Money managers are looking for a ‘unicorn.’ Could REITs fit the bill?

Perceptions of rate-hike struggles belie actual prospects, says Hazelview's Head of Global Securities

Money managers are looking for a ‘unicorn.’ Could REITs fit the bill?

With multi-decades high inflation weighing on the global economy and rate-hike campaigns in the offing, investors are expecting tough times for REITs. After all, the real estate industry does depend on capital investments and borrowing to a large extent.

But according to Corrado Russo, Managing Partner and Head of Global Securities at Hazelview Investments, the reality isn’t so clear-cut.

“Historically, the perception has been that rising rates are bad for REITs, whether it’s due to increased cost of capital or rising debt costs,” Russo said in a recent interview with Wealth Professional. “When it’s obvious that rate hikes are imminent, you tend to see underperformance [among REITs]. That’s what we’ve seen in January and February, and frankly over the last little while.”

With countries around the world facing record-high inflation numbers over the past few months, central bank policymakers are being forced to unwind the dovish measures they had put in place during the onset of the pandemic. Aside from talk of rate hikes, recent language has focused on plans for monetary tightening, which has contributed to REITs’ recent struggles.

From Russo’s perspective, the markets appear to have fully priced in negative perceptions concerning the negative impact of higher rates and tighter policies. That means investors could be ready to accept the empirical reality that when rates start rising, REITs are typically a solid area to invest in.

“Interest rates typically rise in an environment where you have a strong economy, strong jobs growth, and inflation,” he says. “Those three things are the biggest drivers of growth in top-line revenue and net operating income. The income growth tends to offset any potential rise in cap rates or debt costs.”

As a stable asset class with recurring income that also has the ability to grow, REITs could hold appeal for investors looking for alternatives to weather the current economic uncertainty. Because of that, a lot of capital flows away from the fixed-income universe, which doesn’t have any growth and tends to respond to upward interest-rate moves in a formulaically negative way, have gone into the REIT space.

The current environment of high inflation and rising rates, Russo adds, creates a conundrum for money managers. Traditionally, one way to offset higher costs of capital from rising rates has been to invest in growth stocks; however, their past decade of outperformance relative to value means growth stocks are trading at lofty multiples compared to history. At the same time, today’s extreme levels of inflation means no one can just blindly buy value stocks, since most of them don’t come with much growth.

“Every money manager is looking for a unicorn, and that unicorn is value-with-growth companies that are trading at reasonable valuations, where they are also able to grow earnings at least in lockstep with inflation,” Russo says. “From a broader market perspective, when you look at REITs’ valuations compared to equities, bonds, and even the private markets versus where they were in history, it feels like REITs are that unicorn.”

According to Russo, many REITs are still trading at discounts even as they show remarkable earnings growth coming out of 2021. He also sees the current snapback in demand following an easing in the threat of COVID and the resulting reopening as a sign of economic strength, even as the economy faces a continuing supply crunch from lingering supply-chain issues that are expected to worsen because of the Russia-Ukraine crisis.

Because the volatility stirred up by the conflict is likely to weigh on all sectors aside from energy, de-risking should be the order of the day for many investors. Russo believes REITs could prove to be relatively safe because of the captive recurring income and capital flows embedded in their business models, though he stopped short of saying they’re a haven everyone should flock to.

“I do think you could see some capital flows go into the market. Obviously, REITs with exposure to Europe will be more volatile, and certain sectors will potentially be punished more as travel in Europe becomes more difficult,” he said. “But I think multifamily REITs – whether they be in Europe, the U.S., or anywhere else – can still do very well.”