By Rich Hill, head of real estate research and strategy at Cohen & Steers
What happened?
Listed REITs returned 11.9% in November, the 5th best month ever for the asset class, which we believe is a strong historical indicator for next-12-month returns. Every sector was positive, ranging from +20% for cell towers to +4% for apartments. While listed REITs are long-term investments and short-term returns can be volatile, we believe it is notable that the rally has continued in December with listed REITs returning 6.2% through December 13.
This follows an autumn selloff when listed REITs sold off 3.1% in October, 7.0% in September, and 3.3% in August. The primary driver of that decline was the Fed messaging that interest rates would remain higher for longer, combined with seasonal weakness. Market sentiment has now turned.
What drove the rally?
The November rally was driven by a combination of real rates that declined 43bp and REIT debt spreads that tightened 23bp. This is only the 5th month since the beginning of 2022 where both real rates and credit spreads have tightened. Real rates continued to decline in December (through December 13) by -25.5bp to 1.73%, while investment grade credit spreads tightened 3bp to 101bp, and REIT debt spreads tightened 8bp to 1.39%.
The market believes that the Fed may be done raising interest rates as inflation cools and economic growth slows. This was further stoked by dovish comments at the December FOMC meeting where the Fed indicated they will pivot to cutting interest rates in 2024. This is consistent with our views that the end of Fed hiking cycles should deliver above-average returns, and that recessions create attractive entry points for listed REITs, with the best returns historically occurring early in the cycle.
What may be next?
Listed REITs look slightly expensive relative to their history, but they look more attractive to 10-year Treasury rates than they did over the past several months. We also maintain REITs are cheap compared with the broader equity market, while unlevered internal rates of return (IRRs) at 7.4% and levered IRRs at 8.9% are reasonable (before considering potential alpha generation through active management).
As we look out to next year, we believe real rates, investment grade corporate credit spreads, and net operating income (NOI) growth, are the three factors most critical to the performance of listed REITs in 2024.
Current real rates are 1.73%. Credit spreads are currently 101 bp. And NOI growth for listed REITs was 4.6% as of 3Q23 according to the National Association of Real Estate Investment Trusts, known as Nareit. With that as the fundamental backdrop, here’s what we might expect for listed real estate in 2024 given various scenarios:
We think the market is pricing in a soft landing where real rates decline to 1% while credit spreads are stable and same-store NOI growth decelerates to the mid-3% range. This would support a funds-available-for-distribution multiple of ~21.5x compared to ~21x today and could drive total returns to a projected +13%.
A hard economic landing would likely produce modestly negative total returns post the recent rally, but we believe listed REITs would likely outperform the broader equity markets given what’s in the current valuations. The risk is that interest rates remain higher for a longer period, which we think would result in a give-back of recent returns.
Also, keep in mind that November was the 5th best month ever for listed REITs, which has historically been a leading indicator of strong next twelve-month returns.
Consider the following:
- Listed REIT returns were positive over the next 12 months when analysing the four prior best months for returns.
- The average next-12-month return for the top-50 months ever is +12.9%, and the median return is +15.5%.
- Next-12-month returns have been positive for 41 out of the 50 best single return months, or 82% of the time.
Finally, it’s important to remember that listed REITs can overshoot to the upside as well as the downside. Indeed, listed REITs produced +20% returns in six different years since 2009, though have had returns below 20% in two years during that same period.
