Schwab Sector Views: The State of Real Estate
Real estate investment trusts (REITs) have not been at the epicenter of the COVID-19 crisis, but they are certainly collateral damage.
The massive government stimulus efforts and rapid expansion of the vaccine distribution have boosted optimism for a return to normalcy, but questions remain about how potential long-term changes in consumer and business behaviors might affect REITs. Trends in e-commerce, internet entertainment, and how businesses leverage technology have accelerated, but work-from-home and social distancing might have an enduring impact on office, multifamily, and retail segments of the REITs sector.
Considering the positives, negatives, and uncertainties, I think that a market-weight allocation to the sector as part of a well-balanced portfolio is appropriate.
COVID-19’s impact on REITs
While the Real Estate sector has rallied sharply from its market lows, it has sharply lagged the overall market since the beginning of 2020.
The Real Estate sector has underperformed amid the COVID-19 crisis
Source: Bloomberg as of 3/10/2021. Past performance is no guarantee of future results.
However, as the chart below shows, the impact on various types of REITs has varied throughout the crisis and recovery. Those segments with strong structural tailwinds—like specialized and industrial REITs (including data centers, telecom infrastructure, and warehouse/distribution centers)—did well due to strong trends in e-commerce, technology, and telecom. On the other hand, office, retail, hotel & resort, and residential REITs clearly have not fully recovered from the COVID-related downturn.
Performance has varied within REITs
Source: Bloomberg. Total return of the S&P 1500 REITs Index and the sub-industry indexes of the REITs Index from 1/1/2020 to 3/10/21. Past performance is no guarantee of future results.
Despite the rally in the overall market and strong economic recovery, investors seem to be pricing in the uncertainties of the post-COVID world, in terms of travel, working from home, and self-imposed social distancing. For example, the rise in e-commerce is positive for industrials and warehouse/distribution centers, but is a significant headwind for traditional retail space.
Industrial and specialized REITs have outperformed
It’s not news that everything technology did well throughout the crisis—industrial and specialized REITs categories included. As can be seen in the chart below, the percentage of total retail sales through e-commerce surged to a record high during the height of the crisis. Government stimulus checks and a sharp decline in eating out and travel left consumers with plenty of cash (and time) to shop online, at grocery stores, and at big-box retailers—all of which need warehouse and distribution centers. Some of the biggest industrial REITs count e-commerce giant Amazon as their largest tenant. While there have been some zigs and zags in the chart, the trend is decidedly higher.
Online retail sales have trended higher over the past decade
Source: Bloomberg as of 3/16/21. Chart reflects the U.S. Census Bureau’s US Retail Sales Electronic Shopping & Mail-Order Houses SA as a percent of Total Retail Sales SA. Available data for online sales is through January 2021
Many of the larger REITs in the specialized category own properties associated with communications infrastructure and data centers used for cloud computing services, among other types of properties. The secular tailwinds for this segment are clear, and the COVID crisis increased demand for internet and cellular bandwidth, as well as information technologies needed to support the mass transition to employees working from home. REITs that own these facilities are benefiting from not only increased demand for space but have also maintained high collection rates on leases. With more people now accustomed to online purchases, robust demand for e-commerce-related warehouse and distribution space is expected to continue.
Together, the market cap of the industrial and specialized REITs account for nearly 55% of the S&P 1500 REITs sector—up from just 32% in 2016—and have been the driving force behind the recovery in the overall sector.
REITs are dominated by industrial and specialized REITs
Source: Bloomberg. Reflects weights for the S&P 1500 REITs Sector in January 2016 and January 2021
Hotel, health-care and retail REITs have struggled
It’s the other 45% of the REIT sector that remains underwater amid ongoing uncertainties—despite the economic rebound and record stimulus to keep them afloat.
- Hotel REITs are a small segment of the overall S&P 1500 REITs index. Their outlook is dependent on the vaccine rollout and risk of COVID-19 variants. While hotels have received emergency funding, hotel REITs typically are paid per agreements to share hotel revenues—which were down 50% or more in 2020. A U.N. World Tourism Organization survey showed that a full recovery in the industry isn’t expected until 2024.
- Health-care REITs—which account for about 10% of the S&P 1500 REITs index—were at risk from reduced elective surgeries and doctor visit shortfalls, but volumes have rebounded from the depths of the crisis. However, nursing home facilities have experienced a sharp 15% drop in occupancy due to a high COVID-related death rate and decline in enrollments. While there are short-term risks for the health-care segment, long-term age demographic trends are a tailwind.
- It’s notable that retail REITs now have a much smaller footprint in the S&P 1500 REITs index than in 2016. The impact on small retailers—particularly restaurants and bars—has been extreme, driving down valuations as thousands of businesses have shut their doors. With the ongoing strong economic recovery and vaccine prospects, the $28 billion earmarked for retailers in the latest stimulus package should help stem the bleeding.
However, there are longer-term issues at play. With the rise in e-commerce in recent years, retail was already in bad shape prior to the crisis and the market cap of many of these REITs were already in retreat. Mall traffic had been down significantly, and the surge in anchor-store bankruptcies and closures has only made matters worse. JCPenney—which shut 150 stores in the past year—and Neiman Marcus both filed for bankruptcy; while Macy’s has not, it plans to shutter 125 stores by 2023. When anchor stores like these vacate, other retailers typically have an escape clause from their leases if the space is not filled within a year and a half. In a bid to slow the decline, consortiums including REITs that own the malls have bought some troubled and bankrupt retailers as a way to maintain anchor store presence. While many of these major retailers are growing their e-commerce businesses, the ongoing decline in their brick-and-mortar footprint is likely to continue.
To be sure, retail sales have returned, helped by the massive stimulus packages and gradual decline in unemployment—although restaurant & bar sales are still off more than 16% and clothing is off 11% from year-ago-levels. It’s the mix of what is being purchased, how it is being purchased (in person or online), and where it is being purchased.
In non-city centers, the Paycheck Protection Plan has been particularly helpful for the smaller businesses in malls and standalone retail space. While occupancy rates have ebbed, collection rates in many cases have recovered to pre-crisis levels. However, many of the retail REITs are exposed to a greater degree to major business centers, where work-from-home appears to have kicked off a migration from the urban areas to the suburbs.
Urban flight, unemployment, and multi-family REITs
It has become apparent that work-from-home policies are having a significant impact on REITs—particularly office and multi-family. Since stay-at-home orders went into effect last year, people have taken the opportunity to move out of high-rent major cities to more affordable cities and suburbs.
The de-urbanization to the suburbs is hurting the major-city markets where much of the REIT-owned apartment properties are located. The map below reflects the decline in apartment prices in many major high-cost cities (blue) and the corresponding rise in rents (red) in areas with rising demand. At the extreme, Zumper.com reports that the average rent for a 1-bedroom apartment in San Francisco was down 24% in February from a year ago. This comes after several high-profile defections from Silicon Valley, including decisions by both Oracle and Hewlett Packard to move their headquarters to Texas. However, with rising mortgage rates, tight housing supply, and rapid rise in median house prices nationwide (existing single-family home prices were up 14.8% year-over-year in January), the migration out of urban areas could slow.
Average rents have declined in major high-cost cities, and risen elsewhere
Source: www.Zumper.com with permission
Even if the urban flight slows, multi-family REITs still have a high unemployment rate to contend with. The Census Department’s recent pulse survey found that 17% of renters—predominately low-income unemployed families—are behind on paying rent. Moody’s Analytics has estimated that there is $57 billion in outstanding delinquent rents, utilities, and late fees. Fortunately, the latest stimulus legislation provides $22 billion in renter subsidies—on top of the $25 billion in the previous stimulus package—which helps buy some time. Yet with 10 million people still unemployed and the vaccine distribution not expected to be significantly completed until the end of May, eventual losses to multi-family REITs are uncertain. Of course, as the recovery continues and social distancing restrictions ease, the unemployment rate should continue to decline.
Office space: Will workers return?
While multifamily lease delinquencies and non-renewals become apparent in fairly short order, the impact on the office space is opaquer. The contracts are longer, and it can take years for corporations to make real estate decisions. While there has been a slight uptick in lease vacancies in major markets, collections have been maintained at year-ago levels and lease values have remained stable. However, record low absorption rate (newly rented office space as a percent of total available after accounting for vacated space over the period) and rapidly rising office space available for sublet point to downward pressure on lease price per square foot and real estate values in the future. The chart below, provided by JLL Research, shows that the negative net absorption has far surpassed that seen in the 2008-09 financial crisis, and likely reflects the uncertainty surrounding what corporate real estate needs will be post-COVID. Businesses are holding off on making new lease decisions.
Negative net absorption has surpassed the drop seen in 2008-2009
Source: JLL Research with permission
Currently, office use in 10 major cities is down 76% on average from prior to the crisis, according to Kastle Systems, which provides commercial property occupancy data based on daily entries into Kastle-secured buildings. Future demand for office space will be heavily affected by the number of workers who will continue to work from home. With concerns about worker productivity, burnout and onboarding new workers, it is safe to say that most employers will bring their workers back to the office. However, according to a University of Chicago Booth School of Business paper, 22% of employees are expected to work remotely at least part time, up from 5% prior to the crisis. There is growing consensus that this could result in a 15% decline in demand for office space, which would likely have a significant negative impact on office REITs.
Source: Bloomberg as of 3/9/21.
Interest rate risk is rising
Recently, 10-year Treasury yields rose to a post-pandemic high of 1.6%, as Treasury prices (which move inversely to yields) declined amid expectations for improving economic growth and rising inflation. We expect yields to pull back near term, but think that they could move higher later this year, which would be a headwind for REITs in general.
The chart below compares the sensitivity to interest rates relative to the other sectors. The negative sign for the Real Estate sector coefficients reflects the historical tendency for the sector to underperform when rates rise (and vice versa).
Real Estate tend to be more affected than other sectors by rising interest rates
Source: Charles Schwab. The sensitivity coefficient (also known as beta) is a measure of the historical price change in sector as a function of the weekly variation of interest rates from 1/1/2015 to 1/1/2020. The time period that excludes the COVID crisis was chosen based on the premise of it likely being a better representation of historical relationships. Past performance is no guarantee of future results.
The REITs sector is considered defensive in nature, and is negatively affected by rising interest rates, in part because real estate is capital-intensive and highly leveraged. There are many REITs that are more cyclical—particularly those specializing in hotel properties, self-storage, and apartments—which typically have short-term leases and are less sensitive to rates. These REITs stand to benefit the most from the economic recovery once the unique COVID-related barriers are removed. However, the majority of REITS—such as health care, industrial, telecom infrastructure, office, malls, and large chain store spaces—are less sensitive to the economy and carry longer-term leases that make them more sensitive to interest rates.
Valuation is relatively attractive
While nearly all sectors’ valuations are currently rich, the Real Estate sector’s valuations are well below that for the overall market. In the chart below, the bars represent value composites that include up to six different valuation metrics that provide a holistic perspective on current valuations relative to each of the sectors’ own historical valuations, as well as relative to the other sectors.
Real Estate valuation is below the overall market
Source: SCFR, Bloomberg as of 2/28/2021. Bars represent z-score for value composites that include up to six different valuation metrics that provide a holistic perspective on current valuations relative to each of the sectors’ own historical valuations, as well as relative to the other sectors. Standard deviation is the statistical measure of volatility, measuring how widely the data is dispersed from the historical mean or median. Z-score is the number of standard deviations from the mean or median. REITs valuations reflects the forward price/funds from operations.
Bottom line: Marketperform
Attractive valuations need to be assessed in the context of the mixed macroeconomic environment for the sector—with stronger growth but a headwind from higher interest rates. Fundamentals of the group are mixed, with industrial and specialized REITs well positioned as strong technology and e-commerce trends remain in place.
While apartment REITs will likely recovery as the economy heals and the unemployment rate subsides, retail is likely to continue to struggle from the e-commerce trends, and there are too many questions surrounding the path of work-from-home trends and their potential impact on office REITs. Considering the positive, negatives and risks, I think that a neutral or market weight allocation to REITs within a well-balanced portfolio is appropriate. While the resolution of many of the risks could set the sector up for outperformance, I’m maintaining a marketperform rating on REITs for now.
What do the ratings mean?
The sectors we analyze are from the widely recognized Global Industry Classification Standard (GICS®) groupings. After a review of risks and opportunities, we give each stock sector one of the following ratings:
- Outperform: likely to perform better than the broader stock market*
- Underperform: likely to perform worse than the broader stock market
- Marketperform: likely to track the broader stock market
* As represented by the S&P 500 index
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