Constructive on REITsFeb. 13, 2023
While BMO Equal Weight REITs Index ETF (Ticker: ZRE) underperformed the broad market in 2022 (-17% vs TSX -6%), we believe 2023 will be more constructive with interest rates expected to normalize.
In higher inflationary markets, when rates are rising, there is a bit of push and pull when it comes to performance in REITs. On the bright side, real estate has the benefit of being a real asset that tends to hold value in periods of inflation. Furthermore, lease resets give REITs the ability to pass on inflation through reset rent agreements. On the negative side, however, higher interest rates impact the REIT’s cost of capital and make the hurdle rate for new projects to be cash-flow accretive more difficult. The “bond-proxy” quality of REITs can be a negative. In any event, the condition of the economy does play a large role, so if rate increases occur during a state of economic prosperity, or an economic slowdown, impacts on valuations and markets will be different.
Data suggests that REITs may provide better performance in higher inflation environments. To demonstrate, below are some data points from Alliance Bernstein (from the U.S. market) looking at Real Estate and REIT performance in different CPI/inflationary environments (CPI YoY change on the left):
|Since 1970||U.S. REITS, YOY||Real Estate Index, YOY|
|-1 to 0||-11.10||-4.34|
|0 to 1||3.67||3.95|
|1 to 2||17.71||5.37|
|2 to 3||22.50||4.26|
|3 to 4||21.90||4.68|
|4 to 5|
Source: Ken French database, AQR, Robert Shiller’s database, FactSet, FRED, Datastream and Bernstein analysis from 1970 to May 2021.
Physical Real Estate typically performs well in high CPI periods however, the best REIT performance has occurred in more normalized inflationary regimes. As an incidental note, the strongest REIT performance vs stocks in the U.S. market came in the 1976-1981 market - a period where 10yr treasury yields increased by 8.5%, U.S. REITs gained 137% vs equities at 46%. This is a period that many are comparing to the current environment to.1
In 2022, we have seen the negative impact of higher rates outweighing the positives. Looking forward, while the future remains uncertain, one could argue that much of the rate recalibration has occurred. We are seeing CPI come down in North America and globally, and this would indicate that the rate increases are having the impact that central banks are intending them to have.
In terms of interest rate hikes, future increases are muted – with a pause from the BoC over the next few meetings and only a 50bps rate increase from the FED before year end (being priced into the markets). To make a long story short, with the potential negatives looking out of the way, this sets REITs up more positively for 2023. We are already seeing REITs trade constructively in 2023. ZRE is up 9.98% to start the year, versus the S&P/TSX Composite Index return of 7.41%.
|ZRE - BMO Equal Weight REITs Index ETF||9.98%||-6.78%||7.66%||7.66%||9.14%|
|Solactive Equal Weight Canada REIT Index||10.04%||-6.22%||3.27%||8.48%||9.89%|
Source: Bloomberg February 7, 2022
1 Michael Orzano and John Welling, “The Impact of Rising Interest Rates on REITs,” S&P Dow Jones Indices, July 2017.
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