Following the challenges of 2020, leading real estate fund managers expect REITs to benefit from improving fundamentals in 2021.
The REIT sector looks poised to regain its stride in 2021, leading real estate investment fund managers say, after the social and economic upheaval triggered by the coronavirus pandemic weighed on performance last year and resulted in a 5.12% decline in total returns for the FTSE Nareit All Equity REITs Index.
Several factors are expected to support the anticipated upturn, including improving fundamentals as the COVID-19 vaccine rollout picks up, low interest rates, and attractive pricing within those sectors that saw the most negative impact from COVID-19.
REIT magazine recently spoke with five fund managers to discover their strategies for navigating 2021 and the opportunities and challenges they see ahead.
After a year in which REITs underperformed the broader market, what do you see for 2021?
Keith Bokota: Overall, I have a favorable outlook. We saw a nice benefit from the vaccine announcement in November, and I think that increases the confidence in the forward economic recovery and ultimate return to normalcy.
We view the low interest rate environment as supportive of the group. Also, when we look at where the valuation levels are relative to bond markets or fixed income, we believe there’s a strong case for forward returns.
Brian Jones: We think there will certainly be opportunities for real estate stocks to perform well in 2021. A number of sectors were severely impacted by the pandemic. As the rollout of the vaccines continue and economic activity improves, and we begin to return more toward normal life, some of the sectors, such as retail, hotels, and the office sector—to a degree—may begin to see a recovery in their fundamentals. That could help lead to better performance within the REIT asset class as we move through 2021.
Lisa Kaufman: REITs finished 2020 with a strong rally but ended the year well below year-ago levels. At the same time, financial conditions have eased materially over this time frame, and fundamentals are bottoming or have bottomed in most sectors.
We believe the combination of repricing that’s already occurred, ultra-low interest rates, and improving fundamentals provides a very strong setup for REIT returns this year.
Jeff Kolitch: We are optimistic about the prospects for REITs. Much of real estate lagged in 2020, in part because the business models of several segments are based on the assembly of people. We expect this headwind to begin to reverse in the year ahead. In addition, several segments of public real estate are attractively valued relative to equity, bond, and private real estate alternatives.
We think real estate is at the doorstep, or the very early stages, of a new real estate cycle. And, REITs and real estate generally should be one of the prime beneficiaries of an improvement in economic conditions if, in fact, a large swath of the population is vaccinated over the course of 2021.
Jason Yablon: Just as REITs were disproportionately impacted by the pandemic in 2020, we also believe they’re poised to recover as vaccines get distributed across the country in 2021. We also think REITs tend to perform well in the early stages of a business cycle, where fundamentals are improving, and the Federal Reserve remains accommodating.
How has COVID-19 affected REIT returns?
Kaufman: It was especially challenging for property sectors that were reliant on social interactions—offices, hotels, retail—while the newer economy sectors that are not hubs of personal interaction, such as cell tower, data center, life science, storage, and industrial companies, produced strong returns.
Bokota: We found the strongest returns from data centers, industrial, storage, and single-family rental. Those sectors were less impacted by social distancing and saw demand actually benefit from the pandemic. On the other end, some sectors were more heavily impacted by social distancing, so you saw pretty severe demand declines or comparatively weaker collection activity.
Jones: The pandemic has impacted REIT sectors in different ways. Some have seen a severe decline in occupancies and a decline in cash flows related to changes in behavior. Hotels are generating very low occupancy rates as business travel has been severely curtailed. In addition, retail centers were closed for portions of the pandemic, and an outgrowth of the crisis has been a stairstep growth in e-commerce penetration.
Additionally, the work-from-home dynamic has left many office buildings less occupied by tenants, even though most are continuing to pay rent. There are some real questions as to whether the work-from-home trend will continue, even as the pandemic recedes.
Following what we saw in 2020, do you plan to make any adjustments to your investment strategy?
Yablon: We are always making adjustments driven by valuation, so what we focus on is getting our forward-looking view of national growth and value into our numbers, and we readjust as the valuation and/or the stocks move. We’re going to continue to adjust where we think we can generate the best returns for our investors, and that will be dictated both by whether our view of value changes, but also as stocks change.
Bokota: We’re largely maintaining the status quo. In recent years, we’ve preferred areas of the REIT market that are less sensitive to economic conditions. Industrial or wireless infrastructure or data centers are examples of that, and many of those preferences continue for us. But we have been looking for ways to include cyclicality into our portfolio as well, if we see those investment opportunities as offering attractive longer-term value. So, we’re being pretty selective and targeted.
Kaufman: We are value-oriented investors, so our investment strategy is to maintain an up-to-date view of what we think fair value is for every stock we cover and to look for mispricing, and that strategy doesn’t change year in and year out. We’re going to continue to be nimble, to mine the valuation signals we see in our model and take advantage of the opportunities the market gives us.
Kolitch: We actively manage our real estate portfolios and will modify them if we believe it is prudent to do so. In the last four to five months of 2020, we reoriented some of our holdings and investment themes with an eye towards 2021 and 2022 and an expectation that economic conditions would improve as COVID-19 vaccinations are widely administered.
How is investor interest in ESG (environmental, social, and governance) issues affecting your investment strategy?
Jones: We have recently integrated ESG factors into our investment approach for the REIT market, so we pay close attention to the ESG factors that are most important to real estate. On the environmental side, those include green buildings and reducing greenhouse gas emissions. On the governance side, we pay close attention to the alignment of management compensation and to total shareholder returns. We pay close attention to board structure in terms of having a majority of independent board members, and we’re increasingly focused on diversity throughout a REIT’s employees, management team, and board of directors.
We score each of the REITs in our investable universe as it relates to ESG, and those scores influence our investment decisions and how we construct our portfolios.
Kaufman: ESG is an important area of focus across LaSalle’s platform, and appropriately so. Real estate has a major impact not just on the world’s carbon footprint but on the safety, comfort, and well-being of society at large, which presents the whole real estate industry with a lot of responsibility, but also a lot of opportunity to effect meaningful change.
ESG is factored into our company underwriting and is an important component of our assessment of a company’s fair value. We don’t redline companies that have weaker ESG scores, but we ascribe less value to them and more value to companies that have a thoughtful approach to environmental sustainability, take care of their employees and communities, and have sound governance. We think we can have an impact on company behavior through investment and through engagement, and we take that advocacy role seriously.
Yablon: We’ve always integrated ESG into our valuation process, and we continue to do so. Our focus is to try to capture it in our discount rate and in our valuation, to try to price it in as best we can.
Bokota: Our investment strategy has always been focused on investing in quality companies at reasonable prices. So, for us, ESG is an integral part of our process. We view quality as multidimensional, not just about asset quality or the locations of the assets, but it’s also inclusive of ESG considerations. Incorporating ESG factors into our investment process results in a more holistic approach to investment decision-making.
Which commercial real estate sectors do you think will perform the best in 2021?
Kolitch: We believe many of the laggards of 2020 will generate solid returns in the year ahead. This group may include certain apartment, office, retail, hotel, and gaming REITs. Data center REITs are benefiting from secular growth in the outsourcing of information technology, increased cloud computing adoption, and the growth in U.S. mobile data and internet traffic.
Wireless tower REITs are positioned to grow for several years as the demand for data intensive devices accelerates and new wireless technologies emerge. Industrial REITs should continue to benefit from robust warehouse demand, in part due to broader e-commerce needs.
Bokota: Our favorite sector for 2021 is residential—both single-family rentals and manufactured homes. We’re seeing increasing levels of demand, record-high occupancy levels, and strong pricing power as people look to get more space. They’re also still trading at very reasonable valuations. Other sectors to highlight would be wireless infrastructure and industrial, as we see continued strong tenant demand.
Jones: The single-family rental sector has benefited as young families in particular are looking for more space. Relatedly, REITs that own timberlands and, in many cases, manufacture lumber and other wood products, have also benefitted because their primary use is in new home construction.
Kaufman: We like the residential sectors—single-family homes, manufactured homes, apartments. We also like shopping centers, which I think is a bit contrarian today. We see good value in that sector following the underperformance of last year. We also see value in some of the sectors that have maintained pricing power and outperformed during the pandemic—cell towers, for example.
Yablon: We think fundamentals in the self-storage business are reaccelerating quite meaningfully as people continue to move around the country and repurpose their spare rooms, and therefore move belongings into self-storage. We also have a view that a lot of the sectors that have been negatively impacted by the pandemic will begin the recovery story. We think gaming, health care, high-quality malls, and net lease are attractively valued right now, but they’re also vaccine recovery stories.
Which sectors do you feel will face the biggest challenges in the coming year?
Jones: I would be cautious on hotels and office. For the hotel sector, travel is still very depressed, particularly business travel. We think that even as the vaccine rolls out, corporations will be conservative in terms of adding to their travel budgets. The story on leisure travel is a little more constructive in that many families haven’t had traditional vacations for the better part of a year, so we could see strong pent-up demand for leisure travel by the summer.
As it relates to office, the work-from-home dynamic and the good productivity that corporations have been able to maintain may encourage them to embrace aspects of remote work even when the pandemic recedes. If that is the case, this could serve as a moderator of office demand.
Kaufman: We think retail and office will be the most challenged. Lodging also faces a tough road to recovery. We’re expecting positive operating income growth, though, for all sectors by 2022. That includes office, lodging and retail, but we do think that the rate of growth will lag for the office sector.
Yablon: We continue to think that office will struggle. Even as the country becomes vaccinated, companies are thinking about their space needs and how to fulfill the needs of their employees, and I do think there will be a structural shift, where the percentage of people working from home will increase pretty dramatically, even in a post-vaccination world.
What are some of the key potential risks or headwinds to REIT performance in the coming year?
Bokota: A couple of areas we’re watching are the vaccine and the return to normalcy, as well as the continued aggressive stimulus, both fiscal and monetary. If we saw any cracks in those positives, I think that would be negative for all investment markets, including REITs.
The other thing is keeping an eye on interest rates. REITs have sometimes had poor relative performances if rates moved up too far too fast, even if rates were moving up because the economic environment is improving.
Jones: One thing to pay close attention to is the pace of recovery within real estate markets as the pandemic recedes. We would expect the sectors that have been hurt by the pandemic to begin improving in the second half of 2021, but there are certainly open questions about the pace of that improvement and some questions as to whether the pandemic has led to changes in behaviors that will endure even as the risks from the virus recede.
Kaufman: I think the biggest risk for REITs remains the virus. We’re very optimistic that science has prevailed here. We see the vaccines coming, but there’s risk that the process could be derailed by mutations of the virus or issues with the rollout or even the long-term effectiveness of the vaccines. In all likelihood, there will be some bumps along this path to recovery, and it will be uneven. We think some of the behavioral changes that have occurred during the pandemic may endure, and those will impact certain geographies or certain sectors longer than others.
Kolitch: A further reopening of the economy is critical to an improvement in occupancy, rent and cash flow growth, and return performance for several real estate categories. This will not happen overnight, but perhaps over the course of 2021 into 2022. If interest rates spike, certain real estate companies and segments could face headwinds and lose their relative appeal.
Yablon: Vaccine distribution is a key concern. We’re focused on virus mutation and if that will change the efficacy of the vaccine. Separately, some people consider higher interest rates as a risk, but from our perspective, if it is driven by improving economic activity, REITs can perform well in that environment, certainly on the back of a return-to-normal trade in a post-pandemic world.