REIT Returns Falter As Q3 Ends

NEW YORK CITY—REITs' debut as a standalone sector within the Global Industry Classification Standard coincided with a stretch of underperformance in the sector, according to reports from Barclays Capital and Trepp LLC. A key factor, according to a Barclays note to investors, was the “more hawkish” tone recently from the Federal Reserve on interest rates, although Trepp notes that the Fed's decision not to raise rates at its September meeting drew a positive response from the market.

However, writes Susan Persin at Trepp, “more Fed officials are disagreeing with the decision not to raise rates. As a result, a December rate hike, falling after the November elections, seems more likely.”

Persin notes that the REIT sector posted a second consecutive month of negative total returns during September, “causing investors to worry about interest rates and whether REITs and their underlying real estate are overvalued. The FTSE NAREIT All REIT Index declined 1.41% for the month.” Furthermore, a team of Barclays analysts led by Ross L. Smotrich notes that the RMS total return REIT index was down 1.5% during the third quarter, lagging both the S&P 500 (+3.9%) and S&P Financials (+4.0%) in Q3.

Yet in spite of the sector's pullback during the past two months, “year-to-date total REIT returns of 12.57% are well ahead of broader indices,” writes Persin. Moreover, the All REIT ndex's total returns have risen generally since 2008. “However, with the sector off to a weak fourth quarter start, will REITs continue to outperform?”

The Barclays analysts answers that question with a qualified maybe. “Given the UK's June vote to leave the EU and continued global growth concerns that have led to monetary easing abroad, we think US real estate assets will continue to be viewed as a safe haven investment within a safe haven country.”

In such an environment, according to Barclays, cap rates are likely to remain stable. “Expectations for the Fed to move at a measured pace could cause the spread between cap rates and Treasury yields to remain relatively attractive. As such, we think REITs may outperform if market volatility spikes and/or the broader markets sell-off.”

Conversely, though, Barclays analysts see absolute upside as “somewhat constrained by the deceleration in REIT earnings growth and current valuations.” Accordingly, they're maintaining their “neutral” outlook for REITs on the whole.

More broadly, Barclays notes that commercial property fundamentals remain on “solid footing across most property types, “especially in the case of high quality assets in or near gateway markets. And in spite of low cap rates, there continues to be a bid for these assets from foreign buyers looking to increase their real estate allocation.

“We think this trend can continue given the relative advantages in these markets including (i) higher liquidity, (ii) low new supply risk, (iii) wide cap rate spread to Treasuries and (iv) greater familiarity by foreign buyers,” according to Barclays. “On the other hand, secondary/tertiary markets don't appear to be recovering at the same pace as prior cycles and new apartment supply is hampering rental rate growth in core urban markets.”

Transaction volume is down year over year and speculative construction levels remain low, which Barclays attributes largely to declining availability of construction financing. Noting that CMBS issuance was down 39% Y-O-Y as Q3 ended, Barclays predicts that the new risk retention rules taking effect on Dec. 24 “will further impact financing availability and increase issuance costs, making it more challenging to meet return hurdles.”

NEW YORK CITY—REITs' debut as a standalone sector within the Global Industry Classification Standard coincided with a stretch of underperformance in the sector, according to reports from Barclays Capital and Trepp LLC. A key factor, according to a Barclays note to investors, was the “more hawkish” tone recently from the Federal Reserve on interest rates, although Trepp notes that the Fed's decision not to raise rates at its September meeting drew a positive response from the market.

However, writes Susan Persin at Trepp, “more Fed officials are disagreeing with the decision not to raise rates. As a result, a December rate hike, falling after the November elections, seems more likely.”

Persin notes that the REIT sector posted a second consecutive month of negative total returns during September, “causing investors to worry about interest rates and whether REITs and their underlying real estate are overvalued. The FTSE NAREIT All REIT Index declined 1.41% for the month.” Furthermore, a team of Barclays analysts led by Ross L. Smotrich notes that the RMS total return REIT index was down 1.5% during the third quarter, lagging both the S&P 500 (+3.9%) and S&P Financials (+4.0%) in Q3.

Yet in spite of the sector's pullback during the past two months, “year-to-date total REIT returns of 12.57% are well ahead of broader indices,” writes Persin. Moreover, the All REIT ndex's total returns have risen generally since 2008. “However, with the sector off to a weak fourth quarter start, will REITs continue to outperform?”

The Barclays analysts answers that question with a qualified maybe. “Given the UK's June vote to leave the EU and continued global growth concerns that have led to monetary easing abroad, we think US real estate assets will continue to be viewed as a safe haven investment within a safe haven country.”

In such an environment, according to Barclays, cap rates are likely to remain stable. “Expectations for the Fed to move at a measured pace could cause the spread between cap rates and Treasury yields to remain relatively attractive. As such, we think REITs may outperform if market volatility spikes and/or the broader markets sell-off.”

Conversely, though, Barclays analysts see absolute upside as “somewhat constrained by the deceleration in REIT earnings growth and current valuations.” Accordingly, they're maintaining their “neutral” outlook for REITs on the whole.

More broadly, Barclays notes that commercial property fundamentals remain on “solid footing across most property types, “especially in the case of high quality assets in or near gateway markets. And in spite of low cap rates, there continues to be a bid for these assets from foreign buyers looking to increase their real estate allocation.

“We think this trend can continue given the relative advantages in these markets including (i) higher liquidity, (ii) low new supply risk, (iii) wide cap rate spread to Treasuries and (iv) greater familiarity by foreign buyers,” according to Barclays. “On the other hand, secondary/tertiary markets don't appear to be recovering at the same pace as prior cycles and new apartment supply is hampering rental rate growth in core urban markets.”

Transaction volume is down year over year and speculative construction levels remain low, which Barclays attributes largely to declining availability of construction financing. Noting that CMBS issuance was down 39% Y-O-Y as Q3 ended, Barclays predicts that the new risk retention rules taking effect on Dec. 24 “will further impact financing availability and increase issuance costs, making it more challenging to meet return hurdles.”