What next for REITs?

“Typically, REITs are more recession-proof because the best ones lock in earnings streams that are resilient and better than those of equities,” says Corrado Russo, senior managing director and head of global REIT securities at Timbercreek Asset Management.

Typical correlation to global equities is 0.78 (a perfect correlation is 1.0), and to global bonds, 0.63, according to numbers supplied by Timbercreek. Well, that correlation to equities doesn’t hold right now. 

However, some specific funds manage to hold well against the storm. It’s the case, for example, for Signature Global REIT Fund, which succeeded in limiting its fall to -22.4% year-to-date.

“We managed to avoid problematic sectors, for example hotels, and Hong Kong, and we like to think that we’ve done a good stock selection overall,” says Joshua Varghese, who manages the Signature fund and many other REIT funds at CI Investments.

Furthermore, some REIT subcategories, up to March 10, were still doing quite well. Data centres had gone up 7.1% for 2020, cell towers by 8.3%, and self-storage by 5.4%, according to Timbercreek numbers. On the other hand, healthcare REITs had dipped by 12.6% and U.S. REITs slipped by 8.6%.

These are usually called “niche” sectors. There are a few others, such as triple-net leases, a real estate deal in which the tenant is responsible for all maintenance, operating and tax expenses. “These are almost like bonds and are most resilient in a downturn,” Russo claims. They have fallen by -5.2% from January to March 10.

The COVID Impact
DBRS Morningstar expects the coronavirus pandemic to affect properties differently depending on the subsector. For example, hotels, recreational properties, and certain retail properties will—at least, in the near term— experience significant stress. On the other hand, retailers of consumer necessities, e-commerce warehouses, and long-term-care (LTC) properties are highly sensitive to the coronavirus but should emerge relatively unscathed.

In a report titled ‘The Impact of the Coronavirus Disease (COVID-19) on REITs and CRE Companies in Canada and the U.S.’, DBRS Morningstar points out that certain factors will serve to support commercial real estate over the next couple of quarters. For instance, countermeasures by global central banks causing lower interest rates or fiscal stimulus introduced by governments, such as security purchase programs and liquidity backstop facilities, should help many corporations obtain liquidity to maintain existing operations, resulting in the continuation of lease payments.

“In contrast, notes the report, other considerations, including rent abatements, would require asset owners to absorb reductions in rent. With the current uncertainty and volatility, commercial real estate firms will likely pause major growth activities. For most sectors, however, the greatest risk is the pandemic, in conjunction with other factors, such as an energy bear market and financial market disruptions, which together could lead to a sustained economic downturn during which occupancies drop meaningfully and rents decline. Firms with lower quality assets, elevated counterparty risk, or material exposure to volatile subsectors of real estate (e.g. hotels), combined with weaker balance sheets, may be at greater risk of cash flow volatility and rating downgrades arising from the ongoing coronavirus outbreak.”

The retail apocalypse
The numbers show that the foremost REIT categories – apartments, office, retail – have not held up so well. Varghese points out that retail has especially suffered thanks to what has been dubbed “the retail apocalypse”, with more than 600 store closings in Canada in 2019 and more than 8,000 in the U.S., including huge names, like Sears, Target and Zellers. The carnage extends globally, with European names like Intu and Unibail, and Asian Mangga Dua.

Retail mall owners who survive still face challenging times, thinks Lee Goldman, portfolio manager at CI. “Even if their tenants want to stay, these will renegotiate their leases and demand renovations. As a result, investors don’t know how to evaluate current cash flow metrics.”

The charge of e-commerce, led by Amazon, has wreaked havoc in the ranks of brick-and-mortar retailers. However, “it would be an error to think that brick-and-mortar outfits are dead,” warns Kate MacDonald, also a portfolio manager at CI. “Community retail is continuing to do well, she notes. The hardship has happened mostly in non-dominant fashion retail. Oxford and Cadillac Fairview in Canada are still holding fairly well.”

But other factors also precipitated retail’s downfall: an overabundance of space, where the rate of mall openings was double the growth of population, and bad management. Now, e-commerce is forcing retailers to redesign their logistics and distribution, says Varghese, just as Walmart forced them to do so in the 1990s.

A big winner in the e-commerce race has been the industrial REIT sector. “Its growth has happened at the expense of retail,” says Dean Orrico, president of Middlefield Group. So new players who are catering to the needs of the Amazons of this world are riding the wave of e-commerce, like GLP and Prologis (PLD) in the US and Global Logistics Property in Asia. It’s causing many players to reshuffle their assets: Orrico points out that in Canada, Walmart landlord SmartCentres, is not growing any more. Huge parking lots that it owned are being built over with office towers and condos to diversify.

Headwinds becoming tailwinds
But the sun will shine again, and many REIT segments will benefit from basic positive trends, for instance apartment REITs in Canada. “The country has a very good immigration system, with 320,000 new entrants every year, and Canada has done a good job in attracting well-off immigrants, Orrico says. Most settle in major cities, 40% in Toronto only, where home prices have shot up. So they rent, and many landlords profit because those tenants can pay.”

Also, fundamental trends driving the “niche” REITs will continue and grow. Technology developments like e-commerce, autonomous vehicles, crypto-currency mining, 5G cellular will push the sprawl of data centres and cell towers. Russo puts most of his investments in the niche sectors, some of which are growing between 20% and 60%.

The key obviously rests in judicious selection. Especially in a contraction, points out Orrico, “you want to make sure tenants are credit-worthy and diversified, and you don’t want to depend on only one or two tenants. Once that is ensured, we believe that real estate is the best equity income vehicle available.”

And apart from strong trends in key sectors, Russo believes that two factors that acted as headwinds will benefit REITs going forward. Up to the present crisis, growth in stocks and a fear of rising interest rates offered resistance to the performance of REITS. “But people are not afraid any more of rates going up and equities have become more challenged, notes the specialist. The two headwinds are becoming two tailwinds for the next few years.”