The year just gone was no more pleasant for global real estate investors than for those in any other sector. In terms of returns it was the worst year for the asset class since 2008, losing more than 24 per cent.
The macro context of 2022 is well understood, and the sensitivity of the real estate sector to rate moves is not surprising.
Over the course of 2022, the yield on the US 10-Year Treasury rose 243 basis points and this has driven much of the pain in real estate markets.
In terms of sectors, there was really nowhere to hide, with all areas of the market posting negative returns. Offices and residential were the hardest hit as markets queried fundamentals as well as the macro environment.
Learning from history
Entering 2023, there clearly remains a broadly uncertain macro-economic environment with major global economies in or likely to enter recession, and inflation putting pressure on policymakers and consumers alike.
So, what does this mean for investors in the listed real estate market?
There are three core drivers of real estate performance looking ahead that investors should be considering.History has some interesting lessons here, with the maturity of the listed real estate market (active since the 1960’s) enabling performance analysis during similar economic conditions to the ones we find ourselves in.
Research from Nareit (the North American Real Estate Investment Trust Association) shows that on average during the last six recessions, REITs have outperformed equities.
While REITs have typically underperformed private real estate before recessions, as happened in 2022, they have outperformed private real estate during and after recessions.
The reality of private markets lagging public markets is one that creates an opportunity for investors considering allocating to listed real estate at the start of 2023.
In a recessionary environment, quality of earnings (rather than lofty growth expectations) is an important focus area.The consistent challenges around liquidity and gating for the UK direct property funds is another factor that could drive investors away from private real estate, and towards the listed real estate market.
Identifying bright spots
On a fundamental basis, there are three core drivers of real estate performance looking ahead that investors should be considering as they look to deploy capital.
First, in a recessionary environment, quality of earnings (rather than lofty growth expectations) is an important focus area. Many REIT sub-sectors can offer investor exposure to high-credit tenants providing mission-critical assets for their tenants.
Healthcare and communications real estate are two good examples here, and the strength of dividend distributions provides evidence of underlying health.
As a component of total return, dividends can play a particularly important role during a recessionary environment. This consideration also highlights continued challenges facing more traditional sectors such as offices and retail, where the recalibration of working practices post-Covid is sustaining uncertainty.
Investors need to remain highly selective in the sorts of underlying assets they seek exposure to in these areas.
Second, balance sheet strength and access to capital is increasingly important. The era of free money is over, and REITs with conservative balance sheets and good access to capital will be able to out-grow their competitors.
The regulatory scrutiny being applied to buildings and landlords is only going in one direction: net zero.Third, the challenge and opportunity posed by sustainability is one that is continuing to shape the sector and forward-looking returns.
Operating costs for tenants are going up, and the regulatory scrutiny being applied to buildings and landlords is only going in one direction: net zero. This is driving a bifurcation in the market, where owners of older, less energy-efficient real estate will both struggle to attract tenants and be hit with large capex bills to meet an ever-rising regulatory bar.
REITs that are already at the leading edge of this debate will enjoy the opposite; better tenants on better terms, cost efficiencies and easier access to capital.
This is where real estate investors should be investing in order to capture the best opportunities during 2023.
As we apply this approach to selecting and investing in specific listed REITs, we focus on companies active in structural growth sectors with high-credit tenants, and with management teams that can demonstrate a clear and genuine focus on embedding sustainability into their long-term strategies.
This can include, for example, companies prioritising net-zero retrofit of logistics assets, or REITs that are deploying energy efficiency measures across their portfolios.
Mark Brennan is co-manager of the Foresight UK Infrastructure Income Fund
