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Extreme makeover – Changing the face of REITs

At the height of the first wave of the COVID-19 pandemic, the listed real estate sector looked in need of an extreme makeover. Prices of real estate investment trusts (REITs) tumbled more precipitously than those of other asset classes as markets assumed the most pessimistic outcomes of restrictions on movement and lockdowns. REITs have been written off as an asset class before, during the depths of the financial crisis in 2008/2009, but events this time looked even more damaging.

In fairness, listed real estate has underperformed the wider equity market so far in 2020 in the face of COVID-related headwinds, with the US S&P 500 index up by 11.9%, while US REITs are down by 7.1% (in USD).[1] However, some of those sub-sectors considered ready for demolition may have more value than appeared to be the case at first sight; in the rally following Pfizer’s upbeat vaccine news on 9 November, retail REITs rose more than by 25%.

Indeed, this year’s largely disappointing returns from listed real estate mask significant divergences in performance between segments. A generally outdated image of the real estate sector overlooks the asset class’s expansion to include companies that own a more economically diverse set of properties. In recent years, the composition of the global, but particularly the US, sector has extended to companies that own and operate assets in areas historically not viewed as mainstream property sectors.

This old house

The typical image of investing in commercial real estate is owning offices, shops and apartments, and perhaps industrial property. This has led some to consider property and especially listed real estate with extreme caution in the wake of the COVID-19 pandemic’s impact as offices emptied, shops shuttered and people exchanged urban apartments for houses in the suburbs.

A look at US REIT indices reveals this be an outdated view. The changes in the 21st century economy have led real estate investment companies to expand their portfolios to include other forms of real assets. Digitalisation has seen REITs include specialised sectors such as telecom towers, datacentres and infrastructure. Within the more traditional property segments, manufactured homes and single family rentals have been added.

Renovation nation

Public companies are at the forefront of developments in specialised real estate in the US and globally. Exhibit 1 shows that residential, retail and office have declined from comprising 53% of market capitalisation across all REITs in the US in 2010 to 29% in 2020. In contrast, specialty, infrastructure (including cell towers), datacentres and timber REITs have gone from around 10% in 2010 to 38% in 2020.

Even when we exclude the speciality, infrastructure and timber sectors, the office, residential and retail sectors have declined in importance, Exhibit 2 shows that these three sectors have fallen from 57% of the REIT market cap in the US to 38%. Datacentres, industrial and storage have increased from around 15% to 39% of the market cap.

Exhibit 1: US REIT sectors by % market cap weighting in the index – all equity REITS

Exhibit 2: US REIT sectors by % market cap weighting in the index – equity REITs

Source: NAREIT, 31 October 2020. The value of your investments may fluctuate. Past performance is no guarantee for future returns

These changes look set to continue. The Emerging Trends in Real Estate survey by the Urban Land Institute[2] revealed that US investors expect the rise in e-commerce and digitalisation to boost demand for infrastructure, industrial property and datacentres. However, investors also agreed that traditional sectors would recover as pandemic fears waned. More than half of respondents to the survey expected to be using more office space in three years’ time than they do now.

Caveat emptor - COVID and core real estate

The diverse structure of the REIT sector in the US and elsewhere is reflected in sector performance in 2020. The datacentre, storage, industrial and infrastructure segments have been more exposed to the out-of-office, lower-mobility economy of the COVID lockdowns and have outperformed significantly. Lodgings and retail, which are focused more on the leisure economy, have notably underperformed as have offices confronted by the shift to working from home.

Exibit 3: Performance of US REIT sectors in 2020 – all equity REITs (total return, in %)

Source: NAREIT, 31 October 2020. The value of your investments may fluctuate. Past performance is no guarantee for future returns

But as events in November have illustrated, some of these developments may not be permanent, with sectors such as lodging, malls and shopping centres rallying impressively after the news on the vaccine.

Trading spaces

REITs used to typically own commercial properties such as office buildings, apartment complexes and shopping centres. The dramatic changes of the last decade may have gone unnoticed, but as economic activity shifted online, demand for datacentres, wireless communication and warehousing accelerated. This is being reflected in the makeup of REIT portfolios.

Is it premature to write off shopping malls, movie theatres and hotels, and office working? As the last decade has demonstrated, our use of real estate is complex and changes constantly, shaped by the forces of disruption, but also demographic shifts.

How different economies emerge from the pandemic will influence demand for property as will our preferences for where and how we live, work, and relax in our free time. This will probably present new opportunities for the traditional sectors as well as those that have already benefited from disruption and digitalisation. Public companies should be well placed to exploit this evolving landscape due to their highly qualified management teams, strong balance sheets and competitive access to the capital markets.

[1] Source: Bloomberg, in local currency, 31 October 2020

[2] Emerging Trends in Real Estate 2021 Urban Land Institute, Price Waterhouse Coopers, October 2020

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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