New year, new interest rate cycle: can the rally in global property persist?
Listed property has weathered a perfect storm over the last four years. After Covid’s blow, listed property finds new footing as businesses reshape and investors return.
Nicolas Lyle
Property Analyst/Portfolio Manager
Covid and rates: Listed Property’s double whammy
The response to the Covid-19 outbreak played havoc with people’s lives, including by restricting their movement through shelter-in-place orders. As consumers stayed home, many businesses closed (especially in hospitality) or reconsidered how much space they needed in the new world of remote working. Commercial real estate occupancy slumped and so did investor sentiment.
Equities bottomed on 20 March 2020. The S&P 500 reached a new high five months later, invigorated by US government fiscal stimulus, but global property indices did not recover their losses for another nine months. By that time, the S&P 500 was 24% higher than before Covid.
Occupancies were just starting to recover in 2021 when the world was gripped by a wave of inflation, as Covid stimulus coincided with supply chains dislocated by the pandemic. Central banks were compelled to increase interest rates and did so at the fastest pace in decades: in August 2023 short-term rates peaked at their highest level in 20 years.
The disruptions caused by the response to Covid, together with sharply higher interest rates, were sequential body-blows for commercial real estate. They depressed rental income in 2020-2021 (it has subsequently recovered) and increased debt servicing costs in 2022-2023. The first event depressed operating profit margins, the second hit net profit margins for global REITs.
The most negative point for risk assets in general and global property in particular occurred in October 2023, when long-term bond yields in developed countries touched generational highs: the yield on the 10-year US Treasury bond hit 5%, a level last seen in 2007. Many investment-grade REITs with locked-in free cash flow per share growth in 2023 and 2024 were trading at double digit free cash flow yields, creating the cheapest entry point into the sector since the Covid-related sell-off in early March 2020.
How has global property performed?
This one-two punch of lower occupancy and higher rates has made the last four years one of the most challenging periods for property stocks in decades. However, long-term investors who stayed invested earned a total return in rands of about 29% over the four years to 31 December 2023, equivalent to a compound annual return of 6.5%. In fact, last year’s return from Global Property (see table below) was by far the highest among the asset classes typically found in a balanced portfolio.
Diversifying your risks
Seasoned investors know that diversification improves risk-adjusted returns and supports the steady, long-term accumulation of wealth. Physical property houses the global population and almost every form of business enterprise. Unsurprisingly, it is the world’s largest asset class. Global REITs offer investors exposure to the highest-quality real estate and the best managers across more than 40 countries which have enacted the relevant REIT legislation. Numerous studies over the last 20 years have shown that South African investors without exposure to global REITs have missed out on diversification and hard currency returns. This is also why the world’s leading pension funds have steadily increased their allocation to property assets over the last ten years to over 10% today, as shown below:
Looking ahead
Financial market investors are usually rewarded for respecting strong historical patterns. One of those patterns is the outperformance of property stocks in the 12 months after interest rates peak. Once the rate cycle has turned, investors can project long-term funding costs with greater confidence and price stocks accordingly. Even if the economy slows (but avoids a deep recession) we expect global REITs and listed property stocks will continue to deliver positive returns, supported by structural drivers of cash flow growth over the next 12 months. Indexed rents will rise to incorporate the recent bout of inflation and expiring leases will be renewed at much higher market-level rents. We believe that global REITs offer investors positive real returns with low risk: most of them have investment grade credit status, reflecting their high-caliber management teams, high-quality portfolios, strong interest cover and relatively low levels of leverage, with well-laddered maturities and a diversity of funders.
Conclusion
The current macroeconomic backdrop contains risks, but it offers a very promising outlook for global property. We expect global property will deliver a total return in dollars of about 10% in 2024, driven by current mid-single digit dividend yields and mid-single digit growth in free cash flow. Valuations are not stressed: global REITs are on average trading at 15-year average multiples. We are at the top of the interest rate cycle looking down and ahead. Falling interest rates would add upside to our base case, whereas signals of an accelerating recession (such as a sharp rise in unemployment or a drop in house prices) would cool our enthusiasm.