Doug Basile, senior portfolio specialist for the Select Equity team at Allspring Global Investments, is joined by colleagues Garth Newport, portfolio manager, and Joe Bachmann, senior research analyst and real estate sector head, as they discuss real estate investment trusts, or REITs, and the merits of owning them—particularly in the current market backdrop. This discussion is a follow-up to their recent blog post.

 

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Doug Basile: I’m Doug Basile, senior portfolio specialist for the Select Equity team at Allspring Global Investments, and you’re listening to On the Trading Desk®. Today we’re discussing real estate investment trusts, or REITs, as they’re commonly referred to, and the merits of owning them—particularly in the current market backdrop. This discussion is a follow-up to our recent blog post entitled Seeking Investment Trust? Consider REITs. Joining us today are my colleagues Garth Newport, portfolio manager, and Joe Bachmann, real estate sector head, who manage our Select Real Estate Equity strategy. Garth and Joe, thanks for being here.

Garth Newport: It’s great to be here, Doug.

Joe Bachmann: Thanks for having us.

Doug: Given the current market conditions of markedly higher interest rates and elevated and sticky inflation, we’re getting a lot more questions around the benefits of REITs as an asset class. Can you describe what a REIT is and how they may be able to provide some resiliency in an inflationary environment?

Garth: So, REITs are publicly traded companies that own, operate, and finance income-producing real estate. They generate total return through dividends and share price appreciation. They enable investors to quickly deploy substantial capital to scale geographically diverse companies. They also offer a host of other advantages. REITs can provide some protection against inflation, as real estate rents and property values will tend to increase in response to rising replacement costs. As REITs push through rent increases to tenants, their cash flows and dividend growth provide a reliable stream of income that can offset inflationary pressures. Also, there’s the higher costs of labor and capital, which reduce the incentive to build new supply. That’s limiting competitive pressures, so this has also been important in providing cover for many REITs to increase the rents in line or above general inflation the last few years. Additionally, REIT dividend growth has tended to outpace inflation over long periods of time looking back historically. And, finally, REITs have outperformed broad-based equities during long periods of moderate to high inflation since the 1970s.

Doug: Great. Diversification has long been deemed the only free lunch in investing, so how do REITs typically behave relative to other asset classes in both the short and long term?

Joe: First, as Garth mentioned, it’s really important to remember that REITs themselves are a highly diverse group. And they allow investors to access a tremendously broad portfolio of real estate across geographies and across different property types. And in terms of performance, like most asset classes, REITs aren’t immune to short-term shocks. And you can potentially see some higher correlations over shorter periods of time. We’ve seen some of that behavior year to date with REITs down alongside stocks and bonds. But when we look over longer periods, REITs behave like real estate and they’ve exhibited lower correlations to bonds, commodities, and equities. And, historically, adding REITs to a portfolio has the potential to reduce volatility and improve returns for a given level of risk.

Doug: What types of yields can investors expect from REITs, compared to other asset classes?

Joe: Because REITs are required to pay most of their taxable income as dividends, dividends have formed a key component of the total return REITs provide. And, historically, those dividend yields from REITs are very competitive with fixed income and equities. And unlike bonds, which have a fixed stream of income, REIT dividends typically grow over time as those underlying rents increase. And so, historically, roughly half of listed REIT total return has come from dividends. And we think this is a really attractive feature for investors seeking steady and growing income in today’s environment.

Doug: The number one question that we are fielding from clients and prospects pertains to the differences in returns between public REITs and private real estate this year in 2022. Can you comment on the main reasons for the returns’ disparity and offer some insight as to how public REITs may serve as a complement to a private real estate allocation?

Garth: Public REITs are traded regularly, and due to that, they incorporate a changing operating and macro environment in real time. This year, we’ve seen strong operating fundamentals driven by the inflationary environment persist for many real estate categories. However, as we’re all aware, we’ve also seen the Fed (Federal Reserve) react to these inflationary pressures by dramatically increasing interest rates. This rapid rise in financing costs pressures all real estate prices as buyers and developers factor in higher debt costs. This has broadly pushed real estate prices down. On top of that, the Fed slowing economic growth and fiscal stimulus not being renewed is leading to increasing concerns about future economic growth. Those concerns have reduced the outlook for rent growth, which again is a pressure on both public and privately owned real estate prices. So, these negatives have been quickly priced into public REITs. Private real estate, however, is mark-to-market on a much slower and infrequent basis, often via updated appraisals. That process can give the illusion of stability and continued strong gains. However, given private and public real estate prices can’t diverge for long, we believe it is likely that private real estate owners will be forced to mark their properties to reality with substantial cuts to asset prices over the next few quarters. In this current environment, the lack of real-time pricing and limits on liquidity can be costly for investors and private real estate funds. Hey, Joe, I’d love to hear your thoughts on this dynamic.

Joe: It’s a really interesting time to be in the real estate market. And a real-time example of the divergence between public and private real estate returns that we’re seeing is with BREIT, Blackstone’s backed real estate fund, which has reported positive year-to-date performance where a lot of public REIT returns are negative. As investors have been questioning the sustainability of that divergence and then looking to allocate funds away from BREIT, we’ve actually seen redemption gates go up, limiting those investors access to their funds at those prices. And with this sudden lack of liquidity combined with some really high fees, we think investors could relook at the optimal mix of real estate within their portfolios. And we think public REITs deserve a place in that conversation. They have daily liquidity, transparency, access to capital, and great diversity across geography and real estate asset types. And, so, we believe REITs offer a compelling complement to an investor’s private real estate holdings.

Doug: Hey, Garth and Joe, can you explain to our listeners some of the types of real estate investments that may serve them well, and how does your approach in active management play into that?

Joe: You can get anything you want in the property markets, a real estate company that’s building office space in a mall or building apartments next to a retail complex. You can also get a lot more specialized, getting into data centers or cell phone towers. And the great thing about being active REIT managers is that we can pick from all those different categories to find the best return for our investors.

Garth: And to Joe’s point, we can do that quickly through the liquid public REITs. And then with our ability to add diversification for our clients.

Doug: Garth and Joe, do you have any final thoughts that you may want to leave with our listeners?

Garth: These uncertain markets can certainly create a lot of investor angst, but we found that these are often the best times for us to find mispricing to take advantage of. And these coming opportunities keep us really enthusiastic about public REITs and our REIT strategy.

Joe: And as the asset class continues to mature and grow in size, its positive attributes are simply becoming too big to ignore.

Doug: Great. Garth, Joe, thanks for being with us today and sharing your insights.

Garth: Thanks again for having us on.

Joe: It was a pleasure.

Doug: That wraps up this episode of On the Trading Desk®. If you’d like to learn more about the Select Equity team or read more market insights and investment perspectives from Allspring Global Investments, you can find them at our firm’s website, allspringglobal.com. To stay connected to On the Trading Desk® and listen to past and future episodes of this program, you can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you go to get your podcasts. Until next time, I’m Doug Basile and thanks for listening.

 

Disclosure: Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.

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