Despite a few jitters in late 2021 with the emergence of the Omicron variant of COVID-19, U.S. REITs performed very well in the past year, with a total return of 43 percent in 2021, according to the Nareit Equity REITs Index. And listed real estate performed well across property types, led by regional malls and self-storage, up 92 percent and 79 percent, respectively.
“Big picture, I think REITs are in a pretty good position from a fundamentals position,” says Eric Rothman, a portfolio manager with CenterSquare. He notes 2021 was stronger than expected, and REITs in 2021 were playing catchup from 2020. “REITs were really punished in 2020,” says Rothman.
“COVID created uncertainty, and public markets react immediately to uncertainty,” says Jahn Brodwin, senior managing director at FTI Consulting. “That’s the good and the bad of the public market.”
“The way we characterize 2020 versus 2021 is as a big reversal in trends,” says Todd Kellenberger, REIT portfolio manager at Principal Real Estate Investors. In the first six months of 2021, the reopening trade was broadly lifting assets. Those REITs that had lagged in 2020 — retail and hospitality, in particular — performed well as they stood to benefit from vaccinations and government stimulus.
“We’ve continued to see gains in the second half of the year,” says Kellenberger. He notes real estate fundamentals have improved, which added tailwinds to the sector.
In the first half of the year, with the rollout of vaccinations, REIT performance reflected improving economic prospects. In the second half of the year, merger and privatization activity were driven by strong capital flows to real estate.
“We identified two big themes in 2021 — how the reopening would differ across property sectors and the potential for M&A given the abundance of private and public capital in CRE,” says Brad Caldwell, a portfolio manager with GEM Realty Securities.
Another factor affecting REITs in 2021 was rising inflation.
“As inflation rose in 2021, in the latter part of the year, REITs’ stock returns increased, and operational performance was good,” says Ross Prindle, managing director and global head at Kroll Real Estate Advisory Group. “REITs clearly saw an influx of dollars invested as investors looked to diversify from stocks as fears of inflation became real.” He notes real estate investment has historically been a good inflation hedge, and investors shifted toward REITs in the latter part of 2021.
Another theme: Capital markets were very receptive to REITs in 2021.
“REITs have raised close to $82 billion in capital — comprised of approximately $27 billion in follow-on equity and $55 billion in unsecured debt — at historically low cost of capital,” says Sheheryar “Sher” Hafeez, managing director, M&A and Corporate Advisory Group, at JLL. He points to ever-tightening spreads to benchmark interest rates (i.e., U.S. Treasury rates) for unsecured notes issuance, at an average spread of 1.6 percent in 2021, even when the Treasuries have risen during the year, resulting in a consistent overall cost of debt.
“Similarly, REITs have raised equity at an average premium to their analyst-ascribed NAV of 11 percent, implying a favorable cost of equity for REITs on average that have chosen to raise capital,” adds Hafeez.
That has translated to REITs being active in transaction markets in the past year.
“REITs have been net acquirers of close to $50 billion in real estate assets in 2021,” says Hafeez. He notes REITs typically account for between 15 percent and 20 percent of commercial real estate transaction volumes, “so their healthy performance has wider positive takeaways for the sector as a whole.”
2022 OUTLOOK — WINNERS AND LOSERS
The FTSE Nareit Equity REITs Index fell 6.9 percent in January, amid a broader market sell-off. The S&P 500 Index fell 5.3 percent in January, and the tech-heavy Nasdaq Composite Index fell nearly 9.0 percent. REITs fell across the board, with only the healthcare segment eking out a positive showing at 0.3 percent for the month. The biggest declines were by infrastructure and data center REITs, down 13.9 percent and 13.6 percent.
Despite the rough start, industry observers are sanguine about what lies ahead.
“A healthy economy and well-functioning capital markets are still tailwinds for the REIT market,” says Kellenberger. “Broadly, we have a positive view for real estate and REITs.”
Hafeez agrees the outlook for 2022 looks strong, notwithstanding ongoing economic and pandemic-related risks. “A particularly encouraging sign is that a substantial majority of the REITs have consistently beat their consensus earnings estimates and have increased their guidance for 2021 earnings as the year has progressed,” says Hafeez. “This momentum should carry over to 2022, with the outlook for the year being a continuation of the tailwinds that have benefited REITs in 2021.”
Rothman notes new construction has been disrupted, which should provide a protective envelope around real estate. “Low supply and growing demand is a pretty good backdrop,” says Rothman.
Most industry watchers indicate the year ahead will see a bifurcation in returns among property subsectors. “We believe there will continue to be a high level of dispersion between property types/landlords/REITs,” says Caldwell. “We expect companies that have pricing power and can pass on increasing costs will outperform.”
“We believe sectors supported by strong secular trends — residential, digital infrastructure, lab/life science and logistics — will be durable,” says Michael Geller, a portfolio manager with GEM Realty Securities. He points to robust demand, low cost of debt and consolidation opportunities. “There are also pockets of retail where cash flows proved to be resilient due to good credit tenants and exposure to necessity retail,” adds Geller.
A general consensus is that multifamily REITs will be supported by demographics and falling unemployment, while industrial REITs may level off, as the sector has strong fundamentals, but valuations are high. Alternative or niche asset types are also expected to perform well in 2022.
“Manufactured housing, cold storage, single-family rental as well as single-tenant REITs that focus on essential businesses will do well in 2022,” says Prindle. “We also expect other specialty REITs that take advantage of the digital economy to do well, such as data center REITs and cell tower–focused REITs.”
On the downside, the office sector continues to face headwinds from COVID-19, and the Omicron variant has pushed off the return to office for many organizations.
“Omicron can still spook the market,” notes Brodwin. “It will be an interesting year ahead,” adds Brodwin, regarding what might happen in the office sector. He says: “Office will continue to have its challenges in the coming year as companies and office employees redefine how they use office space in the near- and mid-term, and landlords will need to respond to the ever-changing market demands.”
“Office is challenged, no doubt about it,” says Rothman. He notes the longer-term leases of the office market will bridge the period of uncertainty, but rising inflation means long-term leases are less desirable. “There’s going to be a diminution in demand for office,” says Rothman. He says tenants have displayed a clear preference for new, modern office. The supply shortage will mean a premium for new office.
“Senior housing–focused REITs, lodging REITs, office REITs and regional malls REITs without the premium-located properties will likely have challenges due to the work-at-home focus for office, lack of recovery of business travel, and continued pandemic-related fears and local restrictions regarding new COVID-19 variants limiting foot traffic at retail,” says Prindle.
What is becoming clear, though, is “there’s not going to be an all-clear whistle that COVID is over,” says Rothman.
AN INFLATIONARY ENVIRONMENT
Inflation is a significant factor for the U.S. economy. And the current level of inflation (the Consumer Price Index was up 6.8 percent on an annualized basis in November 2021) is unprecedented for the modern REIT market, which emerged in the 1990s.
“REITs in the 1970s were nothing like today, so there isn’t good data to draw conclusions from that era. This could be uncharted territory for the modern REIT market,” says Kellenberger.
Many industry watchers believe inflation will last through 2022.
Persistently high inflation is a worry because it could be a headwind for absolute returns across all equity markets, including REITs, explains Kellenberger. “On a relative basis,” he adds, “the tangible nature of real estate and REITs means they should perform fairly well.”
“Inflation is clearly going to be with us,” says Rothman. He points out it “may actually be helpful” by reminding investors of the value of hard assets. “Rising rents will generate rising cash flow and thus better dividends,” says Rothman.
“Real estate has long been a hedge against inflation; therefore, we expect that this could lead more investors to the REIT sector,” says Prindle.
An inflationary environment is likely to support property types with shorter-duration leases, as well as have impacts on overall property supply, given rising construction costs acting as a brake on development.
“Many large institutional funds are buying heavily in multifamily at very low cap rates,” says Brodwin. And in an inflationary environment, “multifamily, in particular, reprices every year, and thus becomes a good inflation hedge.”
Inflation limits supply through rising replacement costs. “Inflation can be a double-edged sword. It can temper supply resulting in pricing power or create headwinds for property sectors that face rising expenses and declining margins,” explains Caldwell.
Rising construction costs and supply-chain issues for the construction industry will likely cause replacement cost of real estate to continue to rise. That limits new supply, which is good for existing properties as they will rise, too, due to the principal of substitution.
“If it costs more to build, existing properties become more valuable. We are bullish on real estate due to this likely scenario going forward,” says Prindle.
REITs are sensitive to interest rates and can react negatively in the short term to higher rates. But, experts point out, the correlation is low over the medium to long term.
The question for investors is whether the rapid increase in interest rates comes at a period of economic growth, says Kellenberger: “Can cash flows offset upward pressure on cap rates?”
“It does depend on the magnitude of interest rate increases, but if increases are moderate, we don’t see a huge effect on REIT returns,” says Prindle.
“Don’t fret about higher rates,” says Rothman. “REITs in particular use far less leverage than their private market peers,” which gives REITs a cost of capital advantage. And they can raise funding in more channels than private real estate firms.
MERGERS AND ACQUISTIONS
One big trend in 2021 was an active mergers and acquisition market, reflecting both REIT mergers as well as privatization transactions from private equity buyers.
“The year 2021 was a record year for M&A activity. At over $135 billion, 2021 surpassed the previous record of $103 billion established in 2006 by a wide margin,” says Hafeez. “What is somewhat more interesting than the headline number of $135 billion is the diversity of the asset classes that represent the number. Industrial, shopping centers, data centers, office, net lease and multi-housing are among the REIT subsectors that have recorded notable M&A activity.”
Some of the big transactions in 2021 included the $3.9 billion acquisition of Weingarten Realty Investors by Kimco Realty Corp.; the $11.5 billion privatization of CyrusOne; and the recently announced $4.0 billion acquisition of Monmouth Real Estate Investment Corp. by Industrial Logistics Properties Trust.
“It’s not surprising there was as much M&A as we’ve had, and we expect there to be more,” says Rothman, although “M&A is always difficult to predict. In sectors with more tumult, there’s no real disadvantage for an acquiror waiting,” says Rothman.
Brodwin also forecasts more privatizations in 2022, as many private equity funds have a lot of capital that needs to be put to work. “We’re looking at an inflationary period, so they can afford to push down going-in cap rates,” he adds.
“On the private capital front, where we spend a lot of time raising strategic capital for best-in-class private operators, some of whom are public and private REITs, we are seeing a strong interest and a deep bidding pool for platforms,” adds Hafeez. He notes capital is plentiful, and its sources include private equity funds’ closed-end vehicles, which have amassed more than $240 billion in dry powder; high-net-worth individuals and family offices, which have accumulated more than $10 trillion in wealth, more than double the level from 10 years ago; and large institutional investors, which continue to increase their real estate allocations “given the time-tested benefits that exposure to real estate as an asset class provide.”
With all this capital flowing into the market, it may be an opportunity for current real estate owners to sell, particularly if their asset allocations are in need of a rebalance, notes Brodwin. And he forecasts more REIT mergers in 2022, especially in situations where the portfolios are complementary. For example, a case where two regional REITs merge to become a national player.
One thing that sets public real estate markets apart from private real estate is that REITs have been big players in alternative or niche property sectors. That is likely to fuel some of the continued privatization activity.
“We see institutional private real estate investors looking to public markets to get access to structural drivers in these niche sectors. The REIT market is ahead of the private market when it comes to alternative sectors,” says Kellenberger. “Public markets have been willing to adopt those sectors for years now.”
“We have also monitored, in recent years, the proliferation of interest by the investor community in the alternative asset classes within the REIT and broader commercial real estate universe,” agrees Hafeez. He says subsectors such as cold storage, data centers, manufactured housing, single-family rental, farmland and life sciences facilities, among others, now make up more than 60 percent of the REIT universe, up from approximately 30 percent a decade ago.
Caldwell notes his organization has been fielding inbound calls regarding the enhanced liquidity profile of real estate through public REITs, as well as access to nontraditional sectors. Caldwell predicts cold storage and gaming REITs are among the sectors that are “next up” to be considered traditional sectors.
REIT industry watchers have some key messages for investors:
- “Public real estate is an exciting and dynamic segment of the real estate investment continuum,” says Caldwell.
- “There are many reasons to invest in REITs, and all of those drivers are poised to be highly prevalent in 2022,” says Rothman.
- “The forward-looking public markets continue to send positive signals for real estate with structural drivers,” says Kellenberger.
- “We think the REIT market provides a unique opportunity for exposure to nontraditional sectors,” says Geller.
At the beginning of 2022, the REIT future continues to look bright.
Loretta Clodfelter is senior editor of Institutional Real Estate Americas.