While expectations for rising interest rates have made investors a little more skeptical in early 2022, Gina Szymanski, portfolio manager at AEW Capital Management, believes there continues to be potential to see double-digit net asset value (NAV) growth for REITs across almost every property sector over the next two years.
Interest rates are certainly one of the macroeconomic factors Szymanski is closely watching right now, but she says they need to be understood in a historical context. Szymanski spoke with REIT magazine to discuss her views on NAV growth, how to put interest rate moves in context, where AEW sees growth in 2022, and why cap rates may even come down this year.
What is your overall outlook for the REIT market in 2022, particularly coming on the heels of such strong performance in 2021?
First, I’d like to point out that 2021 came in much better than forecast. Originally, companies were expected to grow cash flows by 3%-4%, but by the end of the year, results ended up being closer to 8%. Looking forward, we believe 2022 will be another strong year. Cash flows are expected to grow by almost 10%, with every sector, except retail, growing cash flows well above inflation.
On average, North American REITs are trading at 1% premiums relative to their underlying private market values, roughly in line with historical averages. NAVs are expected to grow strongly in 2022 but, unlike last year when REITs were anticipating strong growth and trading at 10%-15% premiums, the market is a little more skeptical this year. This is due to the potential for rising interest rates and the impact that may have on cap rates.
Based on what we know today, we may see double-digit NAV growth in almost every sector over the next two years.
What are some of the macro factors for REITs that you and AEW are keeping an eye on for this year and beyond?
The macro factors we are watching include the potential for interest rate increases, cap rate spreads, valuations, and dividend trends.
Investors often assume rising interest rates are a negative for REITs, but the reality depends greatly upon which interest rate you’re talking about. While cap rate spreads have tightened over the past year, most sectors remain wider than their 2018 lows as they never came down as much as Treasuries did.
REIT dividends continue to look attractive relative to corporate bonds, meaning they trade at better than normal spreads to bonds. REITs are also trading at slightly more attractive levels than normal relative to equities.
The REIT market should benefit from income and NAV growth as the global economy recovers from the pandemic over the next several years.
How are you considering the pandemic’s continued impact on REITs in general?
Hopefully we will never go back to a complete shut-down, but how will things emerge and evolve as the pandemic wanes in sectors that have been most affected, like office and retail?
The sectors currently trading at discounts to NAV are those that have been more negatively impacted by COVID. All but these few sectors of the REIT market have now moved into recovery, while those sectors that displayed resilience during the pandemic remain strong.
Supply has been unable to keep up with demand in these sectors as both materials and labor have been hard to find. As a result, COVID winners such as industrial, single-family rentals, self-storage, and apartments should enjoy another year of strong fundamentals in 2022.
Meanwhile, retail sectors made substantial progress in 2021 as they benefited from flush consumer balance sheets. While Omicron has depressed foot traffic for the time being, our research suggests the retail recovery will continue into 2022.
And while the long-term impact of work-from-home on office demand is likely the biggest single uncertainty in commercial real estate, even office absorption turned positive in the fourth quarter of 2021 and the sector is in the process of bottoming out.
New COVID variants reduce the outlook for business and leisure travel, which would further impact hotels. However, the recovery in hotel fundamentals has not stalled despite the recent rise in COVID cases.
Where are some of AEW’s overweight and underweight positions?
One of our larger overweights is to single-family rentals. This sector benefited from COVID because, relative to traditional apartments, single-family homes give families extra room to live, more outdoor space, or an extra bedroom that can be used as a home office. A strong housing market and wage inflation have also helped to drive strong occupancies and rent growth. Companies have accelerated external growth and are actively acquiring and partnering with homebuilders to secure new homes for rent.
Another large overweight in our portfolio is manufactured homes, which lagged the other residential sectors in 2021, despite stronger growth. We believe this was in part due to the public companies acquiring marina assets for the first time. Investors naturally become more skeptical when companies stray from their core business, which we view as a healthy reaction.
However, marina investments may prove to be a good place to deploy capital, and more importantly there are still opportunities for these companies to grow their core businesses both here in the United States and in Europe and Australia.
We are also overweight in the industrial sector. Demand for industrial space continues to benefit from increased online shopping, higher inventory levels to prevent supply chain disruption, as well as reshoring. Rental growth has accelerated and will most likely stay elevated for a while given that vacancy rates remain at historic lows and most new supply still skews towards pre-leased or build-to-suits.
While we could see office benefit near term from tailwinds such as improved parking revenues, street level retail sales, and pent-up demand for leases that were pushed off during COVID, we still do not see the office sector benefiting from strong demand yet. We also expect cap rates for office assets will continue to be biased higher, given less institutional demand.
We are also underweight health care and data centers, as we think these sectors look expensive on a relative basis given their below average growth outlook.
How will higher interest rates affect REITs?
Historically, REITs on average have outperformed both stocks and bonds when the federal funds rate rose 50 basis points or more. When the 10-year Treasury yield moved that much, REITs underperformed stocks over the following six months, but they still delivered positive returns and dramatically outperformed fixed income.
Investors often assume rising interest rates are a negative for REITs, but the reality depends greatly upon what cap rates do in response. Because cap rates start with a buffer, we do not believe an increase in interest rates necessarily means a similar increase in cap rates. Cap rates may even come down in 2022. If that’s true, REITs will likely outperform the general stock market.
The most difficult environment for REITs is when corporate bond yields are moving up substantially, as this often coincides with periods of credit concern, recessionary worries, and equity market weakness. Economic downturns are a bigger concern for REITs than rising rates.