Peaking interest rates are in the driving seat
Interest rates in developed markets increased significantly in 2022 and into 2023, as central banks fought the effects of spiralling inflation. With inflation falling back towards target levels in 2024, and economic growth slowing, all eyes were on policymakers as the market anticipated their next move.
The European Central Bank made its first cut in June, and the Bank of England followed shortly after in August. While the cuts only amounted to a 25 basis-point (bps) movement in base rates, the significance of that move was far greater. It demonstrated the consensus view that interest rates have now passed their peak in the current cycle. The focus is now on when, not if, the Federal Reserve (Fed) will commence policy easing. At its recent Federal Open Market Committee (FOMC) meeting, the Fed left interest rates on hold. But it provided strong hints that a cut is coming in September, even if it stopped short of pre-committing to this move. The FOMC is clearly feeling more confident around the inflation outlook, following a run of noticeably softer price data, and signs of easing wage pressures. Assuming no major upsets, we expect a move from the FOMC in September, with the market pricing in 25bps cuts at each of the three remaining Fed meetings this year.
What does this mean for real estate investment trusts (REITs)?
Historical research shows that over the 12 months when a real estate cycle begins to move from trough to recovery, listed real estate securities tend to outperform equities and private real estate. This is because of the correlation between bond yields and real estate valuations. The two asset classes share similar characteristics, such as long duration and predictable cashflows. This dynamic unfolded over the latter part of 2023, when the market first became more confident about the trajectory of rates. The FTSE EPRA NAREIT Developed Net Return Index outperformed the MSCI World, in USD terms, over both November (+125bps) and December (455bps). Historical research suggests this trend should continue when the Fed commences its cutting cycle later this year.
Re-emerging cost of capital advantage for REITs
REITs are starting to enjoy a cost of capital advantage, relative to private real estate peers, in some markets. With the balance sheets for REITs improving across several metrics since the Global Financial Crisis (GFC), they are in a stronger position to raise capital and grow through acquisitions. Meanwhile, private real estate investors may still be struggling to raise capital.
Despite strong underlying real estate fundamentals, this capital dislocation has created a number of attractive merger-and-acquisition and asset-level opportunities for REITs.
Backed by a stronger financial footing, and buoyed by attractive fundamentals, many REITs have been able to deploy capital at the bottom of the cycle. This has allowed them to grow externally through acquisitions and to benefit from above-market growth. This provides REITs with a distinct competitive advantage versus private-market peers who tend to rely on bank lending which remains challenging to source.
Access to attractive alternative property sectors
The real estate landscape is undergoing significant transformation because of economic and social structural forces. Global thematic trends – such as the reconfiguration of supply chains, the digitisation of the economy, and demographic shifts – are having a material impact on investment demand. Over the last 10 years, the importance of some sectors – such as data centres, large-scale logistics, and single-family rental accommodation – has grown. These changes necessitate an evolution in the built environment to align with an evolving economy and society.
The REIT market can provide investors with significant exposure to those sectors that are likely to be clear beneficiaries of growing structural trends. This contrasts with private real estate investments, which are largely focused on traditional real estate through a balanced portfolio. REITs hold a competitive edge in this area, thanks to the specialised skills and operational expertise required to manage assets in niche sectors – including data centres, rented residential properties, and healthcare facilities. The industry-leading platforms within the REIT market are more challenging and expensive for private-market peers to replicate, offering a significant competitive advantage to these companies in the years ahead.
Final thoughts…
As always, investors must consider the evolving dynamics within the property sector when considering investment allocations. Embracing the shift towards alternative property investments might not only hedge against the declining allure of traditional sectors but could also position investors to capitalise on the growth opportunities presented by structural changes. We believe REITs are well-positioned to take advantage of this evolving investment landscape by providing fast and efficient access to the most attractive alternative sectors of the global real estate market.