Real Estate Investment Trusts (REITs) have staged a strong recovery since their pandemic lows. In this podcast, Adam Hetts, Global Head of Portfolio Construction and Strategy, is joined by Global Property Equities Portfolio Managers Guy Barnard and Greg Kuhl to discuss the benefits offered by the asset class amid rising inflation expectations, and why an active approach is warranted in a dynamic sector with attractive growth potential.
- Real estate fundamentals are strong, especially for those property types that have pricing power and that are less impacted by the pandemic.
- Historically, a positive relationship has existed between inflation and REITs, thanks to leases that typically have a built-in inflation uplift, boosting income.
- REITs are entering a new era, with improving operational sophistication, better access to capital and more focus on sustainability, which should help drive investor returns.
Adam Hetts: Welcome to Global Perspectives, where we feature candid conversations with Janus Henderson's thought leaders. I'm your host, Adam Hetts, Global Head of Portfolio Construction and Strategy, and today we're talking REITs [real estate investment trusts], and for good reason. REITs come up in just about every portfolio consultation my team does because they're such good asset allocation tools in this environment; because investors are constantly grappling with inflation, with searching for yield, with diversifying U.S. tech risk. And we're going to get into how REITs are an asset class that might help with all of those things. But first, let me introduce our real estate experts, Guy Barnard and Greg Kuhl. Guy Barnard is our Co-Head of Global Property Equities, and Guy and Greg are both Portfolio Managers on our Global Property team. Guy, Greg, welcome to the show.
Guy Barnard: Thanks for having us, Adam.
Greg Kuhl: Thank you, Adam.
Hetts: My pleasure guys. So, first, let's just set the table with where REITs are at right now. How have they been doing in this economic-recovery environment, and what are you expecting to see next?
Barnard: Yeah, I'll kick off with that one, Adam. The 2021 year to date has been a good environment for global REITs. The sector's up around 20% so far this year, so, you know, ahead of general equities, which are up around 15%. And within the sector we're seeing some real leadership from the U.S., where U.S. REITs are up around 28% through the end of July, which actually is the strongest ever start to a year that we've seen from the U.S. REIT sector. So, in absolute terms, you know, it sounds like we've had a great run, and the question will be what comes next. But I think, before we go there, it's important to think about where we came from coming into 2021. 2020 was actually a pretty challenging year for the global REITs sector. The index was down around 9% over the course of 2020, so more than 25% behind global equity markets, which were up close to 17%. So, that's a level of relative underperformance to the general equity market that we haven't seen since the dot-com boom in the late '90s. So, we felt this would be a bit of a catch-up year for REITs. That's very much what we've seen.
We talk about REITs as the landlords to the global economy. So, as we see economies bounce back from COVID, we're certainly seeing that feed through into business and consumer confidence, and that's ultimately good for a lot of landlords in which we invest. We're also seeing a backdrop of very low interest rates, very low bond yields, real yields today touching record lows. That is good for an income-producing asset class like real estate. And I think, if anything, we have been surprised to the upside by what's going on in underlying real estate markets, where the pricing of assets is exceeding our expectations, particularly in those structurally supported sectors. And the plentiful and low-cost credit market is certainly fueling a pickup in interest, not just at an asset level but also at a portfolio and corporate level, as well. And then the inflation piece, I think, is sort of the cherry on the top in terms of – REITs as an asset class typically perform well in periods of rising inflation expectations. We can go into a bit more of why that is later on, but suffice to say, we think this is a pretty good backdrop for real estate as we look forward.
Hetts: If we're talking about REITs more broadly, it's a broad asset class. Like on the economic production side, you've got industrial all the way across the spectrum to retail. Then on the tenants, you've got commercial all the way across to residential. So, can you just talk about some of the dispersion that you saw, or lack thereof, around the numbers – down last year and up so much this year?
Kuhl: So, yeah, as you mentioned, Adam, there is, within listed real estate, there's quite a wide array of different property types, different needs and uses. You think about some of the traditionally core real estate sectors, which would be things like office, retail, residential and industrial. Those, you know, have been well established for many years. You know, we also, in the listed REIT space, have a whole host of other sort of newer property types that would include things like single-family for rent, scientific lab space, manufactured housing communities, cold storage REITs, data centers, cell towers – the list goes on in terms of the different types of asset classes that exist within REITs.
You know, I think there was quite a bit of dispersion through the onset of the pandemic through, let's say, Pfizer Monday, which was the day in November when the efficacy of the Pfizer vaccine was announced. So, from that period – the onset of the pandemic until Pfizer Monday – what you saw was certain sectors of the sort of real estate complex really getting hit pretty hard on a fundamental basis. Those would be, you know, some of the areas like hotels and retail, where their businesses were effectively shut down, and that's where you saw some landlords have issues with cash flows. On the other end of the spectrum, you saw some areas that either were unaffected or potentially got even stronger as a result of the pandemic. And those areas were places that, in our view, were already well positioned for growth in the long term and the pandemic just served to accelerate kind of what was already happening. Those would include things like industrial logistics, warehouses. So, the dispersion was pretty strong between, you know, the haves and the have-nots through that initial period.
I think what we've seen since then, since November – I believe it was November 9th of 2020 that announcement happened – and you then saw a very strong sort of rebound in some of those have-not sectors like retail. And, you know, retail real estate stocks have, in a lot of cases, doubled or more off of those lows that were in 2020. And you've seen some of the other sectors, what we think are the long-term secular compounders, like industrial, didn't experience that same kind of rebound having done better through the pandemic.
So, you know, in our view, it's really important to think about: Okay, now, we're going to be ending what is a period of relatively easy comps for something like retail landlords. Where now, especially as we move into 2022, you don't have that year-over-year comparison benefit that was so negatively impacted by COVID, and you've got to think about, where is growth actually sustainable multiple years into the future? Where do you want to be positioned as an investor where supply and demand is, in the long term, in your favor? And, you know, that's something that we think would lead you back toward kind of those secular compounders – industrial, residential, specialty property types, some of which I already mentioned (cell towers, data centers, manufactured housing) – and, again, I think we're sort of in phase three of this secular dispersion now where I'd say since probably March or April of this year, we have seen those long-term compounders start to work really nicely again.
Hetts: Thanks. I think that’s a helpful part about setting the table here, is that, REITs get talked about like they're one thing, but to your point, there's a lot of nuance and a lot of potential dispersion within the space. And I think we've already mentioned inflation once or twice already. So, what about rent inflation, and then, I guess, broader economic inflation? How are you seeing that affect the space across any of those sectors?
Barnard: Yeah, no, I think when we talk about inflation and real estate, I think most people in inflationary periods are looking toward real assets. And we've certainly seen over the long term that real estate has been a good way for investors to protect themselves during inflationary times. And if you think about what's going on under the hood of one of the REITs in which we invest, you know, they ultimately own a portfolio of assets that are let to many different individual businesses on typically relatively long-term leases. And those leases, although the structures vary around the world, will typically have an annual indexation or bump, either tied to an inflation index or an absolute percentage increase that will be passed through every year. So, as a landlord, you do tend to see an income stream that unlike a fixed income investment, has a degree of growth embedded into the contract. So, you know, that is intuitively a good place to start when you're talking about an inflationary backdrop.
I think where the challenge and debate comes is, what happens at the end of that rental contract? As a landlord, do the assets I own have pricing power with the underlying tenants within it? So, have we seen underlying fundamentals in that asset class grow in line with inflation such that when I come to renew my lease at the end of it, I can sustain that new high level of rent, or is it going to be rebased to a lower point? And I think that's where we still come back to – the best way for us as investors in real estate to protect ourselves from the threat, or the actual evidence of inflation coming through, is to be in those sectors where landlords have pricing power.
And that really reverts back to Greg's point around, you know, these sectors that are benefiting from structural drivers of growth rather than just the ebbs and flows of global economic cycles. Because we don’t believe, for example, that a shopping mall landlord has pricing power today and that if their rents are going up with an inflation index, that at the end of the rental contract that is going to be sustained. Whereas on the flipside, we are seeing areas in, again, Greg's touched on it, in sectors such as the industrial and logistics sector, where global landlords are telling us that rents are growing organically by 5% to 10% a year.
So, you know, inflation is certainly something that I think does lead people to tilt towards real estate as an asset class. But as bottom-up fundamental investors, I think it's also very important to be asking yourself whether the increases in rental income are sustainable, and does a landlord have pricing power over the long term. And I think that's where you're going to continue to see this divergence between structural winners and losers.
Hetts: Yeah, I think the theme I'm picking up on so far would be these subsector dispersions, whether it's in overall performance or in reaction to inflation. And Greg, you mentioned, I think you framed it, the third stage of this secular dispersion among subsectors. So, whether it's returns or inflation, I feel like there's a little bit more underneath that. So, can you explain a bit more about what you're talking about with this third stage of dispersion?
Kuhl: So yeah, going back to the start of the pandemic, you had kind of the first phase of dispersion within sectors, which really, that was a continuation of what we had seen for a few years prior, where it was those property types that have pricing power had been doing better for quite some time. That accelerated immediately following the pandemic. I think, you know, phase two, again, is post the vaccine announcement. That's where I think the market was just hungry for things that had sold off a lot without a whole lot of consideration, in our view, for longer-term fundamentals. And then I think phase three is really, it's back to fundamentals matter. So, you know, in our view, it started again in probably April timeframe, I would say, roughly. And it's, you know, our perception is, it's investors looking forward to 2022 and beyond, and thinking about the fundamentals after an immediate rebound and where can they be positioned.
Hetts: Okay, thanks. You're laying a lot of reason for optimism on REITs. But in our database, for example, of U.S. advisor portfolios, about 80% of the advisors in our database don't own REITs. And like I mentioned, it's coming up every day in our client consultations because they're such great asset allocation tools. But what do you think the reason is that the majority of investors aren't owning REITs at the moment?
Kuhl: Yeah, it's a good question. And I think obviously it's hard to know the answer for certain, but listed REITs are, in our opinion just entering maturity as sort of a really investable core part of the portfolio. You know, we call it, the current phase that we're in, we started calling it REITs 3.0. Just to give a quick background of why we say that and sort of what the different phases of the asset class are, [I’ll] give a quick rundown of the history.
So, you know, REITs came into being in the U.S. in the 1960s. So, that's obviously quite a while ago, but if you think about, you know, REITs 1.0, as we would call it, it was kind of the 1960s through kind of the early 1990s. And to be fair, there just wasn't a lot happening in terms of listed equity REITs at that point. Most of the REITs that were listed tended to own mortgages. Very different business than owning commercial property from an investor perspective and a return and risk perspective.
Really, as we know them today in the U.S., listed equity REITs didn't start proliferating until sort of the middle part of the 1990s. So, throughout the second half of the 1990s, there was 150 or so REIT IPOs [initial public offerings]. And in a lot of cases, those were private businesses, some of them were family-owned businesses. They generally ran with pretty high leverage. You know, leverage that we would say is too high on the balance sheet side. They, in a lot of cases, were subscale. It might've been limited to a specific geographic market, usually one property type and just small in scale. And, you know, management teams in a lot of cases that weren't particularly savvy necessarily in the public markets; they would've come from private backgrounds and had that mentality.
So, that's kind of REITs 2.0, and we would say that lasted up until a few years ago. And throughout that period, you saw management teams get better, a little bit more savvy. The sector grew in scale quite a bit. The GFC [Global Financial Crisis] happened. It was a major event for REITs, which to us was really kind of a watershed moment for the sector to get its act together from a financial leverage and financial risk point of view.
And that's, I think, part of what leads us into REITs 3.0, which it's hard to pick dates for these things, but we've sort of picked the start date of the current era of REITs as 2016, which a couple things happened that year for U.S. REITs. The market cap of the sector surpassed $1 trillion (USD), and REITs were added as the 11th GICS sector. You’ve seen by that point balance sheets operating with much, much less leverage than they had previously. You’ve seen management teams get far more sophisticated of the REITs, both in terms of their ability to do creative things operationally to drive value but also, the way that they use their access to capital is hugely important for listed REITs. And I would argue up until pretty recently, we hadn't seen a lot of really savvy use of the capital markets to create value by these management teams, but we are seeing that now. They can use their access to capital as an offensive tool to create value, and, for example, raise equity at the price that their stock affords them to and then go acquire buildings in the private market at a price that might be better than that.
And then the final point around sort of REITs 3.0 is there are so many different property types today than there used to be. I mean we used to have only the four core property types: retail, residential, office and industrial. Today, there's a long list of specialty property types that generally are only best available in the public markets.
So, I think that this whole evolution, you know, it's really been the last 20 years that REITs have been a sizeable, investable liquid asset class on the listed side with lots of different options. And in terms of it being, you know, a highly sophisticated public asset class where these companies are not just passive owners of real estate, they are platforms that have tremendous value and the ability to create value for shareholders. You know, to us, we've just started into that phase in a real way, and so that's, as we look forward, something that's really exciting about the asset class and its potential for growth.
Hetts: So, you said 2016 is when this sort of REITs 3.0 came into being, where the asset class hit $1 trillion and became officially the 11th GICS sector. Leading up to that, you mentioned 2008 being this watershed moment where obviously anybody vaguely familiar with REITs knows there was a ton of volatility, to put it lightly, because of the leverage that was in the system, and that was certainly not specific just to REITs. But is that watershed moment in 2008 sort of the necessary precursor to the asset class evolving to this 3.0 stage? What would you say about the structure of REITs, the leverage and risk of REITs, compared to what the asset class looked like 15 years ago?
Kuhl: Yeah, I think that sort of 2008 timeframe is definitely in a really important precursor to where we are today. You know, a lot of REITs went through this sort of progression I'll discuss here. They had been borrowing in really aggressive CMBS [commercial mortgage-backed securities] markets throughout kind of the early to mid-2000s. A lot of those loans had short-term maturities, you know, three to five years. And so, they did too much borrowing and they did too little laddering of maturities. So, you saw in the Global Financial Crisis a whole lot of debt coming due all at the same time. And, you know, a lot of REITs were in a really challenging position with these looming maturities, and that's why you saw a number of the stocks decline, really, so dramatically.
The way out of that was for those companies to effectively recapitalize themselves by issuing equity. You know, those equity issuances were hugely dilutive to existing shareholders, but they did fix the problem. And in 2009, you saw a dramatic sort of rebound in the asset class for those companies that had issued equity and sort of solved their problems. And I think that was an important lesson. It finally drove home the importance of operating on a conservative leverage basis to a lot of these management teams that, just by definition, had grown up in the private real estate sector.
And then finally, there's very few, if any, sort of examples in listed REITs today where you have this maturity wall. You know, I think all these companies are very conscious of that. They've been really diligent about laddering out their maturities, so, yeah, 2008 definitely a huge step forward in the asset class and, you know, it feels like we're in a vastly different position today, certainly on the capitalization perspective, as well as some of the others I mentioned.
Hetts: Yeah, thanks Greg. And I think, personally, that's one of the most important things we're discussing today. There's nothing inherently so volatile about REITs that makes them more volatile than equity. There’s a very specific set of risks and circumstances leading up to 2008, which are demonstratively different, as you just explained, and there's evidence in volatility and the statistics about how the asset class has evolved and its risk perspective in the context of a broader portfolio.
Another thing that you mentioned about this REITs 3.0 is just the public markets, capital markets access and the savvy use of capital. So, maybe that's a good entry to talk about public REITs versus private REITs. Just what do you guys think about as the tradeoffs between public REITs and private REITs? Do you have examples of where you've seen public work out better, and then examples of where private REITs work out better?
Barnard: We spend quite a lot of time in the real estate world talking about the importance of location, location, location, location. And I think it's equally applicable to investors when they think about how are they going to get their real estate exposure. Obviously, there are many different vehicles and structures that one can look at when, you know, thinking about that real estate allocation. I think there are probably three key considerations that we would urge investors to think about.
One is just the underlying structure of the investment that they are making. One of the great benefits of REITs and REIT funds is the liquidity that they provide. REITs themselves trade on stock markets like any other equity, which means we have ongoing liquidity on any given day to be able to move very significant amounts of money into or out of what is now a very large sector. And therefore, if an investor in an open-ended fund wants their money back, you know, they can have it. Now that liquidity clearly isn't always present in other forms of real estate investment. So, you know, there are many funds – closed-end funds, non-traded REITs – that can't guarantee that same sort of liquidity.
Clearly with liquidity there is a tradeoff, though, and the tradeoff in the case of REITs is the daily volatility of stock markets. So, on the short-term basis, at least, you see much more volatility in REITs and REIT funds than you would see in many of these other, more closed-end or non-daily traded vehicles, which are typically valuing their assets every, three, six, or 12 months based on typically pretty backward-looking valuation evidence. So, you know, there's this tradeoff between liquidity and volatility. The reality is that the true volatility of real estate probably sits somewhere between the two vehicles, REITs and non-REIT real estate funds. But we continue to highlight that if you look at REITs in the same way that you look at your other real estate investments, i.e., with a medium- to long-term time horizon, then what you will see on the other side is typically a return that is very highly correlated to the underlying real estate. And then, actually over time, it’s typically outperformed many in these other types of real estate vehicles.
I think another important consideration is really to ask yourself, ‘What am I getting within this structure?’ So, what sits within that wrapper? We've spent quite a lot of time today trying to articulate our view to, you know, we are seeing very different supply and demand dynamics, very different return prospects across different types of underlying real estate. So, the underlying real estate sectors are going to have a very different outlook in terms of the returns that they would generate. And to Greg's point on REITs 3.0, you know, when we look at the REIT sector today, it's giving exposure to those parts of the real estate market that are, in our view, structural winners through large dominate platforms that frankly cannot be replicated in the vast majority of private real estate vehicles. And the other ability you get from global REITs is a much higher level of diversification. You know, companies spread around the world that themselves will own hundreds or thousands of buildings let to many, many individual tenants typically within each asset. So, if you think of real estate as a diversifier, and that is, you know, certainly one of the key attributes of the asset class, you're just getting more of it in the REIT sector, and that is very, very hard, again, to replicate through direct investment. It's very hard to get a true global platform, you know, in some of these other forms of ownership.
Hetts: That's very helpful. And with public REITs doing so well in the recovery trade this year, like you talked about earlier, the dominate theme across public equity markets more broadly is this value-versus-growth trade. So, as you're seeing the recovery trade play out and the performance of REITs, do you attribute that to following with part of this value-versus-growth theme? Or do you feel like REITs as diversifiers are sort of sitting to the side of that value-versus-growth debate and there's more independent factors feeding into these REIT returns?
Kuhl: Yeah, that's a good question. Within the sector, I think we have seen our own version of kind of the value-versus-growth phenomenon with, you know, some of those property sector dispersions that I spoke about earlier. You know, for us, the equivalent to “value” is something like regional malls, which by the traditional definition of value, they trade at low multiples. And those did quite well in sort of the early phase of the recovery. The growth side could be represented by something like industrial logistics, which trade at higher multiples, offer more growth. You know, those lagged a little bit, let's say, from November 2020 until April/March of this year. That, as I mentioned is, has, seems to be waning at this point, and we're back to sort of, you know, what we think are just long-term fundamentals.
You know, the other thing, which is even a bit counter to the whole inflation discussion but, you know, low rates. We've seen base rates, the 10-year [Treasury yield], decline quite a bit. That filters through into really inexpensive cost to capital, and for a capital-intensive asset class that can be beneficial. It also makes the income component of REITS that much more attractive. We have long-term, high-quality contractually guaranteed income streams on offer and pay a really attractive yield as an asset class relative to general equities or fixed income, and that has only gotten more attractive as we've seen rates go down in sort of the ongoing search for income. So, that's helping as well.
And then I think the final piece of it is going to be this ongoing sort of realization of REITs 3.0, and that these are dynamic companies that can really create a lot of value above and beyond simply kind of the passive ownership of their real estate. And we see more and more examples of that happening, and that's only going to drive values higher for those companies as there's more of them in the U.S. and around the world. But it feels like there's a number of tailwinds for the asset class today besides just a rebound after a tough year.
Hetts: I feel like we keep getting back to the same two key themes here in this conversation. And the first, you just explained Greg, is that REITs are a really good equity portfolio tool, in that they've got a lot of very productive risk factors as far as the inflation defensiveness built into it, the yield and the traditional equity diversification that is, as you're framing it up there, it's a way to invest in equities and avoid the value-versus-growth dilemma that's torturing a lot of equity investors right now.
And then the other part is, just the depth and dispersion and granularity of the asset class and the need for the active management that you guys are describing. That leads to my last question: As far as active managers, I mean everybody's talking about ESG and sustainable investing in real estate. What does sustainable investing mean for your team personally?
Barnard: I think the first thing we would say is that we do not believe that a robust ESG integration into an investment process is something new. You know, this is not something that we have not been doing before. Really, the way you think about ESG, you should really sit hand in glove with how you thought about other factors that affect underlying security performance. So, this is something that I think, as you say, plays to the active management piece, and it plays to a focus on, you know, a really detailed bottom-up understanding of what's going on within different companies.
Now, within the real estate sector specifically, I think an area that has been a huge focus for us over many, many years is the importance of management in governance. We have seen time and time again over the years, examples where poor corporate governance has resulted in some very negative outcomes for shareholders. You know, the difference between good and bad management teams in what might look from the outside is a fairly homogenous set of real estate assets has resulted in some vastly different returns from, you know, what are similar assets over time. So, the importance of governance, the importance of management and the time we spend getting to know them, understanding their strategy, seeing how they execute on it, is really a key focus for us within the broader ESG piece. And, as I say, it’s not something new; that's always been incredibly important for us.
I think what is increasingly in focus, and rightly so, is the sustainability piece in the context of the real estate market. And the data tells us it's important because when you look at overall greenhouse gas emissions, around 40% of that is coming from real estate assets across the broad suite of residential and commercial real estate types. So, we do firmly believe that real estate needs to be part of the solution when you talk about a pathway toward carbon neutrality. You have to ask yourself the question of what is important in the context of environmental and sustainable factors. And I think for us, we're really trying to dial in on that carbon piece. Not just the ongoing emissions of buildings, which would tell you to knock every asset down and rebuild a new shiny one that is more environmentally sustainable, but the embedded carbon of real estate. So, you know, how can we improve what we've already got? What are new processes, techniques, technology so they can enable companies to produce, as I say, buildings that are going to be more sustainable going forward.
And that's something that we're spending a lot of time trying to get good data for. You know, there's a real risk here of garbage in, garbage out. Comparing companies across different types of real estate is still pretty hard. You're not necessarily comparing apples with apples. I'm not even sure you're comparing apples with pears, in some cases. So, you know, it's about really getting a handle on the data, and that means we need to do a lot of that legwork ourselves and a lot of the analysis and interpretation. There is still a very wide range of views even among what would be the, I guess, banner ESG rating companies as to what is good and what is bad. So, if they don't know, how is an end client, an end investor going to know? And I think that’s why we've got to take a view as a team as to what's important and try and focus on that and engage with companies to do a better job where we can.
And I think it is now becoming clear that when you look at the value of assets that are meeting, you know, these more sustainable criteria, you are starting to see a polarization between those assets, which are meeting the high standards of environmental sustainability and those which don't. And a good example is what's happening in the office market today. You know, we haven't really touched on it today, but I'd imagine most of us are doing this recording from our home rather than our office. So, clearly, there is a structural change taking place in the office market, and that is going to affect demand for space going forwards. But what's quite interesting is when you look at the leasing transactions that have taken place over the last 18 months, most types of assets by age are losing occupies. So, there is negative net absorption in older buildings, which are typically those that are less sustainable. Where you are still seeing positive net absorption and where you are seeing the greatest rental tension is in those new, more sustainable buildings. So, it's not just a hypothetical concept. It is something that is very real when you look at the value that a company is going to be able to extract from their portfolio because there is clearly now a green premium in terms of your ability to lease a building and the value you will get from investors for those assets. And on the flipside, a brown discount, if you like, from those less sustainable assets, many of which we believe will ultimately become stranded without significant capital investment.
Hetts: Great thoughts on sustainability. I feel like there's a ton we can get into there, but we've been going for long enough, so I think I'll let you guys catch your breath on sustainability, on the evolution of the asset class, and REITs 3.0, and just the dispersion and nuance among securities and subsectors within the REIT sector. All great updates. So, thank you guys. Appreciate your time today.
Barnard: Thank you.
Kuhl: Thank you, Adam.
Hetts: And, always, for our listeners the views of Janus Henderson’s other investment teams and thought leaders are freely available within the insights section of our website. So, we look forward to bringing you more conversations in the near future.
CMBS: Commercial mortgage-backed securities are fixed income products backed by mortgages on commercial properties. CMBS provide liquidity to real estate investors and commercial lenders.