Managing partner explains why a change in interest rate regimes, and stronger underlying balance sheets, should set up property assets for significant recovery
The ongoing downturn in REITs has been shallower than it was following the great financial crisis, but it has gone on for longer. The broad sector has been sold since the onset of central bank rate increases in early 2022. The REIT downturn in the GFC, which was far greater when measured peak to trough, only lasted from September of 2008 to March of 2009. Given the length of time these assets have struggled for, and the macroeconomic changes that have begun to take hold, Sam Sahn believes REITs are at an inflection point.
Sahn is the managing partner and portfolio manager at Hazelview Investments, a global real estate manager. He outlined why the US and Canadian economies are now changing in a way that supports recovery in the REIT market. He highlighted the assets on either side of the border which are well positioned and emphasized how advisors can talk to their clients about REIT allocations now.
“The current valuation dynamic of REITs, because of the massive underperformance over the last few years, sets the stage for a very strong recovery in stock prices and a very strong recovery, on an absolute basis and relative to the S&P 500 and TSX 60,” Sahn says. “It's about what is going to drive REITs going forward. Fundamentally you still have a very strong market in terms of supply and demand. There is no supply. Supply is declining, and typically supply that kills cycles within the real estate space, but that's just the opposite of what we're seeing. Higher construction costs, higher rates, and higher inflation has created a steady decline in new supply, so we don't see that changing over the next several years. And the demand side of the equation is fairly strong.”
What held REITs back in the past few years, according to Sahn, was the impact of higher interest rates. Real estate generally holds a high degree of exposure to interest rate increases, given the use of debt to purchase, upgrade, or build properties. Investors shied away from REITs because they expected the high interest rate environment would weaken REIT fundamentals.
That was perhaps most obvious in the case of office REITs, which have struggled to recover from the impact of the COVID-19 pandemic and the sudden shift towards widespread remote work. Valuations have come off, liquidity has dried up, and the price of debt has made investors more wary. Office, Sahn says, has become the poster child for the broader REIT market. However, he thinks that the underperformance in office has hidden a broader property market that’s been more resilient than many investors expected.
In the US and — to a lesser extent — Canada, economic resilience has been a watchword for the past few years. While cracks are beginning to show more meaningfully now, we have seen both economies hold in stronger than anticipated given the pace of interest rate increases. While Sahn acknowledges the cracks forming now, he puts weaker employment numbers in the context of historical norms to note that we have not deviated far from average levels. That weakening, though, sets the stage for the comeback that Sahn predicts, because central banks are now cutting rates.
The Bank of Canada has already cut its overnight rate by 0.5 per cent and is predicted to deliver at least another 0.25 per cent cut in its September meeting. The US Federal Reserve is all but guaranteed to make its first cut at its September meeting. Lower borrowing costs offer tailwinds for REITs and shift investor appetites. The start of a cutting cycle, Sahn argues, should be the inflection point for these assets.
Looking at specific opportunities in North American real estate now, Sahn is particularly bullish on a few property types. Senior housing, which includes assisted and independent living facilities, has long been an area where he sees growth. Supported by demographics in the form of aging baby boomers, Sahn sees a huge ongoing uptick in demand for these properties.
He is bullish on data centres, too, as key infrastructural components of our ongoing tech reliance and the rise of AI. He is also still bullish on key multifamily housing markets in Canada, given the lack of new supply, as well as the US trend towards single family rental housing. He advocates for an approach that looks at asset classes within particular markets, noting the different growth drivers and dynamics present in each location for each asset class.
Sahn’s view of the REIT market comes down to property fundamentals and macroeconomics. He emphasizes that throughout history, these assets do well in a declining rate environment. We’re now in that environment and he expects REITs to perform accordingly.
“REITs significantly outperform over a 12 to 24 month time period from the month leading into a rate cut,” Sahn says. “When you look at the performance of the sector quarter to date, which is really when the signs were out there that inflation is starting to moderate, REITs in Canada are up over nearly 14 per cent. REITs in the US are up over 10 per cent. We think there's a lot of catch up to do, and a lot of those returns should happen within the first 12 months.”
