In late November when REIT magazine interviewed Jerry Ehlinger, a managing director and portfolio manager with global real estate investment firm Heitman, the financial markets were only beginning to digest the impact of Republican candidate Donald Trump’s win in the 2016 presidential election. With regard to real estate investment, Ehlinger took a measured view of the GOP upstart’s unexpected victory. As for speculation about the far-reaching policy priorities of Trump and a Republican-controlled Congress, he said “change is not likely to happen quickly.”
Ehlinger talked Trump, the relationship between REITs and real estate, interest rate policy and more in the interview for the latest edition of “Capital Markets.”
REIT: “REITs are real estate.” True or false, and why?
JERRY EHLINGER: REITs are absolutely real estate. REITs are portfolios of real estate that are no different than any private real estate fund other than the mechanism for ownership and pricing. Historically, REIT returns track the value of the underlying real estate. More than 90 percent of a REIT’s value typically consists of income-producing real estate with the remaining value from real estate-related activities.
REIT: What does that mean for investors, both institutional and retail, who are trying to construct diversified portfolios?
EHLINGER: Real estate is a large and fundamental asset class alongside bonds and equities, so all investors seeking a diversified investment portfolio should include real estate.
How does one obtain a diversified portfolio of real estate? Buying the real estate directly would require billions of dollars, and there just aren’t many investors with that capacity. In fact, this is why REITs were created in the first place—to provide investors with the benefits of investing in real estate in an accessible, liquid form.
For retail investors, this is especially true, as they can invest a portion of their portfolio in real estate (via REITs) while maintaining diversification, regardless of the size of their portfolios. For institutional investors with the ability to invest directly, including REITs alongside their private real estate holdings has shown to improve performance over time while providing liquidity necessary to handle fund obligations.
REIT: Do you think portfolio managers and the investing community as a whole share your position?
EHLINGER: The majority of dedicated REIT managers, particularly ones that are part of large real estate investment platforms such as Heitman, certainly share this view. Most of them grew up in a market where institutional capital was the largest driver of REIT demand and their clients looked at it as real estate. These managers still tend to understand the long-term driver of REIT returns is the underlying real estate.
That said, the key factor necessary to understand REITs as real estate is time. Over short periods of time, the appraisal method for direct real estate can differ significantly from the public market value.
REIT: How should real estate investors look at a Donald Trump presidency? Does the political climate really affect the real estate market?
EHLINGER: Without question, anything that impacts the economy— and, therefore, demand—will impact real estate. The political decisions over the next four years are certain to impact the economy. Further, the structure of direct real estate investments and REITs are often heavily influenced by changes to tax policy, which Trump intends to focus on.
As far as how investors should look at Trump’s presidency, I would advise them to view it cautiously. The market has rallied during the first couple weeks on optimism over reduced regulation, business-friendly policy and tax changes. The reality is no one knows what the final plan will be and what campaign talking points will actually find the light of day. Ultimately, other than optimism, change is not likely to happen quickly. Tax law changes will not take effect until 2018 at the earliest, and regulation changes will likely go through some debate before they are able to impact business.
REIT: What’s your general outlook for the REIT market in 2017?
EHLINGER: The real estate market has been entering the later stages of the recovery for the last year or so. Supply is reasonable, but increasing, and rental rate growth is slowing for all but a few property types, such as industrial and data centers. Prior to the election outcome, this trend appeared the most likely to continue into 2017 as well. Post-election, the outlook appears a bit more positive, in that higher rates could slow development of new supply and we could see a slight economic bounce toward the end of 2017 and into 2018 if the Republican-controlled government can find agreement on truly stimulative policy.
REIT: Any specific sectors that are catching your eye?
EHLINGER: We are very bullish on the data center sector. The secular demand driver of increasing data storage and communication is still strong, and the infrastructure necessary to facilitate this creates a huge external growth opportunity for REITs.
REITs were created to provide investors with the benefits of investing in real estate in an accessible, liquid form.
– Jerry Ehlinger
We are also positive on the industrial sector as changing supply chains have created demand for industrial in excess of what economic activity would predict based on prior cycles. Smaller niche property types such as single-family homes, student housing and medical office buildings should also continue to perform well due to stable demand drivers and controlled supply.
REIT: Do you have a position on the relationship between rising interest rates and the performance of REITs?
EHLINGER: We have seen historically that interest rates and REIT prices are negatively correlated in the short run, particularly when rate moves are large and swift. This correlation has been most pronounced since mid-2013, where we have witnessed about a -0.3 to -0.4 correlation to the 10-Year Treasury yield.
The good news is that correlations decline in the long run as the benefits of inflation and economic growth that are typically the drivers of higher interest rates kick in. Real estate has shown to have good performance during times of rising inflation and economic growth due to an increase in replacement cost of the assets and a landlord’s ability to pass through inflation to tenants as part of the nature of leases or to push rents higher as demand increases.
Jerry Ehlinger is a managing director at global real estate investment firm Heitman, and he currently sits on the NAREIT Real Estate Investment Advisory Council. He acts as the lead portfolio manager in Heitman’s North American public real estate securities group.