As yields rise, do REITs still have a place?

In the decade-long search for yield that preceded the recent rise in interest rates, many advisors flocked to the REIT space. Real Estate Investment Trusts offered exposure to real estate with high income yields that could fill in for what fixed income wasn’t paying. Now, however, fixed income is paying attractive yields once again. At the same time, a mixture of post-COVID changes in real estate demand as well as interest rate sensitivities in some asset classes have left REITs struggling. So as we look at the prospect of a ‘higher for longer’ environment, how should advisors be looking at the REIT space?

Two asset managers remain bullish, despite some of those short-term headwinds. Dean Orrico,  President & CEO of Middlefield, and Samuel Sahn, managing partner and portfolio manager at Hazelview Investments, both argued that underneath the headlines, much of the REIT space remains attractive. They outlined a range of reasons why, even as fixed income yields look more attractive, advisors might still want to be considering the REIT space.

“I think public REITs have got well covered yields, higher than what you’re getting on a GIC and a valuation that is, historically, trading at a very deep discount relative to where REITs have traded,” Orrico says. “Our favourite REITs are trading at about a 15-20% discount to what we think those assets are worth. So now you’ve got this yield, but you’ve also got what I think will be a rerating and a closing of that discount over time.”

Orrico notes that some caution is needed, even though he sees the space as “extremely attractive.” He sees offices as a potentially risky area and expects we’ll see continued high rates of vacancy over time. The ongoing debate about hybrid work will continue to depress office real estate values, in Orrico’s view.

On the opportunity side, though, Orrico believes that multifamily apartment REITs, grocery-anchored retail REITs, and industrial properties are all well positioned in Canada. Senior living REITs, too, are seeing high levels of demand and Orrico thinks current valuations are attractive on these real estate assets from a cashflow perspective.

That opportunity set was largely echoed by Samuel Sahn. He added that a few US-based trends can also be seen as attractive, including data centres vital for cloud computing and the rise of AI, as well as single-family rental housing which is enjoying higher demand from cash-strapped millennials moving to the suburbs. He echoed Orrico’s positivity around senior living REITs, highlighting a huge demand as baby boomers age, as well as a lowering of labour costs following the highs of the pandemic.

REITs do show some sensitivity to interest rates, and will likely see the costs of their debt rising in line with interest rate hikes. Orrico, however, argues that many of the REITs he values have lower debt levels and stronger balance sheets than they showed in the leadup to the Great Financial Crisis and the pandemic.

While interest rate increases may impact the cost of debt for some REITs, Sahn sees a longer-term growth trend: supply constraints.

“We think you're going to have an under supply situation in most property types around the world. Because the cost of financing and construction has gotten so high over the last 12 months projects no longer makes sense. People, developers, investors, they're going pencils down,” Sahn says. “We think that over the next 18 months as supply declines, you're going to end up in a situation where the owners and operators of commercial real estate and residential real estate is going to be in a very, very enviable position.”

Sahn believes that a higher for longer interest rate environment will hurt valuations, cap rates, and debt costs when REITs refinance. Nevertheless, the resulting supply constraints could result in strong revenue growth and even possibly strong margin expansion.

As advisors engage with their clients on the subject of REITs, and discuss the new opportunities presented by fixed income, Sahn believes the conversation needs to be framed around the full picture of what REITs can deliver.

“People choose to invest in REITs partly for the income, but also for the real estate exposure,” Sahn says. “They buy REITs because they want inflation protection, they want hard assets, they do want income but they also want an attractive risk-adjusted return.”

Check out the best REITs to buy in Canada for 2023 in this article.