Five Factors Which Could Contribute to REIT Outperformance in 2020
At Timbercreek, we have the expertise and understanding to identify attractive REIT opportunities in the eyes of the investor. We believe REITs are poised to deliver another year of double-digit returns in 2020 as outlined in the Timbercreek Global Real Estate Securities 2020 outlook paper. Our forecast is based on 5 key factors;
REIT outperformance typically grows in magnitude and frequency in a modestly growing economy
Over the past year we have spoken to many investors about how REITs fit in a slower economic growth environment. Using the U.S. as an example, consensus estimates call for U.S. Real GDP growth of 1.8% in 2020, that is down from 2.9% in 2018, a ~38% deceleration in economic growth in the past 24 months. Over the past 45+ years, when U.S. Real GDP growth averages between 1% and 2%, REITs outperform the S&P 500 Index 62% of the time and by over 600 basis points annually generating an average annual absolute return of +18%. We see similar trends in other markets too, such as Canada. Consensus estimates for global developed market Real GDP growth (i.e. excluding emerging markets) in 2020 is 1.4%, that is down from 2.2% in 2018. Including emerging markets, consensus estimates for 2020 global Real GDP growth of 2.5% is better but still slow, putting REITs in a favourable position around the world to deliver growth superior to current economic conditions.
REIT earnings growth potential in 2020 is attractive on an attractive and resilient on a relative basis
The rate of earnings growth for equities declined materially in 2019 from double-digit increases in 2017 and 2018 due to a slowing global economy. REITs, on the other hand, delivered stronger absolute earnings growth in 2019 as REIT cash flows tend to be more predictable because they are tied to contractual leases that hold up better to changes in economic conditions. If we use the Q3 2019 reporting season in the U.S. as a guide for global activity, more REITs beat (60%) or met (25%) consensus estimates with greater frequency than historical averages. As mentioned earlier, we believe there is strong empirical evidence linking earnings growth and share price performance and as we look toward 2020, we anticipate REITs will deliver ~5% earnings growth, attractive on an absolute basis and resilient on a relative basis should the global economy experience further hiccups.
REITs solve the yield conundrum in a lower for longer interest rate environment
In 2017 and 2018, rising interest rates served as a headwind for the REIT industry in so far as investors re-allocated nearly US$40 billion of capital away from REITs to other sectors of the economy with a more cyclical growth profile. That changed in 2019 with nearly US$167 billion of capital flowing out of equities almost none of which came from REITs. We believe it is unlikely that Central banks will raise rates again until they see a clear-cut return to growth AND inflation, making it unlikely that REIT fund flows will serve as a similar headwind in 2020 as it did in 2017 and 2018. With interest rates expected to remain lower for longer, investors face the unpleasant choice of either taking on more risk or lowering their long-term return expectations. Over $11 trillion in government debt globally now has negative yields, meaning investors are paying for the opportunity to invest their capital. This has created a yield-conundrum and we believe REITs are a solution.
Relative valuations have room to expand
Valuation multiples have expanded over the past 12 to 15 months as investors have put greater emphasis on sectors with better earnings resiliency. During this time period (Q4 2018 thru Q4 2019), global REITs outperformed global equities by ~500 basis points8. Despite the recent outperformance, REIT relative price-to-cash flow multiples are still slightly below its long-term average. We believe that in a more modest growth environment, REITs can trade at premium multiples to their long-term average, like the 2009 to 2013 time period.
Looking at valuations through a private real estate lens, real estate risk premiums have not compressed to levels seen prior to the global financial crisis, suggesting further cap rate compression is possible (particularly in Europe, Australia, Japan and the U.S.) if interest rates remain lower for longer, with the caveat being we would only expect to see cap rates compress in those property types and geographies where rents are growing or where yield spreads over fixed income investments are above the long-term average. From an underwriting perspective, we are NOT assuming additional cap rate compression, however, it is comforting to see that a buffer exists between where cap rates currently are and where bond yields trade suggesting that if bond yields do rise, there is room for cap rates to absorb such an increase.
Globally, REITs are trading at a -4.8% discount to NAV, roughly in-line with the average discount over the past 15 years (i.e. -5.6%). We are seeing wider variations in discounts to NAV by region and property type which is why we believe country and security selection will play an even more important role in creating alpha in 2020.
Large unfunded commitments will support real estate valuations
the amount of cash available for real estate transactions continue to rise, recently surpassing the US$300 billion threshold for the first time. When levered 50%, that creates over US$650 billion of purchasing power which we believe will serve as an anchor for private market asset values. In addition, there are currently ~800 funds in the process of raising capital with a cumulative targeted raise of just over US$250 billion. We believe a portion of this capital will make its way back into the global REIT market through M&A, the acquisition of REIT assets or joint ventures that lead to additional growth opportunities for REITs.
Sources pertaining to all figures and statements cited above are available in the Timbercreek Global Real Estate Securities 2020 Market Outlook Report. This document is for informational purposes only and is not an offer or solicitation to deal in securities. Any opinion or estimate contained in this document is made on a general basis and is not to be relied upon for the purpose of making investment decisions. The statements made herein may contain forecasts, projections or other forward-looking information regarding the likelihood of future events or outcomes in relation to financial markets or securities. These statements are only predictions. Actual events or results may differ materially, as past or projected performance is not indicative of future results. Readers must make their own assessment of the relevance, accuracy and adequacy of the information contained in this document and such independent investigations as they consider necessary or appropriate for the purpose of such assessment. This document does not constitute investment research. Consequently, this document has not been prepared in line with the requirements of any jurisdiction in relation to the independence of investment research or any prohibition on dealing ahead of the dissemination of investment research. Any research or analysis used in the preparation of this document has been procured by Timbercreek Investment Management Inc. for its own use. The information is not guaranteed as to its accuracy.