Commentary - September 2023CenterSquare Real Estate Fund
Portfolio Manager Eric Rothman covers real estate investment trusts’ (REITs) rare discount percentage to net asset value (NAV), the historical performance of REITs after the terminal rate has been reached, and the case for investing in REITs.
Would you please discuss the significance of REITs’ current discount to NAV?
Generally, publicly traded REITs trade at net asset value. As of October 2023, REITs, as measured by the FTSE Nareit All Equity REIT Index, traded at a 15-20% discount to NAV, which is highly unusual. When we look back over the past 25 years during the modern REIT era, REITs have only traded at a 15% or greater discount 8 times. Each period has been brief, on average, and after these periods, REIT performance has been strong. Over the following one and three years, REITs have increased an average of 28.6% and 59.6%, respectively, on a cumulative basis.
We believe the current period offers an opportune time to invest in REITs. Prices appear to be driven by fear, which tends to be short-lived. Historically publicly trade real estate has experienced quick snapbacks and appreciate in value. As an example, when the Federal Reserve paused rates in November 2023 for a second consecutive time, it signaled to the market that the terminal interest rate may have been reached. Following the news, during the week of October 30 and November 3, the FTSE Nareit All Equity REIT Index gained approximately 9%.
What has historically happened when the terminal interest rate has been reached?
This time period has historically been a positive period for real estate. After the Federal Reserve ceases its rate tightening cycle, REIT returns have been strong, outperforming the overall market. Over the past approximately 30 years, there have been four periods when the Fed stopped its rate hikes. In the ensuing 90-day, 180-day and 1-year periods, REITs have risen an average of 9.3%, 13.9% and 20.1%, respectively.
How is the Fund positioned in the “higher for longer” interest rate environment?
With higher rates, REITs will need to fund future growth at a higher cost of capital. Therefore, for the Fund, we have focused on maturities that extend beyond 24 months. Fortunately, the REIT market tends to have long duration balance sheets that average approximately seven years, which helps cushion the impact of higher rates.
In addition, with an ongoing concern about a recession over the past year, we prefer REITs with healthy cash flow coverage. Overall in the REIT market, dividends and dividend coverage remain solid.
Lastly, the Fund remains diversified across the real estate spectrum, investing primarily in Class A properties that include data centers, cell phone towers, warehousing logistics facilities, cold storage, medical office buildings, self-storage units, and single-family rentals.
What is the case for investing in publicly traded REITs in this macroenvironment?
Publicly traded REITs tend to possess defensive characteristics including the following:
- Durable cash flow. At the property level, REITs have averaged about 3% net operating income growth over the past 25 years.
- Healthy dividend payouts. Year-to-date 2023, nearly 70 REITs have increased their dividends by an average of 10%.
- Lower market correlation provides diversification.The 10-year average correlation between the S&P 500 and the FTSE Nareit All Equity REITs Index was 0.72.1
In addition, unlike private real estate funds, the Fund invests in publicly traded securities, strikes a daily NAV, and offers daily purchase and redemption of shares without restrictions.
1 eVestment as of 12/31/22. Data based on monthly performance.
Past performance is not a guarantee of future results. Index returns are not indicative of fund performance. Click here to obtain Fund performance.
The NFI-ODCE (NCREIF Fund Index – Open-End Diversified Core Equity) is a fund-level capitalization weighted, time-weighted return index and includes property investments at ownership share, cash balances and leverage (i.e., returns reflect the fund’s actual asset ownership positions and financing strategy).
Correlation measures the extent to which two variables are related. Cash flow is the total amount of money being transferred in.