These REITs are meeting a demand that continues to expand as aging millennials with growing families still demonstrate a higher propensity to rent rather than own. The uncertainty of COVID-19 only reinforces this trend.
In another example, we see a seismic transition in the demand for IT infrastructure. As we move from the digital age to the virtual age, populations will not only rely on the electronic delivery of information but will also begin to demand the electronic delivery of experiences. As advances in technology increasingly allow us to enjoy virtual reality in more situations, our need to go into an office, attend a sporting event, or visit a doctor in person will diminish over time. While this evolution will result in lower demand for physical real estate, it will increase the secular growth of the data centers and cell towers required to power the rapidly expanding grid. With capacity and bandwidth pressures, investments into this infrastructure can be expected to continue in earnest. Here also, REITs provide the value of a strong platform with global connectivity and the niche operational expertise to succeed.
Access to alternative property types is difficult to achieve via core private real estate strategies alone, where today more than 55 percent of the assets comprise office and retail. These two sectors are going to face significant challenges brought on by behavioral shifts already in progress and which have only been accelerated by COVID-19. In contrast, the REIT market has more than 60 percent exposure to alternative sectors, showcasing an impressive evolution that has taken place since before the global financial crisis when these sectors only represented about one-third of the REIT market.
We believe part of this evolution has been driven by the pressures of the equity markets, which have compelled REITs to further develop their competitive advantages in several meaningful ways over the past decade. Capital has consolidated with better management teams, higher-quality assets, and best-in-class business models, propelling the REIT market to evolve more quickly than the private markets and positioning them well for the future.
THE NEW ‘CORE’
The REIT market not only offers access to evolving property types but also offers insights into evolving real estate valuations. For instance, it was as early as 2016 when the REIT market started to imply significant shifts in cap rates for retail versus industrial. Here, the impacts of demand patterns have evolved rapidly, creating an existential change in how real estate is valued. Key aspects of value such as landlord pricing power and accretive versus non-accretive capital expenditures have shifted between different real estate sectors. These shifts have favored alternative sectors.
A current example can be found in the office sector, where secular trends have created headwinds for traditional landlords. Tenant needs for quality space have evolved and accelerated amidst COVID-19 into demands for healthy workplaces with effective airflow systems, touchless entryways and configurations that promote social distancing. Simultaneously, the remote workforce — or at least a portion of it — will remain intact, reducing occupancy needs and placing downward pricing pressure on landlords. Capital expenditures, especially for older spaces, are being deployed defensively just to remain relevant.
On the contrary, companies are finding their dollars being better spent investing in their data centers, where the demands for usage and processing speed are increasing exponentially. Here, we will see higher rents, with accretive capital expenditures creating value over the long term. As these types of evolutions take place, it begs the question: What is a “core” investment today? Is it a physical office and shopping mall? Or is it the data center and industrial building enabling cloud processing and ecommerce supply chain execution? Investors who do not respond to these shifts and fail to address a potential overallocation to “traditional core” strategies may find themselves standing in an obsolescent footprint and on the wrong side of history as the world continues to evolve.
The REIT market has ascribed valuations to these evolving trends much more rapidly than the private market. For many of these alternative sectors, the REIT market is imputing lower cap rates than the private market. On the other hand, compared to the private market, the REIT market is discounting those core sectors with significant structural headwinds. Increasingly, the REIT market has demonstrated that, in the case of a persistent valuation gap, the public market tends to be more directionally correct in real estate price discovery.
COMPLETING THE PORTFOLIO OF THE FUTURE
Not only do REITs have the broader menu from which to choose, they also offer an efficient way to access these opportunities. Investors can complement existing “core” property portfolios with a “REIT completion” strategy. This approach, which involves investing in a customized REIT portfolio alongside a private strategy, can be used to achieve two primary objectives: 1) an access objective, which grants exposure to alternate real estate sectors that are difficult to find in the private markets, and 2) a valuation objective that helps achieve pacing goals while taking advantage of REIT pricing discounts to private-market valuations.
A successful REIT completion strategy can complement a private real estate investment portfolio. The Open-end Diversified Core Equity (ODCE) Index combined with a REIT completion portfolio outperforms both the standalone ODCE index and the FTSE Nareit All Equity REITs Index across all time horizons, with a minimal increase in risk.
CONCLUSION
The rationale to invest in the REIT market has expanded, and now provides investors with an opportunity to reposition portfolios by accessing alternative growth sectors. Price discovery amid COVID-19 and the global recession have begun to take place in the listed market; REITs are trading at a substantial discount to what are likely stale private-market valuations. All these factors reinforce the REIT value proposition for those investors engaged in a listed strategy today, and create a timely opportunity for those considering a tactical shift. Either way, investors have a clear choice as to how they wish to be positioned and should be mindful not to be left behind a revolution already under way.
Scott Crowe is chief investment strategist and Uma Pattarkine is an investment strategy analyst at CenterSquare Investment Management.