2024 Listed REITs Outlook (2024)

By Kelly Rush, CFA, Chief Executive Officer, Public Real Assets & Chief Investment Officer, Real Estate Securities | Todd Kellenberger, CFA, Client Portfolio Manager, Real Estate Securities

Overview

REITs - Nearing an inflection point

After lagging equities for the past two years, REITs offer an attractive investment opportunity in 2024. The headwind of higher bond yields and central bank rate hikes is likely to abate and may turn into a tailwind if our view about an impending economic slowdown and decelerating inflation trends is correct.

Peaking or falling yields have historically been a catalyst for strong REIT market outperformance. With durable and visible cash flows from staggered lease renewals phased over multiple years, REITs provide defensiveness against sharp earnings declines as the economy slows. The prospect of lower interest rates is an additional tailwind for this capital-intensive, longer-duration market.

Clear evidence of a growth slowdown and moderating inflation has increased our conviction that global central banks are nearing the point of peak rates and will need to start cutting by mid-2024. Wage growth and the American consumer showed more meaningful signs of deceleration in Q4 '23. In Europe, economic surprise indices have been in negative territory since May 2023, while China appears to be flirting with deflation.

REITs screen cheap relative to public equities, trading at EV/EBITDA multiple spreads over one standard deviation away from long-term averages. The discount against public equities compares to levels seen during the global financial crisis (GFC).

Public REITs also look like good value against private real estate. U.S. REIT share prices are implying meaningful cap rate expansion versus private real estate across major sectors.

Property sectors with resilient, structurally-driven demand dominate REIT markets and should hold up better during a recession. These sectors address the demands of a changing economy and society and offer attractive long-term growth. We prefer sectors with such defensive growth attributes.

Inflation is waning and U.S. leading economic indicators strongly suggest a recession is approaching. The rate hike cycle is at or near its end.

There are encouraging signs that the steep central bank rate hikes are starting to bear fruit. The U.S. economy has started to show more marked signs of deceleration in the fourth quarter of 2023. Leading economic indicators are now in recessionary territory and the labor market is cooling more visibly.

Meanwhile, the downward trend in core CPI inflation ex-food and energy looks very encouraging. All these suggest that interest rates have likely peaked or that we are much closer to the tail end of rate hikes than ever before. We are expecting a sharper slowdown, if not recession, in the U.S. in 2024 as the delayed impact of higher interest rates and bond yields takes effect.

The peak or fall in interest rates is historically a significant catalyst for REITs.

As real yields peak, the prospect of falling interest costs and lower discount rates provide meaningful tailwinds for the capital-intensive, long-duration REIT market. Historically, REITs have delivered strong positive returns and against equities in the 12 months after real yields have peaked.

We believe the 1999-2003 Fed Fund cycle, accompanied by a mild recession, provides a possible road map for REIT market behavior for the current cycle. REIT stocks started their rally during the Fed pause in 2000 and continued to outperform materially as the Federal Reserve cut rates.

REITs have outperformed during conventional recessions, with recent crises more the exception than the norm.

REITs provide defensiveness with durable and visible cash flows from staggered lease renewals phased over multiple years. This should buffer against sharp revenue declines, drawing investors to these long-duration stocks as interest rates peak on more visible signs of an economic slowdown. Conversely, more economically sensitive companies in the broader equity market could lose pricing power in a downturn.

The COVID and GFC crises were more the exception than the norm. REITs have proven to be defensive during the more "normal" recessions experienced over the past 35 years.

Valuation in favor: REITs are now looking cheap against equities and private real estate.

Against public equities, the earnings multiple discount is near historical lows. Such large discounts have historically been a harbinger of an extended period of strong relative performance against equities going forward.

Current REIT implied cap rates offer an attractive yield pickup over private real estate, which has been much slower to correct given appraisal-based valuations and limited price discovery in today's transaction markets.

While the absolute direction of REITs is less certain, we have conviction that on a relative basis, public REITs should outperform both public equities and private real estate at these valuation levels.

Property sectors with lower economic sensitivity and resilient, structurally-driven demand should outperform amidst the prospect of an economic slowdown in 2024.

The public REIT market experienced significant transformation over the last 10 to 15 years and is no longer dominated by traditional sectors such as office and retail. Instead, a proliferation of non-traditional sectors has taken over. The structural tailwinds experienced by these non-traditional sectors will drive above-average long-term cash flow growth enhancing the resilience of the REIT asset class during a downturn.

Our bottom-up approach favors a number of these alternative sectors given the favorable growth characteristics and attractive relative valuations.

A few examples of property types experiencing favorable structural demand drivers

As of 31 December 2023. Source: FactSet, Principal Real Estate. Expected earnings growth represents year-over-year growth in FFO per share. There is no guarantee that any forecasts made will come to pass. It should not be relied upon solely to make investment decisions.

Caveats to our expectation of REIT outperformance in 2024

1 A strong economy and sticky inflation scenario could cause REITs to lag equities.

If growth continues to hold up with inflation sticky, interest rates will stay elevated or go higher and REITs could underperform relative to general equities.

2 A recession-triggered financial crisis is especially bad for REITs.

The worst-case scenario is that of more banking troubles akin to those from early 2023 metastasizing into a full-blown banking crisis. In this tail-risk event, the capital-intensive real estate industry, including REITs, will come under pressure.

3 Should a harder economic landing materialize, equity market pullbacks are likely and investor patience might be necessary, but investor rotation into defensive equities would benefit REITs.

With equity markets today anticipating either no recession or a very shallow one, all forms of equities including REITs may suffer short-term selling pressure if expectations shift toward a moderate or deep recession. We believe it's likely REITs still outperform equities as yields are likely to go lower.

Important information

Risk considerations

Investing involves risk, including possible loss of Principal. Past Performance does not guarantee future return. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed. Potential investors should be aware of the risks inherent to owning and investing in real estate, including value fluctuations, capital market pricing volatility, liquidity risks, leverage, credit risk, occupancy risk and legal risk. All these risks can lead to a decline in the value of the real estate, a decline in the income produced by the real estate and declines in the value or total loss in value of securities derived from investments in real estate.

Important information

This material covers general information only and does not take account of any investor's investment objectives or financial situation and should not be construed as specific investment advice, a recommendation, or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. The opinions and predictions expressed are subject to change without prior notice. The information presented has been derived from sources believed to be accurate; however, we do not independently verify or guarantee its accuracy or validity. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that the investment manager or its affiliates has recommended a specific security for any client account.

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MM13821 | 01/2024 | 3319239-012025

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