In a macroeconomic landscape dominated by decades-high inflation and soaring interest rates, real estate investors are facing an undeniable catch-22.
On one hand, the asset class has traditionally been beloved for its inflation-hedging qualities. Not only is real estate generally less correlated with the stock market, but its potential for cash flow generation can also increase investors’ incomes as prices rise. On the other hand, real estate is traditionally more sensitive to a rising rate environment, with the sector lagging behind the broader S&P 500 index by two percentage points year-to-date, according to a report published on September 8 by Bank of America.
“Real estate’s unique mix of cyclical and secular exposure also weighed on the sector, with the cyclical part being hurt by slowdown concerns and the secular growth part being hurt by a rising cost of capital,” continued the team at Bank of America, led by strategists Savita Subramanian and Jill Carey Hall.
Going by historical precedence, at least in the near future the sector may still face overwhelming headwinds. Subramanian and Hall pointed out that real estate generally performs the best during the late stage of the economic cycle, outperforming 75% of the time in the past. But an impending hard landing has threatened to drag the US economy into the downturn phase — a historically weak stage for real estate, which has consistently underperformed in previous recessions.
While the odds certainly sound hard to beat, Subramanian and Hall also emphasized the real estate sector’s current strengths — solid fundamentals, a tilt towards higher quality assets, and multi-year secular themes conducive to overall growth.
“Consensus 2022 earnings per share has risen 10% year-to-date and real estate, energy, and utilities are the only sectors with more upward revisions to earnings estimates than downward revisions over the past three months,” they wrote. “Moreover, 77% of real estate companies posted positive real sales growth (versus CPI) in the second quarter, much better than just 54% for the S&P 500.”
And the aforementioned staggering headwinds have also had little to no impact on real estate demand, which remains healthy as the sector continues to exceed analyst expectations. The sector also stands to benefit from production reshoring, added Subramanian and Hall.
“Real estate is largely domestic and should be more insulated from increased cost pressure from reshoring. There are also pockets of real estate, such as industrial real estate investment trusts, that are likely going to benefit from reshoring, with increased demand for domestic warehouses and industrial activity,” they explained.
Besides these factors, Subramanian and Hall also highlighted the sector’s strong pricing power and its historical outperformance during times of rising wages. Real estate has also pivoted towards higher quality assets in recent times, indicated by a rising percentage of high quality stocks versus the historical mean and by a decrease in the sector’s earnings volatility to below the S&P 500’s average.
Despite real estate’s current strengths, a looming recession cannot be ignored — but it can be mitigated by investing in high quality real estate investment trusts, or REITs, said Subramanian and Hall.
“Quality is a key attribute to stock outperformance late cycle. We believe higher quality REITs will offer the best earnings and distribution growth in 2022 and 2023,” they explained. That’s because the characteristics of quality REITs — high pricing power, earnings visibility, and strong balance sheets and global inflows — have the capability to beat upward multiples revisions and grow above average while simultaneously serving as an inflation hedge for investors.
Diving into the subsector level, Subramanian and Hall listed industrial, residential, self-storage, and shopping centers REITs as the areas possessing the strongest pricing power. Office REITs, which are “facing a secular decline in demand as companies figure out their space needs,” remain the biggest area of weakness, they added.
To that end, Subramanian and Hall identified five top REITs for investors to consider, listed below along with their respective tickers, market capitalizations, real estate subsectors, and corresponding analyst commentaries.
Ticker: AMH
Market cap: $12 billion
REIT subsector: Single-family rental
Commentary: “High quality single family rental REIT portfolio: AMH owns the second largest single family rental REIT portfolio in the US. Based on our estimated stabilized forward NAV, AMH’s valuation is attractive with a strong balance sheet. We remain positive on AMH’s portfolio, limited new supply of single-family homes, structural demographic tailwinds with aging millennials, accretive consolidation/development opportunities, margins growth prospects, amenity fee upside and a strong management. With fears over a recession, we would expect single family rentals to be a defensive sector.” – Jeffrey Spector
Source: Bank of America
Ticker: FRT
Market cap: $8.4 billion
REIT subsector: Shopping centers
Commentary: “National Strip REIT who owns, operates and develops high quality retail properties: FRT’s community center portfolio consists of 100+ properties across majority coastal markets with a focus on strong demographics and 1st ring suburbs. FRT trades at a significant discount to its historical premium vs. peers which presents deep value for a REIT which owns a top ranked portfolio along with a strong balance sheet and management team. On a long-term basis, we expect FRT to have growth above its Strip peers. Key catalyst include (1) quality portfolio skewed towards higher income & 1st ring suburbs which will be more resilient to cyclical downturns, (2) record leasing volume and solid fundamentals, and (3) tenant demand and flight towards quality properties as retailers are focusing on omnichannel efforts to improve profits.” – Jeffrey Spector
Source: Bank of America
Ticker: PSA
Market cap: $59 billion
REIT subsector: Self storage
Commentary: “Largest U.S. Self Storage REIT with improving margins from tech investments: PSA is the largest owner & developer of storage facilities in the U.S. and is the only national self-storage development platform. PSA has the strongest balance sheet in the sector. Key catalysts: 1) PSA’s investments in technology and data analytics are paying off with higher conversions, revenue and improving margins; 2) PSA’s non-same store portfolio is now 25% of its assets, which will boost internal growth as these assets lease up; 3) PSA is seeing their customer’s average length of stay increase, further driving revenue & 4) Concerns over higher supply into ’23 are fading with recent updates indicating a potential decrease 23/22.” – Jeffrey Spector
Source: Bank of America
Ticker: REXR
Market cap: $11 billion
REIT subsector: Industrial
Commentary: “Local sharpshooter in tight Southern California infill Industrial market: REXR owns, acquires, redevelops and operates warehouses solely in infill Southern California markets near large population centers. We expect the strongest rent growth in REXR’s markets with high tenant demand to serve the local population and supply shrinking from conversions to higher and better use. This will keep market conditions tight and help REXR deliver the strongest internal growth in the sector. REXR’s 3.8x leverage provides flexibility for investment activity and a fortress balance sheet.” – Jeffrey Spector
Source: Bank of America
Ticker: UDR
Market cap: $15 billion
REIT subsector: Apartments
Commentary: “Diversified Apartment REIT with strong operational platform: UDR is an Apartment REIT with a geographically diversified portfolio, strong operating platform and well respected management team. The Next Generation Operating Platform is a differentiator that has enhanced controllable expense margins and is currently in the second phase of operating initiatives which represent over $100M in potential incremental NOI. We like UDR’s focus on technology especially as the world continues to change with a focus on low touch experiences and services. UDR’s national mix with Coastal and Sunbelt markets position the REIT well as more renters return to the office.” – Joshua Dennerlein
Source: Bank of America
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