Prior to the onset of the coronavirus pandemic, real estate investment trusts (REITs) had been among the better performing asset classes over the longer term.1 In the wake of the pandemic, however, REITs have been dogged by market commentary and investor misconceptions that imply the asset class has become a challenged sector. We disagree.
REITs in a post-COVID world, in our view, can be separated into three categories: 1. property sectors with continued tailwinds, 2. sectors with short-term coronavirus impacts but strong recovery potential, and 3. sectors with longer-term uncertainties. Active managers with the ability to balance exposure between structural growth and attractive value while avoiding the trouble spots may be well positioned to navigate the new market environment. Looking beyond the current turmoil to a period when the capital markets have stabilized, investors can likely expect structurally lower interest rates and slower economic growth. A low rate and slow growth environment has historically been favorable for commercial real estate and may prove to be so again.
Potentially attractive opportunities in commercial real estate. US REITs generated a 29% total return in 2019 and have been among the better performing asset classes over the last 15 years.2 (See Figure 1.) But since the pandemic hit and the world went into lockdown, market commentators have speculated about the longer-term impact of COVID-19 on commercial real estate. Their outlooks are often guarded and frequently paint all property types with the same broad brush. Not surprisingly, some investors have become more cautious on the asset class. It is certainly true that the historic collapse in the economy and concomitant spike in unemployment have been headwinds for real estate—just as they have been for most industries. In our view, however, this broad-brush approach to real estate is misplaced. We believe there are opportunities for potentially attractive returns combined with solid risk-adjusted returns in both US and global real estate today; just as there were in the wake of the global financial crisis, the dot-com bust and even the Gulf War recession 30 years ago.
Figure 1: Attractive total returns
Real estate has outperformed traditional stocks and bonds
Segmenting the real estate market in a post-COVID world. There are more than a dozen distinct property types in the listed US real estate market and the global market.3 (See Chart 2.) Because various property types will be impacted by the coronavirus differently, we think it makes sense for investors to segment the market by growth opportunity as well as human density. The latter attempts to assess the longer-term impact of the coronavirus and the risk of persistent social distancing by property type. In a post-coronavirus world, we believe the real estate market can properly be segmented into three categories: 1. property sectors with continued tailwinds (often driven by technological change); 2. sectors with shorter-term impacts from COVID but with strong recovery potential (typically driven by persistent demographic trends); and 3. sectors with longer-term uncertainties. The key point is simple; commercial real estate is comprised of various property types driven by different growth dynamics facing different impacts from COVID. Some of the highest growth property sectors account for over 40% of the US listed real estate market and face little to no impact from COVID. In contrast, some of the most challenged sectors comprise just 5% of the market.
Figure 2: US real estate property type exposures
As of May 31, 2020
Sectors with continued tailwinds. Three property sectors below account for 44% of the listed US real estate market and enjoyed structural tailwinds before the pandemic because of their locus at the intersection of technology and real estate, meaning they will likely face limited effects from the coronavirus. In fact, demand for several of these property types may have even improved as a result of the pandemic.
Infrastructure (22% of US market): Infrastructure REITs, which include cell phone tower operators, small node providers and fiber players, had benefited from strong growth in mobile data usage before the pandemic. They are also meaningful beneficiaries of the wireless network upgrade to 5G and have even benefitted from the current work-from-home environment which has significantly increased the load on wireless networks. Since this sector has almost no human density, it is largely unaffected by the coronavirus. Unsurprisingly, these REITs have generated positive total returns year-to-date despite a challenging market environment.4
Data centers (11% of US market): Data centers REITs, which are basically high security computer warehouses, had also benefited from the consistent growth in data usage before the pandemic. These facilities are essential for the fast and efficient operation of the internet, and they are beneficiaries of growth in cloud computing, e-commerce and the work-from-home economy. Since they too have very limited human density, data centers have been largely unimpacted by the coronavirus. Not surprisingly, many data center REITs have generated positive total returns year-to-date as well.5
Industrial (11% of US market): Industrial REITs, which include gateway distribution centers, bulk warehouses, infill warehouses and more cyclical property types as well, have been significant beneficiaries of the 11-year expansion in the US economy as well as consistent growth in e-commerce. They have also benefitted from the advent of no-touch home delivery, serving as important components in the last mile of the distribution chain. The impact on this sector of the current recession, the slowdown in global trade and COVID will vary depending on property type. For example, a longer-term disruption in trade could cause a drawdown in warehouse inventories without the goods being replaced, a negative impact for certain businesses. On the other hand, the massive bulk warehouses that are primarily operated with robots have low human density and should face limited impact from the coronavirus. Once the economy starts to grow again, we would expect trade volumes to increase which should meaningfully benefit this sector.
Sectors with shorter-term impacts from COVID but strong recovery potential. Several property types could face shorter-term impacts from the pandemic but likely have strong recovery potential. These sectors are beneficiaries of demographically-driven growth trends. As the markets stabilize and those demographic trends continue, these property types should participate well in the recovery.
Residential (14% of US market): Residential REITs, which include apartments, single-family rentals, manufactured homes and student housing, have benefitted from a host of factors including structural undersupply, demographically-driven demand growth and relative affordability. Growth trends were positive before the pandemic, especially for higher quality assets in more attractive markets with limited exposure to new supply. We expect the impact of COVID on this sector to vary depending on the specific property type. For example, single family rental homes in the suburbs and manufactured housing have low human density and should be relatively unimpacted. In contrast, high rise apartments in dense urban areas where residents rely heavily on public transportation could be more significantly impacted.
While occupancy rates for apartments have declined marginally during the current recession, some of these headwinds are likely discounted into stock prices. For example, apartments on average were trading at a 16% discount to net asset value (NAV) by the end of May.6 For reference, on a longer-term basis, US REITs have typically traded at a 2%-3% premium to NAV.7 Furthermore, key support for this sector comes from the fact that we all need a place to live, and rent is typically the first check people write
Healthcare, excluding senior living (~8% of US market): Healthcare REITs (excluding senior living) consist of hospitals, medical offices, skilled nursing and life science facilities. These property types have also benefitted from demographically-driven demand growth and the aging of the baby boomer cohort. However, future growth prospects for this sector and the expected impact from the coronavirus vary by property type. For example, life science and laboratory properties enjoyed solid demand prior to the pandemic, especially those facilities located near innovation hubs and major medical/research facilities. For certain tenants, the cost of relocating sophisticated medical and scientific equipment is extremely high, making those tenants sticky and highly valuable. Similarly, the demand for medical offices, especially near high-acuity hospitals, was solid before the pandemic and will likely remain so. Although certain of these property types have been negatively impacted by the coronavirus to varying degrees, they often house essential businesses such as doctors’ offices, testing/treatment facilities and research labs that have become critical in the current environment. On the other end of the spectrum, senior housing was already facing softening fundamentals before the pandemic. We believe it is even more challenged today, in part because it serves a demographic that is particularly susceptible to COVID. Accordingly, we would expect senior housing to lag in a real estate recovery.
Lodging (2% of US market): Lodging REITs, which include hotels and resorts, were performing well before the pandemic. The US was in the 11th year of an economic expansion, the stock market was at an all-time high, and both consumers and businesses were spending on travel. But once the lockdown went into effect, occupancy rates for many hotels and resorts collapsed to zero. A defining characteristic of this sector is its short lease terms, often just one day. In addition, these property types can be impacted by COVID, especially facilities that cater to international travelers. We believe that some of these challenges are likely discounted into stock prices as the sector on average was trading at a 29% discount to NAV by the end of May.8 As the economy has started to reopen, occupancy rates have started to rebound, but the recovery has been uneven. Properties located within driving distance of major metropolitan areas seem to be rebounding the fastest so far.
Timber (2% of US market): Timber REITs own land that is used for the production and harvesting of timber. They generate revenue by selling raw timber and wood-based products. On the upside, demand for wood products tends to grow as the populations need for housing increases. In addition, these REITs do not own buildings, so they face minimal impact from the coronavirus. However, timber REITs are cyclical and generate income based on market prices which are partly a function of demand. In this regard, approximately half of U.S. softwood lumber is used for homebuilding, so wood demand is highly correlated with the strength of the housing market. In the current recession, housing starts have fallen sharply. As the economy stabilizes and housing starts rebound, we expect demand for timber and wood products to rebound as well.
Sectors facing longer-term uncertainties. Finally, several property types faced challenges before the pandemic and continue to face uncertainties today.
Retail ex essential services (5% of US market): Retail REITs (excluding essential services) consist of regional malls and shopping centers. Before the pandemic, these property types faced a host of challenges. Unfortunately, they have been hit hard by COVID as most malls and shopping centers closed during the height of the pandemic. Rent collections for some landlords fell into the 45%-55% range during the three-month period ending in June.9 Looking more broadly, there are approximately 1,200 large malls in the U.S. Before the pandemic, approximately half or more of these malls were on the path to shutdown over the next decade. The start of the pandemic has likely accelerated that process, but by how much is unknown. Persistent social distancing will likely shift more discretionary retail purchases online, and the current recession could amplify the struggles of many large retail chains, sending more of them into bankruptcy. Current valuations seem to be reflecting at least some of these headwinds. By the end of May, regional malls on average were trading at a 52% discount to NAV while shopping centers were trading at a 35% discount.10 We would expect these property types to lag in an economic recovery.
Office (7% of US market): Office REITs in our view represent a question mark in real estate today. Prior to the pandemic, demand for marquee properties in major economic centers and innovation hubs was solid. Employers would often compete for top-flight talent based on the location quality, and related amenities/services of their offices. At the same time, demand at the lower end of the market was softening. Because of the coronavirus and the risk of persistent social distancing, we believe it is unclear what the long-term demand will be for office space in terms of square foot per employee. Some companies have already announced that a portion of their workforce will be eligible to work from home on a permanent basis, thereby reducing the need for office space. In addition, the workplace trend over the last decade of greater employee densification on the office floorplan has likely come to an end. However, we believe there will be continued demand for marquee and other high-end office properties in a post-COVID world. In addition, employers will have to consider a variety of issues when employees return to the office, including social distancing requirements and spacing demands. Of course, it is possible that certain employers may need more square feet of office space per employee in a post-COVID environment. For all of these reasons, we believe the outlook for this sector is hazy. However, some of this uncertainty is likely discounted into stock prices as the sector on average was trading at a 23% discount to NAV by the end of May.11
Key takeaways. We believe that much of the recent market commentary regarding listed US and global real estate has been too pessimistic, painting different property types with the same broad brush and leaving investors with the impression that the asset class has become challenged. In our view, certain property sectors continue to benefit from structural tailwinds while others face short-term coronavirus effects but have strong recovery potential. At the same time, a small part of the listed real estate market faces longer-term uncertainties. Active managers with the ability to balance exposures between structural growth and attractive value while avoiding the trouble spots should be well positioned to navigate the new market environment. In our view, once the market turmoil subsides, US and global REITs that own high-value physical assets, have a stable tenant base along with historically stable and growing cash flows, and offer attractive yields could present a potentially attractive investment opportunity, just as they did in the wake of the global financial crisis.
Past performance is not a guarantee of future results.
1. Source: Bloomberg L.P., as of 5/31/2020. US REITS represented by the FTSE Nareit All Equity REITs Index; Global REITs represented by the FTSE EPRA Nareit Developed Index; US Equities represented by the S&P 500 Index; Global Equities represented by the MSCI World Index; US Bonds represented by the Bloomberg Barclays US Aggregate Index; Global Bonds represented by the Bloomberg Barclays Global Aggregate Index.
The FTSE EPRA/Nareit Developed Index is a free-float adjusted, market capitalization-weighted index designed to track the performance of listed real estate companies in developed countries worldwide.
The Bloomberg Barclays Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets.
2. Source: Bloomberg L.P., as of 6/23/20
3. The US real estate market is represented by the FTSE Nareit All Equity REITs Index and the global real estate market is represented by the FTSE EPRA Nareit Developed Index. See FTSE Russell Sector Indices Factsheet, 5/29/20.
4. Source: Bloomberg L.P., Total return YTD as of 6/30/2020 is 16.60%. Past performance is not a guarantee of future results.
5. Source: Bloomberg L.P., as of 6/23/20. Total return YTD as of 6/30/2020 is 19.18%. Past performance is not a guarantee
6. Source: Invesco Real Estate based on consensus estimates, 5/31/20.
7. Source: Bloomberg L.P., as of 6/23/20
8. Source: Invesco Real Estate based on consensus estimates, 5/31/20.
9. Source: Invesco Real Estate based on consensus estimates, 5/31/20.
10. Source: Invesco Real Estate based on consensus estimates, 5/31/20.
11. Source: Invesco Real Estate based on consensus estimates, 5/31/20.
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A risk-adjusted return is a calculation of the profit or potential profit from an investment that takes into account the degree of risk that must be accepted in order to achieve it.
The Barclays US Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.
Global REITS are represented by FTSE EPRA/NAREIT Global Index is designed to track the performance of listed real estate companies and REITs in both developed and emerging markets
The FTSE NAREIT All Equity REITs Index is an unmanaged index considered representative of U.S. REITs Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions, there can be no assurance that actual results will not differ materially from expectations. An investment cannot be made into an index.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.
REITs are subject to additional risks than general real estate investments. The value of a REIT can depend on the structure and cash flow generated by the REIT. REITs concentrated in a limited number or type of properties, investments or narrow geographic areas are subject to the risks affecting those properties or areas to a greater extent than less concentrated investments. REITs are subject to certain requirements under federal tax law and may have expenses, including advisory and administration expenses. As a result, Fund will incur its pro rata share of the underlying expenses.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
The opinions expressed are those of the author, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds, and is an indirect, wholly owned subsidiary of Invesco Ltd.