After outsized gains, history and recent data suggests sector will benefit from reopening trade and improving fundamentals
In the wake of the COVID-19 pandemic’s initial gut punch to the real estate space, REITs posted a mixed bag of performance as some subsectors were propelled forward by the very same fundamental forces that sent others spiralling.
But a new analysis from Brompton Funds suggests that as the broader economy reopens, the REIT sector has come back swinging, and will have more energy to expend in the later rounds of 2021.
“The U.S. REIT sector returned 28.8% year to date, outperforming the S&P 500 by 11.1%,” the note said, citing figures from Bloomberg as of July 8. “[T]he Canadian REIT sector also posted strong returns, gaining 26.2% year to date versus the S&P TSX Composite Index, which gained 17.8%.”
While some might have expected REITs to experience some weakness due to their negative correlation with the U.S. 10-year Treasury rate, which rose throughout the first quarter, Brompton analysts said the sector should continue to strengthen off the back of the reopening trade and improving fundamentals.
“[O]ver the past two decades, REITs have generally outperformed the S&P 500 regardless of the direction of the 10-year treasury rate,” the note said, citing research from Goldman Sachs. “REITs have outperformed the S&P 500, 56% of the time when interest rates were rising, and 62% of the time when interest rates were declining.”
Drilling down into each subsector, it said retail, apartments, and offices have been the sector’s main drivers over the past six months. After suffering the brunt of COVID-19’s impact in 2020, hotels, retail, and offices have seen the most significant recoveries this year, with expansions exceeding 25% in their funds from operations (FFOs).
Meanwhile, data centres, towers, and industrial REITs have seen the least benefit from the reopening trade, significantly lagging their more cyclical counterparts’ performance. Still, they have continued to show strong fundamentals and have all outperformed the S&P 500.
Citing Goldman Sachs data on the historical behaviour of subsectors, the note said subsectors with shorter lease terms such as hotels, storage, and apartments have tended to benefit during rising-rate environments since landlords are more readily able to adjust to market rates. Office REITs, meanwhile, tend to be interest-rate sensitive, outperforming the broad REIT index as rates rise and underperforming when rates decline.
“This is due to [the office subsector’s] ties with the labour market,” it said. “Employment growth is a major driver for office demand; when interest rate [sic] rise, economic activities, along with employment growth tend to pick up.”
In contrast, industrial REITs have generally outperformed the broader REIT space both in rising and declining rate environments as the secular winds of e-commerce activity have continuously blown in their favour.
Looking out to the rest of 2021, Brompton’s analysts took a bullish view on REITs generally. Residential, retail, and industrial REITs are notable bright spots, they said, with shopping centres set to strengthen off a trough in vacancy rates and stabilizing occupancy.
“As economies get back to normal, leasing momentum and acquisition opportunities should be plentiful,” the note said. “Alongside growing funds from operations, we see industry constituents raising their dividends later this year.”