The apparent disconnect between real estate companies’ buoyant occupancy levels and low share price valuations may end when interest rates move decisively lower.

• As interest rates look set to enter an easing cycle in Europe, the UK and the United States, real estate stocks are trading at relatively low valuations compared with their history.
• Yet high occupancy levels and robust finances suggest that the sector is broadly in good shape.
• When rates move decisively lower, real estate stock prices and the real estate-themed ETFs that track them may start to reflect this positive reality.

When Jay Powell, the chairman of the US Federal Reserve, signaled at the end of August that three years of high US interest rates were coming to an end, he may well have started a new era for real estate stocks and the ETFs that track them.

Speaking during the annual Jackson Hole meeting of central bankers and policymakers, Powell said “the time has come for policy to adjust,” indicating that he was ready to cut US interest rates.

That matters because US interest rates are the most influential worldwide: financial markets duly responded positively. In particular, it’s worth considering the likely benefits for real estate companies, which have much to gain from declining rates as they tend to take on significant borrowings to finance both investment and development.

This comes at a time when real estate stocks look cheap, considering the price-to-book values and price-to-cash flow ratios. Valuations are low compared with their history (see chart below). For sure, it’s unclear how fast interest rates will fall, but investor caution may have gone too far, pausing the sector’s long-term record of outperforming other stocks.

A break in real estate’s long-term outperformance

Source: Bloomberg, Listed Real Estate is represented by GPR 250 Index

Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting an investment.

From strong tenant demand to robust cashflows

Real estate is especially sensitive to the cost of money, which directly affects the sector’s borrowing costs and stifles tenant demand. For this reason, markets are naturally nervous about rates not falling fast enough and perhaps even causing a US recession.

Yet an analysis of US REITs—as the US has by far the largest publicly-listed real estate industry— suggests real estate companies are in good shape even if central banks put off cutting rates for longer than was recently currently expected. Take occupancy levels, the cornerstone of real estate’s prosperity. This is high across all types of US REITs other than offices. The industrial, retail and apartment (housing) sub-sectors are thriving (see chart below). Offices are the exception due to the move to hybrid working since the Covid-19 pandemic.

 Source: Nareit, based on the FTSE NAREIT Equity REITS Index.

Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting an investment.

High occupancy levels have, in turn, bolstered REITs’ finances. Rents comfortably cover the interest payments on their bank loans, despite prevailing high interest rates, (see chart below). This is, of course, an average—there may be exceptions.

 

Source: Nareit, based on the FTSE NAREIT Equity REITS Index.

Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting an investment.

Valuations trade below averages

Given the fact that REITs appear in such good shape, their valuations look disconnected from reality. Viewed through several different valuation lenses across global markets, they are trading below medium-term averages.

Take price-to-book value, for example. An important way to judge the value of real estate businesses that are naturally asset heavy, this ratio stands at about 1.49 for the FTSE EPRA Nareit Developed Index, a REITs benchmark covering global markets. As such, it is a bit higher than historical averages of 1.42 over the last 10 years heavily affected by recent macroecomic and geopolitical event but lower than 1.51 over the five years prior to the Covid-19 pandemic. 

Source: Bloomberg, based on FTSE EPRA Nareit Developed Index.

Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting an investment.

Another key valuation ratio, the price-to-cash flow from operations tells a similar story. It compares stock prices with cash flows. When calculated for the FTSE EPRA Nareit Developed Index, the ratio is significantly lower than its historical average over the past 10 years.

Source: Bloomberg, based on FTSE EPRA Nareit Developed Index.

Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting an investment.

Waiting for interest rate cuts

The past few years have been rocky for real estate stocks, as first the Covid-19 pandemic and then the spike in inflation and interest rates knocked them back. Yet interest rate cuts are on the horizon now and may herald a period of stronger performance.

Indeed, Jay Powell’s Jackson Hole statement could mark a turning point. If so, real estate stocks may rally, resuming their long-term record of outperformance. The ETFs that track them provide a low-cost, diversified and easy way to participate.

Please note that past performance is not a guide to future performance and should not be the sole factor of consideration when selecting an investment.

---