As the economy recovers/reopens, inflation firms, and the vaccine rollout ramps up in the U.S., segments of commercial real estate have some catch-up potential, specifically those sectors that were most vulnerable during the pandemic. Unlike the broader equity market, real estate investment trusts (REITs) remain well below their prior peaks reached in early 2020, and are at the most attractive price level relative to the S&P 500 in more than a decade.
Our work suggests that investors underappreciate how dramatically the industry mix has shifted within the REIT asset class over the past decade. The pronounced divergence in performance across sectors last year was a true reflection of an evolving asset class, where some sectors were hit hard by the pandemic, while others gained.
A full recovery will take time and be uneven, but there are signs of fundamental improvement across certain property types. We favor a more diversified approach with meaningful exposure to growth-oriented technology sectors along with those cyclical sectors that stand to benefit from the U.S. recovery.
The pandemic forced business closures, travel restrictions, working from home, and social distancing measures, creating an external shock to an otherwise healthy U.S. economy and commercial real estate landscape. Equity REITs are companies that own, operate or finance income-producing real estate and are a liquid and tradable proxy for the commercial real estate market. While all risk assets declined sharply during the first two months of the pandemic, REITs faced even greater pressure in light of these restrictions. On the whole, REITs were down more than 40% compared to the S&P 500’s 33% loss during those initial months. That was especially true for sectors like lodging (i.e., hotels and resorts) and retail, where vacancies rose and commercial rent forbearances and delinquencies grew. That said, there was some variation in operating fundamentals across property types.
Unlike the broader equity market in 2021, REITs, in aggregate, have yet to reach their pre-pandemic levels and are trailing the broader market by 25% over the past year. This is the most extreme underperformance since the Global Financial Crisis. Those highly cyclical REIT sectors, such as lodging and retail, however, have regained momentum in recent weeks, recouping much of their 2020 losses as the economy recovers, inflation firms, and the vaccine rollout ramps higher. In our view these beaten-down sectors have further upside potential going forward.
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