By the Numbers
The Shifting REIT Landscape
REITs are very sensitive to business cycles, typically outperforming the general market in good times and underperforming in the presence of external macroeconomic shocks. Weakened demand across all sectors during the first quarter of 2020 persisted for office, retail, and seniors housing/health care — which face uncertainty over the next 12 to 18 months from shifting consumer preferences — placing strain on capital market and leasing activities.
REIT demand recovery is largely impacted by the overall health of the economy, which has been mixed during the first half of 2021. Certain metrics, such as Transportation Security Administration throughput data, show consistently increasing travel activity in the first six months of the year which indicates increased economic activity when compared to the same time last year; the levels, however, remain much lower than their 2019 peak. Employment, a more traditional economic indicator, is showing mixed results. Although not as sluggish as April's total nonfarm payroll employment number (278,000), May's total of 559,000 still fell short of expectation. Still, cooperative monetary policy and low interest rates are likely to buoy REIT valuations in the near term, even for the stragglers. The data shows recovery with total REIT returns across all sectors nearing or surpassing their 2019 year-end peaks at the end of May 2021.
Due to structural changes in spatial demand caused by COVID-19, some slices of the REIT universe have seen their fortunes rise — namely REITs invested in self-storage and industrial properties, as well as properties that host tech infrastructure such as data centers. The boom in the industrial sector is driven largely by both the organic growth in e-commerce over the past several years, which is expected to continue, and the pandemic-related spike in e-commerce due to stay-at-home orders in many parts of the U.S. All industrial subsectors are expected to experience stable, positive rent growth in the coming years. The multifamily sector is also experiencing growth in certain geographies that have benefited from pandemic-induced migration (for example, Texas and areas of the South). The multifamily and industrial sectors are expected to see robust rent growth in the coming years.
Data centers, which have been vital in supporting the remote workforce during the pandemic, have emerged as winners in the pandemic landscape, capitalizing on the opportunities presented during these uncertain times. There are only five publicly traded data center REITs in the U.S.; two of those, Equinix and Digital Realty Trust, rank in the top 10 largest REITs in the country by market capitalization.
While office REITs largely made it through the bulk of the pandemic unscathed, as tenants continue to pay rent and retain their space for an eventual return to the office, the prolonged work-from-home environment means that the decisions around the need for physical occupancy will dictate the long-term health of the sector as companies begin to reassess their space needs. Concurrently, the fall in effective office rents might entice companies without a physical footprint to lease space. Nonetheless, office and retail are both expected to have declining effective rent growth of 5.9 percent and 6.8 percent, respectively, this year. These sectors are not projected to experience rent growth that would be indicative of a positive outlook until 2023.
REIT cap rates in the core four sectors have trended downward since peaking after the Great Recession in 2010. Since 2020, however, sector cap rates have diverged. Residential and industrial continue to trend slightly downward, with office cap rates seeing a slight increase, and retail's cap rate trending sharply upward. Moody's Investors Service predicts an increase of 30 basis points and 100 basis points in 2021 from 2020 in the sluggish office and retail markets, respectively, with asset values in these sectors likely to weaken. The potential for office sector operating income and value declines in certain central business districts that have experienced worker exodus will also lead to increased cap rates. Residential and industrial cap rates are likely to remain largely unaffected as they have managed to maintain values throughout the pandemic and are seeing upticks in value.
The liquidity profile of REITs remains positive as investment-grade REITs, whose high-quality property portfolios are largely unfettered by debt, are able to readily react to changing market conditions. Some REITs might also look to sell assets as an option to maintain liquidity. The tax benefits of REITs continue to be a lucrative attraction to investors. As long as these incentives remain in place (they are expected to remain unchanged during the current administration), REITs will still attract a healthy level of investment, particularly in sectors that are experiencing growth — for example, data centers and logistics/industrial. Although the outlook for office and retail REITs in the near term is cautious, the forecasted rent growth of about 2 percent to 3 percent that all sectors will achieve within the next five years indicates that REITs will remain an excellent investment option in the long term. It is important to keep in mind that the current discussion on REITs is unavoidably very nuanced due to the ongoing uncertainty as we slowly begin to emerge from the pandemic.