Janet Mui: Reits should still shine in 2022 despite interest rate hikes

Real estate investment trusts (REITs) ended 2021 as one of the best asset classes and generated strong returns during the year, after the initial decline at the start of the Covid-19 pandemic.

The strong recovery in economic activity, inflation and historically low interest rates supported the sector.

Certain areas of Reits have also benefited from structural changes in the use of space as a result of the pandemic.

Fundamental factors

Economic fundamentals are important because tenants’ ability to pay rent and landlords’ rent increases depend on the health of the economy.

GDP growth this year in developed markets is expected to slow from high rates in 2021 while remaining above trend. There is optimism that the Reits will perform well in 2022, although performance will be less impressive than in 2021.

Cash flow and rental growth are expected to be strong due to improving occupancy rates and inflation. Continued reopening and normalization of pre-pandemic trends, meanwhile, should be particularly beneficial for the leisure, retail, student housing and high-quality office segments.

The headwinds of rising rates

Inflation is an important factor to watch. REITs generally perform well in an inflationary environment because commercial leases are often linked to inflation.

A strong economy and a tight labor market should support the pricing power of REITs and therefore earnings growth. That said, if inflation is too high or too persistent, central banks will be forced to raise rates more aggressively.

REITs are interest rate sensitive. All other things being equal, higher interest rates directly reduce the valuation of assets via discounted cash flows.

Since the sector is often highly leveraged, higher interest rates mean higher borrowing costs and can worsen certain financial leverage ratios.

With expectations of around six rate hikes in the US and five more in the UK in 2022 alone, investors need to consider potential headwinds from monetary policy changes.

In 2022, we expect the current high inflation to eventually ease in the latter part of the year, but to remain above 4%. Modestly high inflation and modestly strong growth suggest that Reits should still do well.

Market Movers

Another thing to consider is that publicly traded REITs are moving broadly in line with public stocks.

If the global stock market continues to rise, REITs will likely continue to rise as well, offering a higher yield than cash, bonds and other alternatives.

However, if equity markets correct, sentiment on Reits will also turn sour despite relatively good fundamentals.

What about the relative performance of Reits versus stocks in 2022? From a macro analysis perspective, the dividend yield spread has always been a good predictor of next year’s performance for REITs.

Their dividend yield gap relative to the broader global market has narrowed sharply. If history is any guide, it indicates that Reits have underperformed equities this year.

Long-term trends

Looking beyond 2022, investors should look beyond short-term fundamentals and focus firmly on long-term trends.

We like REITs that are exposed to trends in digitalization, supply chain management and sustainability. We believe that some of the habits and ways of doing business related to the pandemic will persist and companies will invest to make the most of the space.

Real estate will play an important role in this transformation, with investors and regulators placing increasing emphasis on environmental factors as major economies have made net zero commitments.

E-commerce has accelerated dramatically during the pandemic and people have adapted to a new way of shopping.

Businesses have faced significant supply chain disruptions and will look to invest in better solutions.

We believe there will be continued strong demand for industrial space, warehouses and logistics-related real estate.

Digitization is another important topic and should be a continuous tailwind for data centers, for example.

One segment that lacks clarity is retail and office REITs. While we believe there should be a recovery in these areas in 2022, the shift to a hybrid work model and online shopping urges caution regarding future demand.

The view from here

Overall, a diversified exposure to Reits makes sense. We have a preference for Reits with an overweight towards industrial warehouses and data centers.

Investors should look for REITs with underlying assets that have a high percentage of inflation-linked rents, low vacancy rates, and a high percentage of rent collection.

Given that we are now heading into the late-cycle phase of the economic recovery, investors may also be considering whether they would prefer REITs that are defensive on the downside or less sensitive to GDP growth, over those that are most focused on economic recovery. .

Investors can also benefit from specific attention to the integration of ESG considerations into the investment process.

This article was written by Janet Mui, Head of Market Analysis at Brewin Dolphin, and first appeared in the March issue of Portfolio Adviser magazine

Stephen V. Lee