Portfolio Perspective –

Portfolio Perspective

March 22, 2023

Stay cautious on REITs as headwinds persist

Key takeaways

  • We expect tightening credit conditions in the wake of turbulence in the banking sector to weigh on REITs’ relative performance as well as the underlying real estate market despite REITs’ improved leverage profile since the financial crisis.
  • Relative price trends and fund flows from operations, the primary measure of operating cash flow for REITs, have been weak and valuations aren’t supportive.
  • The diverse sector composition of REITs is a positive given the wide range of characteristics, though certain areas like offices are likely to face continued pressure.
  • The weight of the evidence in our work leads us to remain cautious on REITs given our base case of a recession in 2023.

Our take

Real estate investment trusts (REITs) had a rough 2022 on the back of stickier-than-expected inflation, the Federal Reserve’s most aggressive tightening cycle in decades, and elevated interest rates. Late in the year and early in 2023, there were signs of stabilization in relative price trends for REITs, but those have since reversed and are nearing the October 2022 relative lows. Importantly, REITs are not a homogenous asset class and have a variety of exposures – including defensive, growth-oriented, and economically-sensitive characteristics – that we view as supportive and able to provide some level of stabilization in a wide range of economic environments. Within REITs, our view is that the office sector will likely continue to be weak given the weakening economic backdrop in the near term and the permanent increase of remote work, which decreases demand for space.

The macro and credit environment are key for REITs due to elevated levels of leverage compared to the broader S&P 500 and their underlying exposure to real estate markets. While the leverage profile of REITs has improved since the Great Financial Crisis, REITs still carry heavier debt levels compared to U.S. large caps generally, which is a unique feature to the asset class. Given our expectations for a tighter credit environment, especially in the wake of the recent turbulence in the banking sector, this is likely to be an overhang on the asset class on a relative basis. Similarly, high levels of inflation generally increase operating expenses for REITs, while higher interest rates tend to increase interest expenses, both of which put downward pressure on margins. Lastly, our base case is for a recession later in 2023, and our research shows that, on average, REITs have lagged the S&P 500 during the six months leading into recession.

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