REIT performance signals positive outlook for direct real estate valuations

There is a strong correlation between the performance of REITs and the valuations of direct real estate. Whatever the REITs are doing, we would typically expect direct real estate to follow suit six to nine months later. And, judging by recent months, there is great reason to be hopeful.

Early in Q2 2024, we made a call that investors should be overweight listed real estate. This decision was based on several factors, not least the strengthening underlying fundamentals of the REIT market, but also our view that interest rates had peaked. REITs have historically tended to outperform general equities and private real estate in a falling interest rate environment.

This has proven to be the right call, with the listed real estate market (as measured by the FTSE EPRA NAREIT Developed Index) outperforming the global equity market, returning 10.98% versus 7.02% for the MSCI World Index between the first rate cut by the European Central Bank on June 6th of this year and October 29th.

Discounts have narrowed and some REITs are now even priced at a premium.

They’ve also ramped up capital raising – issuing significant amounts of equity and unsecured debt (most oversubscribed), which suggests the end of the era of refinancing challenges and the start of an era of expansion.

Equity issuance by REITs in 2024 is already substantially ahead of 2023 and 2022, and the year is not out yet. This issuance has not been for balance sheet repair but for deployment and growth.

Positive outlook continues

We retain our positive outlook on the REIT market and expect those areas of the market that are underpinned by longer term thematic trends, such as supply chain reconfiguration, changing demographics and digitalisation, to be the winners of the future.

At abrdn, we’ve seen strong interest in our listed real estate capabilities, as investors are reconsidering their real estate allocations and analysing the best entry route into the asset class.

This strong growth in the REIT sector is a positive indicator for direct real estate.

UK direct real estate capital value growth chart

This month, we updated our House View again to be overweight real estate - though of course with sector-based nuances. This is the first time we have been overweight direct real estate since June 2022.

Europe and UK particularly appealing

We are particularly positive on Europe and the UK. In the UK, the economic fundamentals look increasingly appealing, supply-demand imbalances are likely to continue – supporting valuations, and swap rates are considerably lower than their peak in 2023, which is encouraging greater activity in the lending market.

The latest data from Bayes Business School indicates that new acquisitions accounted for 45% of loan origination in H1 ’24 compared to 28% for the whole of 2023. All in average real estate financing costs are now below Q4 2022 levels, largely because of increased competition driving margins down across the board.

Similarly in Europe, the weaker macro backdrop is driving the likelihood of more rate cuts, low construction activity continues to constrain supply, institutional investors are returning, and bidding intensity has re-emerged in logistics and residential markets.

The REIT effect

However, in both markets, we continue to see sector divergence.

This is being evidenced in the “REIT effect” which is starting to trickle through, with positive capital value growth in our favoured sectors (industrial & logistics, residential and some areas of retail). While other sectors, predominantly offices, continue to see negative capital value growth.

As the chart below shows, residential, hotels, industrial and retail parks have all enjoyed above average (and importantly: positive) capital values growth in the year-to-date.

It is worth highlighting that the pace of capital value declines for offices has moderated and a polarisation in performance by quality is clear to see.

Source: MSCI Monthly Index, September 30th, 2024

We find residential particularly attractive because of the on-going supply and demand imbalances across the UK and Europe. Any meaningful rebound in supply looks unlikely given more prohibitive construction and financing costs at present. Whether it’s the private rented sector (PRS) or the Purpose-Built Student Accommodation (PBSA) sector, rental affordability remains crucial for both performance and risk, in our view.

In logistics too, we see investors gearing up to boost sector allocations. When monetary policy began its tightening cycle, the logistics sector experienced the sharpest readjustment in pricing, largely as a result of greater liquidity and pricing transparency.

With a more attractive entry point and fundamentals which continue to look attractive, we now see bidding intensity picking up for the right assets.

Future returns

Overall, we forecast three-year annualised total returns for European property to be 9.3%. For our favoured sectors, industrial & logistics and residential, we expect this to be higher: 11.1% and 10.3% respectively.

For the UK, we're forecasting three-year annualised total returns of 8.6% - again with industrial, residential and retail expected to beat the average.

However, every property cycle is different, and this will not be a ‘rising tide floats all boats’ recovery. Quality will prevail and capturing genuine reversion will be very important.