The real estate market has experienced considerable turbulence recently, with property values falling as the post-COVID landscape shifted demand dynamics. A key contributor to these declining values has been the rise in interest rates, yet certain sectors of the property market have shown resilience in terms of rental growth. Now that the global cycle of interest rate hikes has concluded, there are emerging opportunities within listed real estate.
Two major events over the past four years have significantly impacted the property sector. The first was the COVID-19 pandemic, which drastically altered demand in retail and office real estate due to the growth of ecommerce and remote working. The second was the aggressive interest rate hikes implemented by central banks worldwide to curb inflation, resulting in reduced property values. As a result, listed real estate, a sector reliant on leverage, has underperformed.
However, despite these challenges, rental growth has remained strong in various sectors, offering income opportunities for investors seeking yield in a tough market. This highlights the importance of rental income in preserving the attractiveness of listed property investments, even when valuations are under pressure.
When interest rates fall, Real Estate Investment Trusts (REITs) tend to perform well. There has been a clear disparity in how different markets have fared, with the US real estate market proving more resilient than the UK and European markets. The US market’s diversity, particularly its focus on data centres and warehouses, has allowed it to weather recent challenges better. The rise of digitalisation and cloud computing has driven demand for data centres, while the ecommerce boom has fuelled the need for logistics spaces. In contrast, the UK and Europe have struggled, with office and retail properties facing difficulties due to remote working and online shopping trends.
Despite the increased interest rates, loan-to-value ratios have remained stable across sectors. This suggests that while the higher rates have posed challenges, they have not significantly eroded the financial health of real estate companies or REITs. The conservative approach many have taken with their loan-to-value ratios has helped shield them from market volatility and property value declines.
Historically, there has been a strong link between US 10-year Treasury yields and REIT performance. When yields rise, global stock markets typically outperform REITs, and vice versa. Since the interest rate hikes began in 2022, REIT valuations have been impacted. However, with the hiking cycle now behind us and bond yields stabilising, REIT performance has begun to recover. Should bond yields continue to fall, REITs may be set for outperformance.
REITs are not only sensitive to interest rates but also to economic growth. Their cyclical nature becomes more evident during times of economic instability and recovery. REITs have a close relationship with GDP growth, often underperforming when economic growth slows or contracts. In an environment where interest rates are peaking or declining and economic growth is returning, REITs may perform better than equities.
Looking forward, there are potential opportunities for REITs to outperform other sectors, particularly as yields fall and growth remains steady. Depressed valuations in some sectors could provide attractive opportunities for long-term investors. With strong rental growth in certain areas, REITs offer competitive income streams. However, taking advantage of these opportunities requires an active investment approach, as the varied performance across different regions and sectors makes passive investing less effective in the current market.
The evolving dynamics of the real estate market present both challenges and opportunities, with rental growth and active management playing critical roles in capitalising on the potential of listed real estate investments.
Arbuthnot Banking Group PLC (LON:ARBB), trading as Arbuthnot Latham, provides private and commercial banking products and services in the United Kingdom. Founded in 1833, Arbuthnot Banking is based in London, United Kingdom.
