When Will Beaten-Up Real Estate Turn Around?

Commercial real estate isn’t in great shape as an investment, in the U.S. or elsewhere. Real estate investment trusts, the most common way to invest in property, are down 29% this year through last week, according to FTSE EPRA/NAREIT’s global index. That compares unfavorably with stocks in general worldwide: The MSCI ACWI benchmark was off just 21%.

So when will things turn around for these REITs, which cover everything from offices to apartments to warehouses? Conventional wisdom says the economy, now seeming to teeter on the edge of a recession, will have to be expanding once more. But a Northern Trust Asset Management director concludes that now-burgeoning interest rates also need to settle down. Then “you’ll get real estate outperformance,” says Dan Phillips, NTAM’s director of asset management strategy and head of the team that wrote the report.

Escalating interest rates around the world have done a number on equities overall, but have really zapped REIT shares, as they represent an industry that uses borrowed money as lifeblood. At the same time, valuations are low now, which means bargains can be nabbed. The New York Common Retirement Fund, for instance, recently allocated $200 million to buy health-care properties.

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Interest rates are continuing to rise, and that ups the ante on risk, the NTAM report notes. Federal Reserve Chair Jerome Powell upset the stock market last week with his remarks that rates have “a way to go” before topping out. No one knows when that might be.

What’s needed for REITs, the report goes on, is a “stabilized interest rate environment” that will allow investors to “take advantage of attractive valuations and a market that seems too pessimistic on potential growth opportunities.”

The study concludes, after crunching data back to 1994, that REITs worldwide tend to do best when the economy is growing and inflation is low, and with it interest rates. REITs didn’t perform well, for instance, in the late 1990s, when rates were picking up and dotcom companies were getting all the attention. Then in the early 2000s, rates went down, and real estate investments flourished.

The U.S., which commands the global REIT market with a 58% share, sports valuations that “are arguably most attractive.” Apartments and industrials are most compelling, as they have low vacancy levels, the paper says. You wouldn’t know that from equity performance, with apartments down 33.5% this year and industrials off 38.4%.