Lara Castleton: Hello, and thank you for joining this episode of Global Perspectives, a Janus Henderson podcast created to share insights from our investment professionals and the implications that they have for investors. I’m your host for the day, Lara Castleton. [Real Estate Investment Trusts] REITs have taken a backseat in portfolios, as the sector has suffered under higher rates and economic uncertainty.

However, as investors seek ways to complement their technology exposure, potential shifts in interest rates and the broader macro environment may present a timely opportunity to re-evaluate the role of real estate within portfolios. To explore the challenges and opportunities within the sector, I’m thrilled to be joined by Greg Kuhl and Danny Greenberger, portfolio managers on the Global Properties team at Janus Henderson. Gentlemen, thank you both for being here from Chicago.

Greg, let’s go to you first. I don’t think it’s a secret that REITs have struggled broadly over the last five years. I don’t think we want to relive the pain that the sector went through during COVID. But maybe even just addressing the more recent interest rate policy dynamic, why were REITs and real estate hit so hard in the last rate hiking cycle?

Greg Kuhl: Yes, it’s a great question, and I want to frame out the answer, because it’s all relative when we’re talking about underperforming sectors. If we look at the last five years, US REITs have annualised about 8%, which for us is about what we expect on a long-term basis from the asset class, but it’s about half of what the S&P has done. So, it’s definitely lagged on that basis.

I think what you saw was an equity market and capital markets that are sometimes ruthlessly efficient. And in 2022, when we had the bulk of the rate hiking cycle, REITs and commercial real estate needed to be repriced. It is a sort of a rate sensitive asset class. We had the most abrupt, aggressive hiking campaign ever, and that was priced in pretty quickly. So, US REITs were down about 25% in 2022. Since that really tough year, we’ve annualised about 9.5%, which again is pretty good. If you look at the long-term history of REITs, it’s 8% to 10% sort of annual returns. So, we’re sort of doing what we would expect. But again, since 2022, that’s quite a bit behind the equity markets.

So, I think part of the answer here is, this isn’t a sector that’s built to be kind of a go, go, exciting 20% type of growth kind of sector. It’s a slow and steady sector with contractual income. It’s meant to be a diversifier and a steady compounder. And 8% or 9% annualized return maybe isn’t super exciting over the last few years, but if you can generate that type of return year in and year out, that’s a pretty good number for most portfolios.

Maybe one other point to mention is it hasn’t totally been a smooth ride, right? We’ve seen 8% or 9% annual returns, but it hasn’t been kind of ratable over the last few years since that 2022 bottom. Basically, a lot of the returns have come in a couple of periods. One of them was the fourth quarter of 2023, when we saw rates at the longer end of the curve moderate pretty drastically, from 5% to sub 4% within a few months. And then the other period where the sector did really well was the second half of 2024, again, where you saw some moderation in rate expectations getting priced into markets. So, those have been really good periods, but I think if you zoom out and look at the totality, the upper single-digit type of return is kind of what we expect.

Castleton: Nobody can really time the market, so that 8% to 10% actually is very attractive when you put it in that perspective. Danny, if we go to you, just what is different in the environment today going forward? Are interest rates the only thing that’s going to matter here?

Daniel Greenberger: We think that there are a handful of really supportive things in the current backdrop for the asset class, and that rates are not the only thing that matters, although we do think the prospect of lower rates, particularly on the long end of the curve, notably the ten-year, could be really helpful for the asset class moving forward. I think it’s just interesting to point out, in 2023 the ten-year started the year at 3.9%, closed the year at 3.9%. But the asset class, US REITs, advanced almost 14%. And then if we go back to 2024, the ten-year rate actually moved against the asset class, or what some might think is moving against, started the year at 3.9% and actually closed the year at close to 4.6%, and yet REITs still delivered a positive total return of nearly 9%. So, to Greg’s point, the asset class has been performing the last few years. It was really that 2022 year. And I think it’s just important to point out those two years as exemplifying that the contours of the total return in the asset class are not entirely reliant just on where the ten-year is ultimately going to head.

A few things to point out that I think are very promising. One, supply is coming off for the asset class across a variety of different important subsectors, like industrial logistics, apartments, self-storage. Greg’s going to talk a bit about senior housing as well and the really powerful demographics that are unfolding there. So, the supply picture, where we saw a lot of construction post the onset of COVID in 21 and 22, has really come off and our companies are digesting that supply really nicely. And that could lead to much better rental rate growth if we look out into ‘26 and ‘27, which could re-catalyze or reinvigorate more powerful earnings growth for the sector.

And then on top of that, as well, companies are very well capitalized. I would argue, in the modern REIT era, we’ve probably never been this strong from a balance sheet perspective. The sector operates with leverage of about 30%. It’s about half of what we see the leverage in the private market. And so, companies have fortress balance sheets, great operating capabilities, and then they’re going to be headed into a multi-year period, we think, where supply is just not going to be as competitive as what it has been for the last five years.

From a valuation perspective, getting back to those high single-digit total return prospects that Greg had touched on, we think the building blocks for that total return outlook are very much intact, and rates could be a potentially nice kicker to that total return growth outlook. And again, it’s underscored by that balance sheet strength of the sector.

And then if you look out to 2026 earnings growth projections, right now they’re around 6%. And so, if you think total return based on that current dividend yield plus the growth outlook, which we think could be sustainably in the mid-single digits, it gets you to that roughly high single-digit, low double-digit territory that Greg illuminated on a moment ago. So, I think the prospect of lower rates, if the ten-year were to decline, because that is an anchor of commercial real estate asset values, that would be helpful. But as evidenced by the past couple of years, I don’t think it’s necessarily required for the asset class to continue to compound in those sort of high single digits or low double digits moving forward.

Castleton: That’s great to hear. And I think there’s a lot of unpredictability across the board going forward, so laying out those fundamentals is super helpful to think about the outlook for real estate, regardless of what does happen in the rate environment.

You mentioned at the beginning 8% to 10%, pretty attractive, lagging S&P, and definitely technology. There’s been a lot of excitement on AI and technology. Greg, I want to go to you to dive into some of the subsectors. That excitement around AI and technology has led to a lot of conversations around data centers, so maybe you can address the implications of just the AI demand craze as it pertains to data centers for you?

Kuhl: Yes, that’s certainly the biggest area in our world where we see this AI impact. Data centres is an interesting property type. It’s different than other types of commercial real estate in terms of the demand profile, because there’s more demand created every day in terms of data. So, a simple example. If you guys are like me, you probably have thousands of pictures of your family and your kids and stuff on your phone. It’s probably backed up to an iCloud account. And you’re taking more pictures every day, right? So, the data just grows and grows, and that resides on a server in a data centre somewhere. And there’s lots and lots of other use cases like that that you can think of that have existed for years. Now we’ve got this AI buildout on top of that. So, it’s interesting because sometimes in other property types, we talk about leasing like a game of musical chairs, like maybe just hypothetically Janus Henderson moved out of their office and they signed a lease in a different office. They’re not necessarily taking more space. Data centres are different. They’re just always expanding.

So, as a result, you’ve got all of the data centre capacity effectively that exists is basically full. So, this is all about development of new data centres and external growth. That’s the opportunity. I know my colleagues here at the firm are much more in the weeds than I am in terms of what the hyperscalers are planning to do from a CapEx perspective, but the numbers are staggering. The scale of the buildout that is being talked about from an AI investment perspective is unprecedented in terms of CapEx cycles, really across history. Whether or not that comes to be the numbers that are being talked about, I don’t know, but a big chunk of that is going to be for building out data centres.

The challenge for data centres is a couple of things in terms of manifesting that buildout. One of them is access to power. The demands for these assets, from a power perspective, are huge. They need a lot of generation and transmission of power. There are certain localities where it’s a challenge, actually, for the utility to provide enough power for these data centres. And it can also be a challenge for developers to get the right equipment to build the data centres. So those types of challenges we think are best going to be navigated by the most well-established, largest, most experienced players in the data centre space, which are the public data centre REITs. And so, that’s a really good place for them to be. The other big challenge is access to capital. It takes a lot of capital to build out all of these data centres, and there is no better venue that exists besides the public markets to access capital, both from a debt perspective and an equity perspective.

So, the public REITs, as Danny mentioned earlier, the data centres are no different. They have really healthy balance sheets, which is a huge advantage. They can raise equity, they can raise unsecured bonds, and they can do that globally too because they’re global companies. So, they have the ability to really capitalise on this demand that grows every day. And the returns that they’re getting on development are really pretty good. They’re into the double-digit type of returns on the capital that they’re putting out on an unlevered basis, so that’s really healthy. And that goes straight to the benefit of the shareholders of those companies.

Castleton: So, lots of excitement, clearly, and a lot of buildout challenges with it, but it’s seemingly going very well. I’m assuming valuations have to come into play as an active manager, though, because there is a lot of money chasing this one thing.

Kuhl: It’s definitely not a secret. We’ve seen them perform really well over time, although we’ve also seen a couple of hiccups in the broader tech sector outside of REITs. And the data center REITs tend to get pulled along with that. So, I think there’s just a chance to pick your spots there and maybe adjust position sizes when these short-term blips happen. But you can keep an eye on the longer-term demand picture.

Castleton: Great. Danny, I want to turn to you, because a sector that’s in the headlines, maybe not for the best reasons, it seems to be, is us residential housing. Pretty high levels of unaffordability is what we’re hearing. So, what’s your approach and outlook to that sector going forward?

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Greenberger: Sure. Everything we do is anchored by considerations around supply and demand with a particular eye towards demographics. So, which of the age cohorts in the country are growing the fastest versus those that might be growing a little bit slower? We spend a lot of time thinking about those trends and what that might mean for rental housing. So, we look at rental housing across really four different groups, the apartment REITs, the manufactured housing REITs, which tend to cater towards a bit of an older demographic, and then the single-family rental REITs. And then as an extension of that, we’re also paying close attention to and at times investing in the homebuilders, which are developing single-family homes across the country.

Right now, we tend to favor the demographics and the supply outlook, one in the suburbs and assets that are catering towards a bit of an older age cohort. Right now, the senior housing space is growing the fastest. But I’ll sort of dial away from that for a moment. For broad residential housing, we tend to favor that 35-to-44 age cohort. It’s growing about 1.5% a year. It’s one of the fastest growing segments of the population. And folks in that age cohort are starting families, typically want to be in the suburbs and in good, desirable, safe neighborhoods and good school districts. And so, the single-family rental space has been very attractive historically. We continue to favor investment in that space. Families, when they get into these single-family homes, typically will lease for 3 or 4 years. Really, affirmation of the asset class and how much they enjoy being out in those assets, those communities with proximity to schools and local amenities as well.

So that’s one place that is solving the affordability challenges that you note. Those operators are actually bringing on new supply through development and partnerships with the homebuilders as well. So that’s one place where home ownership might be a little bit extended from an affordability standpoint now, when those REITs are doing their best to bring on new supply and adding inventory to the housing stock to make it more attainable for people to live in those desirable neighborhoods in the suburbs. And then we also favor the manufactured housing REITs. They tend to own assets more in the Sun Belt in the country, which is the direction of travel from a population flows and migration perspective. And again, a home in one of these communities can typically run 30% or 40% cheaper than a like-for-like rental or single-family accommodation. So, all of these are a bit of the same theme to your question, addressing these affordability challenges, which are driven by not just the pricing of homes on the existing and the new home market, but also ancillary costs to that, like homeowners’ insurance has gone up faster than rates of inflation, utility expenses, and property taxes as well. So, it’s not just headline home prices that are driving the affordability challenges. It’s the other costs of home ownership as well that have pushed people to rent a little bit longer, perhaps, than they would have historically. So, I would say, in that space we favor single-family rental, the manufactured housing REITs. And then the apartment companies, they have great portfolios, great businesses. We tend to view those as being a bit more cyclical than the other two sectors. The length of stay is elongating, but it’s not quite as long and those assets can be a little bit more cyclical and more prone to economic ups and downs versus the other two segments of the market that I just touched on.

So, I think there are some really attractive plays in the sector, and the entire ecosystem is, I think, doing a lot to address those affordability challenges I noted. And it’s also worth mentioning that the new homebuilders, particularly those that have operated towards the more entry-level part of the market, have done a lot to address the affordability crisis. So, at the onset of higher rates in 2022, they started buying down mortgage rates from close to 7%, using incentives to bring those rates down to 4% or 5% in some cases. And those mortgage rate buydowns persist today to help people meet those monthly payment challenges that they see. And they’ve also been building just smaller square footage homes and going back to subcontractors for better terms so they can pass along those discounts to consumers that want to actually own a home. So, we’re actually favorably inclined long term on the homebuilders, particularly those that are operating at that more entry-level price point, because we think they’re doing a great job of delivering an affordable solution for people who want to buy their first home.

Castleton: So, perhaps the private market is figuring this solution now. Do you hear any rumblings or anything of worries of government intervention to push this forward? It sounds like there’s some great opportunities the private market’s putting forward.

Greenberger: We’ll see what comes there. I think it’s been interesting. If you look at some recent local news in the state of California, for instance, they are reforming [California Environmental Quality Act] (CEQA), which has long been viewed as an inhibitor of more timely development because of very prolonged environmental reviews that have had to happen in the state there.

So, I think you’re starting to see, particularly on the coasts, a more urgent response towards getting development deals passed through local municipalities, and actually to the point where they can start commencing construction. And I think another good example of that, particularly on the East Coast, and New York has championed this I think quite well over the past few years, has been expediting approvals for office-to-residential conversion in places in Manhattan that typically haven’t had a lot of residential. And where you have dormant office stock, that’s now getting converted into residential. So I think it’s more of a patchwork on a local level right now. It’ll be interesting to see if there’s something that comes from the administration in terms of incentivizing a broader and perhaps a quicker path to opening up more construction and development. But I think the private market has responded to these affordability challenges pretty nicely. Just as an example, three years ago the multifamily industry was at a peak level of apartment construction, and now the amount of construction has now come off over the past couple of years because of the onset of higher rates and a slower growth backdrop. But the private market did respond to the increase in rents and the opportunity to add stock. And we saw close to 800,000 units under construction at the peak, which was a 50-year high. So I think the private market’s doing its thing, and hopefully increasingly aided by a more accommodative backdrop from a regulatory perspective.

Castleton: Great. Let’s go back to you, Greg. Any other sectors worth highlighting right now, as you think about the outlook for real estate broadly going forward?

Kuhl: One that’s worth highlighting is health care real estate for us. And there’s maybe a couple of different parts of that property type I touch on. The first one would be senior housing. This is assisted living and independent living. As you probably know, this is a needs-based solution for seniors. People are moving in there because there’s been an issue where they can’t safely care for themselves anymore. So, it’s a really important service. And that dynamic also makes the demand relatively predictable. So it’s unlike a lot of other parts of our business, where it’s harder to predict demand. The demand for senior housing is really just based on demographics, and the demographic that really matters for that property type is 85 and over, and we’re seeing a material pickup in the growth of that population right now. And then, if you look at now over the next decade, we’re going to see that segment of the population grow in the upper single digits per year. So that’s really strong demand growth based on demographics.

And at the same time, we’ve touched on this a few times throughout the conversation, supply is hugely important for commercial real estate. And we do try to keep it relatively simple in terms of how we think about this space. Supply and demand, right? So, demand for senior housing, we know it’s going to be really strong. Supply is very predictable because it takes one, two or three years to build a building from start to finish, so you can see it coming years ahead of time. In senior housing, there’s virtually nothing being started right now from a supply perspective.

So, that means for 2 or 3 years there’s not going to be any deliveries, so you’re going to see the existing stock fill up. And actually, if you play out the supply and demand there, there’s a scenario where the space that exists right now for senior housing is literally full by the end of the decade, based on the demand. So, that’s obviously a really good place to be if you’re an owner of that property type. That’s certainly one of our favorites from a supply and demand perspective.

The one other segment of health care I’d highlight is medical office. Again, demographically driven. So, 1 in 6 Americans are 65 and over today, which I think is the largest percentage that we’ve had historically, and that population is set to double by 2040. And that’s the group that by far uses the most amount of medical services, so that’s going to create demand for more doctors, more medical practices, and more medical office buildings. Again, a really good demand situation. The supply there is also pretty limited, so the outlook, we think, over the next decade for that space is, again, really strong based on demographics.

Castleton: Great. Bringing it back to just classic supply and demand dynamics. That helps really lay the case for the fundamentals of a lot of these sectors going forward. Danny, any final thoughts just to leave us with as we think about the outlook and the rest of this year?

Greenberger: I think the sector is actually very well positioned. It’s, in our view, a bit of a forgotten compounder. And I think the earnings growth from the sector’s history can be underappreciated, and that’s really been the catalyst for the returns that we’ve seen historically, which have been just a shade under 10% over the last 25 to 30 years for the asset class. So I think, again, we’re digesting the supply that was brought to bear in the earlier part of the decade. So the supply and demand outlook, I guess, looking out over the next 12, 18, 24 months I think is quite favorable. And you’re seeing early signs of some of the sectors potentially reaccelerating or bottoming where rent growth had slowed. Industrial comes to mind there. And we could see a resurgence in rental rate growth across a lot of these sectors that have been digesting a bit more of supply.

And then I think the untold story of the asset classes, Greg mentioned this with regard to his comment about data centers, is the access to capital. That can really speed up the pace of growth that companies have because they can go out and raise capital overnight, either equity or debt, and go out and acquire assets that come to market. And so, we still see the private markets a bit stuck in terms of transactions. It’s healing really nicely, but the REIT should have an interesting opportunity to go raise capital, buy assets, bring them onto their platform, and ultimately enhance the pace of earnings growth, which might augment that sort of total return building blocks that we talked about. So, I think capital markets and the debt markets for real estate are really supportive right now. Supply is coming off in a lot of interesting areas at a time when the leasing market is stable, and it sets the table for an interesting backdrop of total returns, if you look out over the next few years.

Castleton: Great case from both of you. And with so many investors having such heavy exposure to particularly US large cap equities, real estate is not broadly represented in the S&P at all. So, what you laid out today is really making a compelling case for them to start to think about building out their own allocation to REITs as a complement.

So, thank you both for being here, and thank you for listening. We hope you enjoyed the conversation. For more insights from Janus Henderson, you can download other episodes of Global Perspectives wherever you get your podcasts or check out our website at janushenderson.com.

I’m Lara Castleton. Thank you. See you next time.