With two weeks to go in 2024, the FTSE Nareit All Equity REITs Index is on pace to end the year posting double-digit growth in total returns. This is roughly in line with the 25-year average of nearly 10%.
Looking ahead to 2025, a combination of factors, including the prospect of a soft economic downturn, lower interest rates, convergence of public and private real estate valuations and sold real estate fundamentals, provide favorable conditions for REITs to perform well.
Nareit, the association representing the REIT industry, outlined these factors in its REIT Outlook 2025, published earlier this week.
WealthManagement.com spoke with Ed Pierzak, Narei's senior vice president of research, about the REIT's recent results and outlook for 2025.
This interview has been edited for style, length and clarity.
WealthManagement.com: Can you start with the big picture? What are some of the key outcomes from your perspective for 2025?
Ed Pierzak: Three things come to mind. One is the economy and whether or not we can manage a soft landing. Second, if we can close the cap rate gap between public/private valuations. Evidence suggests we are on that path. Lastly, if you can get them both, it opens the door for a resurgence in the property transaction market.
When we talk about engineering a soft landing, there is no official definition of what it is. But if you look at real GDP in the US, it came in at 2.8% in the third quarter. You also want a stable unemployment rate. November came a few days ago and rose slightly from 4.1% to 4.2%. But we also had an increase of 227,000 jobs and last month's number was also revised.
With inflation, the latest readings showed the CPI at an annualized 2.7% and the core at 3.3%. And with the Fed, they've done two cuts and the expectation, if you look at FedWatch, says there's a 95% probability of a cut at the December meeting.
Finally, are people worried about a recession? The latest consensus reduces the odds to 23%. You don't have to look far back to see when the odds were greater than 60%.
Add all this up and we're ready for the Fed to have a soft landing.
WM.com: Why is the macroeconomic situation so important to real estate?
EP: Jobs and the overall economy are the main drivers of demand for real estate. Lower rates benefit the real estate market.
All that said, we also have to look at the real estate market and we have to understand that there is a degree of softness in some sectors.
Looking at the four traditional property types (office, retail, industrial and multifamily), we are seeing a softening of occupancy rates and rental growth rates. Overall, year-over-year rental growth is still positive. So it's not a serious situation. But there is a degree of tenderness there. If the transaction markets increase, buyers will have to account for all of this in the underwriting.
WM.com: Just to point out, rents are still going up, just not as fast as they were at one point. And can you put that in the context of whether rents are rising faster or slower than the rate of inflation?
EP: Data in our T-Tracker showed that all of these sectors have higher occupancy rates in the REIT world compared to the broader market. This is a function not only of operational expertise, but of asset selection and how it depends on the choice of where and how you manage the properties.
If you also look at where investors place bets – they tend to be overweight in the modern economy sectors of data centers, telecommunications, healthcare and self-storage. The fundamentals in these sectors are a bit stronger and all have good prospects in 2025.
Compared to inflation, it depends on the sector. Industrials and apartments were oversupplied because of the development that was fueled by the tremendous rent growth they had experienced. Annual rent growth was effectively double digits at the peak. Since then, it has declined. Industrial, the annual rate of the year was 3% in the third quarter, so favorable compared to inflation. However, apartments took a big hit and rent growth is down to 1% today.
In other sectors, retail never saw much growth and rent growth is still at 2.4% per year. Offices have also maintained positive year-over-year asking rent increases of 1% for nearly three years now. But the key here is that demand for rent increases. What are the effective leases or signed leases, we do not know.
WM: Multifamily comes up a little bit given some of the broader conversations in the country about the housing shortage. Is what is happening to many REIT families partly a function of the market segments in which REITs typically operate?
EP: It is supply/demand driven. The very high rent increase caused a strong supply reaction. Demand could not keep up and the market is recalibrating. That said, for many investors, condos remain the asset class they desire.
WM: Moving on to valuations, the difference between public and private is something we've talked about a lot in recent years. Last month you said optimism that the spread would eventually narrow to a more historically normal range. It seems to remain so.
EP: Strong performance in the third quarter of this year helped effectively halve the cap rate spread. When we get to this level of a spread of 50 to 60 basis points, that's an average level that you would see in non-divergent periods. So we're getting to a place where things are back in sync. And I think we're going to start seeing an increase in transaction activity.
When markets are out of alignment, buying and selling activity falls. But once they're online, things speed up. It is our view that we are likely to see this in 2025. When this happens, a number of factors benefit REITs. Not only do they have strong operational performance, but their balance sheets are in order and their access to cost-effective capital is in order. They will have an opportunity to enter a growth cycle and be more competitive.
WM: Something else you regularly monitor is capital growth. In the past couple of years, we've talked about how REITs have continued to access public debt and equity and have been opportunistic in going to market strategically when conditions have been favorable. But I'm curious, given what you're saying about the transaction market, if there's any evidence that REITs are perhaps more aggressive and building war chests, so to speak.
EP: Through the third quarter, new equity and debt issuances for REITs already equaled the total of 2023. So they've come a little bit more to the market.
One of the things we've emphasized is that raising unsecured debt is a cost-effective way to enter the market. But we also had the Lineage IPO and we have REITs forming joint ventures with institutions. They have gone direct, so to speak, without intermediaries.
It says a lot about operational skills to be able to go to some of the biggest and most sophisticated investors in the world. Equinix announced a joint venture with GIC and the Canada Pension Plan Investment Board that is north of $15 billion for data centers. It shows that REITs have many options. They can go to the capital market or the debt market or create joint ventures with institutions directly.
WM: Finally, where do we stand with total returns, both monthly for November and year-to-date for 2024?
EP: REITs rose around 3.5% for both the FTSE Nareit All Equity REITs index and the All REIT index. Drilling into all sectors, almost all were positive. We've talked before about the inverse trend of REITs trading relative to the 10-year Treasury yield. In November, yields started higher and ended lower and this contributed to the REIT's stronger performance.
Year-to-date, total REIT returns were around 14% at the end of November. As we move into December, there have been some returns, but total returns are still around 10%. If you go through history, 10% is average. So overall, we'll end up with a year in line with long-term historical performance.