The COVID-19 pandemic caused waves across the U.S. economy, but one sector that bore the brunt of the move toward social distancing and remote work was real estate. Retail properties were negatively impacted as shoppers stayed home, and offices became ghost towns as companies sent their employees home to work. In short, COVID posed a direct and real threat to the real estate market, including real estate investment trusts (REITs) that own these properties and investors that rely on the income from these securities.
Since the emergence of COVID vaccines and the broad economic reopening, the real estate market has largely stabilized. Retailers that were impacted during the pandemic rebounded as shoppers returned with open wallets. Travelers returned to hotels and workers to their cubicles. Meanwhile, real estate subsectors that performed relatively well during the pandemic, such as industrial data centers, single-family rentals, and storage units, continue to experience strong cash flow and operating metrics.
We believe REITs still hold appeal for investors, but not all subsectors are enjoying the same rebound. We are constructive on certain areas of the real estate market such as multifamily housing and triple-net lease properties, where tenants handle much of the operating expenses (landlords are responsible for most expenses in standard commercial leases). We believe other areas such as healthcare facilities warrant a more cautious approach. Meanwhile, economic developments—from GDP growth to rising inflation—have implications for the future health of the U.S. real estate market.
The sector and economic trends supporting REITs
The pandemic’s impact on the real estate market was challenging, but uneven. As the economy reopens, a positive development is that weaker tenants who couldn’t ride out the pandemic are, in many cases, being replaced by tenants willing to pay higher rents. We’ve seen a strong rebound in neighborhood shopping centers, particularly those anchored by grocery stores and pharmacies. These types of local shopping centers are seeing higher occupancy rates and stronger overall performance than other areas of the retail sector such as malls, which still face long-term challenges.
The reopening of the economy has provided a supportive backdrop for REITs, with economic growth driving tenant demand and historically low interest rates providing cheap access to capital to fuel growth. Those conditions may benefit REITs that specialize in triple-net properties which can capitalize on low borrowing costs to acquire more assets, generate higher earnings growth and diversify their tenant bases. As long as capital remains inexpensive, we expect these triple-net REITs to continue to perform well.
While rising inflation is an economic concern, the real estate market can benefit should inflation rates tick higher. One reason is that real estate offers a relatively good hedge against inflation, another is that rising inflation often translates into higher dividend yields for REIT investors. The real estate sectors where rents can be raised more frequently, such as hotels or apartments, stand to benefit more from higher inflation than areas such as healthcare or office buildings, which typically carry longer term lease agreements.
In real estate, it’s still location, location, location
Geography matters in the real estate market. There’s a perennial debate among real estate investors on where to deploy capital. Should a REIT invest in coastal markets, or in the suburbs outside thriving metro areas? Currently, we are seeing an uptick in capital flowing toward the Sunbelt, into cities such as Atlanta, Charlotte, Dallas and Houston.
Institutional capital has been willing to pay higher prices for assets in these Sunbelt areas than in the coastal urban gateways such as New York and San Francisco, due in part to long-term population and job migration trends that favor the Sunbelt. That trend accelerated during COVID during which New York City was effectively locked down, while the economies in cities such as Austin, Miami and Atlanta were less impacted.
Investors returned to REITs as economies opened which has pushed REIT valuations higher and led some investors to question whether the stocks are overvalued. Our belief is that many REITs still look attractive despite these relatively high valuations. One reason is the relatively low cost of capital which is fueling private real estate transactions and supporting higher prices for properties. Valuation still matters of course, but we don’t believe that today’s valuations are high enough to deter investors from a sector that offers a range of opportunities for growth and income as the economy continues to improve.