latamen
REITs: playing in extra time?

REITs: playing in extra time?

05-05-2022 | Monthly outlook
They’ve long been seen as defensive, since traditional bricks and mortar can usually survive any downturn. But investors should be cautious about relying on Real Estate Investment Trusts (REITs) if the current macro headwinds lead to a recession, says strategist Peter van der Welle.
  • Peter van der Welle
    Peter
    van der Welle
    Strategist SMAS

Speed read

  • REITS are a widely favored cash-generative defensive play
  • Headwinds range from Ukraine war to Fed monetary tightening
  • Sweet spot has passed but still some upside amid high inflation

REITS – a form of mutual fund which invests in anything from shopping malls and skyscrapers to new housing projects – are a perennial favorite among more defensively minded investors. Not only are they backed by real estate infrastructure, they also generate reliable rental streams.

However, the recent perfect storm of significantly higher inflation, rate hikes and quantitative tightening combined with geopolitical factors led by the war in Ukraine call for a more cautious approach, says Van der Welle, strategist with the Robeco multi-asset team.

“Although macroeconomic data releases in developing economies have remained overall positive compared to prior expectations, a growth scare has been building lately, as risks that could derail this expansion further down the road are easy to spot,” he says.

“This sentiment shift is evidenced by steep downgrades for 2022 global real GDP growth by official institutions such as the IMF and World Bank, which downgraded real GDP growth forecasts to 3.6% and 3.2% respectively. It can also be seen in the latest fund manager survey by the Bank of America Merrill Lynch which saw a steep rise in growth pessimism to levels last seen during the global financial crisis.”

“While we expect the current economic expansion to continue for another 6-12 months, since the US Federal Reserve has not yet entered excess liquidity tightening territory and household cash piles as well as developed market corporate balance sheets look pretty decent, we acknowledge that the risks to our base case are tilted to the downside.”

Stay informed on our latest insights with monthly mail updates
Stay informed on our latest insights with monthly mail updates
Subscribe

Four reasons to worry

Van der Welle cites four reasons why economic deterioration may creep up on investors. “Firstly, as the conflict in Ukraine drags on, the elevated probability of a fully-fledged EU boycott of Russian energy leaves a fat tail risk of an immediate Eurozone recession,” he says.

“Secondly, central bankers have gotten their wake-up call as inflation has kept on surprising to the upside in both its speed and breadth. Forthcoming aggressive monetary tightening by the Fed to catch up with (cyclical) inflation pressures could deteriorate financial conditions and cause a further derating of asset prices beyond what is warranted by a typical mid-cycle correction.”

“Thirdly, a very flat Treasury yield curve signals that we are approaching the slowdown phase of the business cycle, with peak corporate pricing power around the corner, as the ability to raise net selling prices is outpaced by stubborn input cost rises.”

“Lastly, the recent growth slowdown in China on the back of elevated lockdown intensity in key manufacturing hubs could have global growth repercussions in the next few quarters, either via supply chain disruptions or through renminbi depreciation.”

Recent REITs performance has lagged the higher inflation risk premium demanded in bond markets.
Source: Refinitiv Datastream, Robeco

Paving the way for de-risking

So, how to navigate these risks? “The current growth scare could pave the way to profit taking and/or de-risking as well as the quest for enhanced diversification among investors as the tide of excess liquidity recedes just as equity seasonality turns negative,” Van der Welle says.

“In addition, as the ‘there is no alternative’ (TINA) narrative starts to be challenged by the recent surge in sovereign yields, investors are likely to tactically shift down the risk curve. They’ll start looking for asset classes that have a lower beta (relative risk versus the index they follow) but which still offer decent excess return potential over Treasuries, so long as the expansion remains on track.”

“Indeed, we already note that momentum in the last month has shifted to sectors with defensive characteristics such as consumer staples, health care, utilities, and especially REITs. In addition, investors are on the lookout for assets that can maintain their pricing power as inflation likely transitions towards a key inflection point in the second half of 2022.”

The sweet spot has passed

Are REITS still a ‘safe bet’ then? “The sweet spot for REITs’ performance has passed, in our view, though as long as the stagflationary twist in the current macro environment does not culminate in the outright contraction of real activity, there is still some juice left in the asset class,” Van der Welle says.

“A growth/inflation mix of decelerating activity momentum during economic expansion and inflation running above 3% (the composition we anticipate in the next 6-12 months) typically sees REITs outperform global equities.”

“This return pattern confirms the consensus view that REITs are a more defensive play, with inflation-hedging capabilities. Yet, judging from the significant positive correlation with the relative performance of cyclicals compared to defensives, REITs behave more like a cyclical asset in practice. They therefore have a high beta to economic activity, which leaves them vulnerable to economic contractions, especially those that morph into recessions.”

The threat of rising rates

Another issue is that most real estate relies on funding – from common mortgages to the corporate bonds issued to build shopping malls or skyscrapers – and interest rates are rising.

“While financing costs are expected to increase for the asset class, we judge that this will be a more gradual process,” says Van der Welle.

“The extension of debt maturities during the recent years of exceptionally low interest rates have lowered REITs’ susceptibility to a sudden surge in financing costs. And their ability to weather a higher interest burden in the near term is still there, given their decent underlying cashflow generation.”

“Global REITs’ leverage is currently not excessive: the net debt to equity ratio is 0.85. Moreover, their ability to service a rising debt burden is currently strong, with an interest coverage ratio of 4.5. Looking at standalone valuation metrics like the discount to net asset value, the asset class is fairly valued.”

Subjects related to this article are:
Logo

Important information

The Robeco Capital Growth Funds have not been registered under the United States Investment Company Act of 1940, as amended, nor or the United States Securities Act of 1933, as amended. None of the shares may be offered or sold, directly or indirectly in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act of 1933, as amended (the “Securities Act”)). Furthermore, Robeco Institutional Asset Management B.V. (Robeco) does not provide investment advisory services, or hold itself out as providing investment advisory services, in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act).

This website is intended for use only by non-U.S. Persons outside of the United States (within the meaning of Regulation S promulgated under the Securities Act who are professional investors, or professional fiduciaries representing such non-U.S. Person investors. By clicking “I Agree” on our website disclaimer and accessing the information on this website, including any subdomain thereof, you are certifying and agreeing to the following: (i) you have read, understood and agree to this disclaimer, (ii) you have informed yourself of any applicable legal restrictions and represent that by accessing the information contained on this website, you are not in violation of, and will not be causing Robeco or any of its affiliated entities or issuers to violate, any applicable laws and, as a result, you are legally authorized to access such information on behalf of yourself and any underlying investment advisory client, (iii) you understand and acknowledge that certain information presented herein relates to securities that have not been registered under the Securities Act, and may be offered or sold only outside the United States and only to, or for the account or benefit of, non-U.S. Persons (within the meaning of Regulation S under the Securities Act), (iv) you are, or are a discretionary investment adviser representing, a non-U.S. Person (within the meaning of Regulation S under the Securities Act) located outside of the United States and (v) you are, or are a discretionary investment adviser representing, a professional non-retail investor. Access to this website has been limited so that it shall not constitute directed selling efforts (as defined in Regulation S under the Securities Act) in the United States and so that it shall not be deemed to constitute Robeco holding itself out generally to the public in the U.S. as an investment adviser. Nothing contained herein constitutes an offer to sell securities or solicitation of an offer to purchase any securities in any jurisdiction. We reserve the right to deny access to any visitor, including, but not limited to, those visitors with IP addresses residing in the United States.

This website has been carefully prepared by Robeco. The information contained in this publication is based upon sources of information believed to be reliable. Robeco is not answerable for the accuracy or completeness of the facts, opinions, expectations and results referred to therein. Whilst every care has been taken in the preparation of this website, we do not accept any responsibility for damage of any kind resulting from incorrect or incomplete information. This website is subject to change without notice. The value of the investments may fluctuate. Past performance is no guarantee of future results. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. For investment professional use only. Not for use by the general public.

I Disagree