Headwinds that challenged the broader equities market—including questions about the pace of economic recovery and the ongoing battles in Washington, D.C. over raising the debt ceiling and the passage of two major pieces of legislation—took their toll on the publicly-traded REIT sector in September. The FTSE Nareit All Equity REITs Index fell 5.92 percent for the month, although it remained up 21.63 percent year-to-date, as of Sept. 30.
That year-to-date figure beats the S&P 500 (up 15.92 percent through September), the Russell 2000 (up 12.41 percent), the Nasdaq composite (up 12.66 percent) and the Dow Jones Industrial Average (up 12.12 percent).
Meanwhile, Morningstar Analysis delivered a piece of good news for the sector in a new report suggesting the optimal portfolio allocation to REITs—depending on an investor’s risk appetite—should range between four percent and 13 percent.
WMRE sat down with Nareit Executive Vice President and Economist John Worth to discuss September’s returns and the Morningstar findings.
This transcript has been edited for length, style and clarity.
WMRE: It was a rough month for the sector. What are some of the takeaways from these numbers?
John Worth: It was a tough month for equities across the board, including REITs. The S&P ended up down 4.65 percent for the month. The All Equity REIT Index did a bit worse and was down 5.92 percent. And as we looked across the sectors we saw some of the sectors that had performed the best over the past year-and-a-half are some of the ones that had the toughest months.
Infrastructure REITs—which are mostly cellphone towers—were down 9.09 percent for the month, although they are still up roughly 17 percent for the year and had a strong 2020. Data centers were down 7.41 percent for the month, although still up 10.09 percent for the year. Self-storage, which has been having an incredible year, is still up 39.06 percent year-to-date even after falling 8.2 percent in September. Residential REITs are also still up 36.29 percent for the year after falling 4.37 percent in September. And retail is up 32.11 percent for the year, despite falling 5.28 percent for the month.
Lodging/resorts was the only sector with positive results, up 1.27 percent, and up 14.72 percent year-to-date. Timber was only down 80 basis points and is up 9.7 percent for the year, while office was only down 2.8.5 percent and remains up 13.03 percent for the year.
WMRE: Any other big picture takeaways from the month?
John Worth: When looking at REITs relative to the S&P for month and year-to-date, even though both were down, REITs are still outperforming S&P by more than five percentage points for the year.
In addition, when looking at the daily data, REITs were still providing meaningful diversification benefits in the month of September and year-to-date. The correlation coefficient for the year between the All Equity REIT Index and the S&P 500 is 0.6 So, among diversifiers that’s an extremely good diversifier. In September, the correlation coefficient was below 0.5. In fact, there was only one day where both REITs and the S&P were both down more than a percentage point. On other days, one or the other index was down while the other was down substantially less. You could see the diversification benefit providing portfolio stabilization even in a month where all the returns were down.
WMRE: Was there anything at the property level or within a certain sector that drove the results? Or are we mostly looking at the effects of a broader market drop? For example, more companies during the month delayed or canceled plans to return to office.
John Worth: We saw some companies delay their return to office, but we also saw Google buy a very large office building in New York. They are clearly making a bet on the future of work-from-office. And we saw that office was one of the better-performing sectors. So overall I think the response to Delta is driving concerns about economic growth more broadly and that is getting reflected in real estate returns.
WMRE: We’ve talked about inflation in the past and how you didn’t see it as a major point of concern. Is that still the case?
John Worth: As I look at the data I see this very much as a supply chain driven issue. The question becomes, “When are the supply chain issues going to filter through?” Our expectation is that this will take some time. When you shut down big chunks of the global economy, it’s going to take some time to restart the machine and you’re going to see hiccups and gaps in places.
Shipping containers in the wrong place. There are backups at major ports. There are issues in the semiconductor supply chain. All of those are case studies in how the smooth functioning of the global economy requires more coordination than you might think about when you’re picking up an item from a store or ordering online. You are not thinking about the supply chain dynamics.
However, whether we are going to see an inflationary cycle [with] wage/price pressures, I think that’s a relatively low risk. Nevertheless, what we’ve seen is that REITs—because they have some of the fundamental characteristics of real estate—have tended to outperform the general stock exchange during periods of inflationary pressures. Real estate leases often have CPI escalators built in and REITs structure their leases so that they have some coming due every year [and] have the ability to renegotiate a meaningful part of their portfolios annually.
The other thing unique about real estate is that it can perform well during both periods of high inflation and periods of low inflation. That’s unlike commodities or TIPS, which can perform well during high inflation, but generally perform poorly the rest of the time. So REITs offer a low cost hedge.
WMRE: We’re also at the end of the third quarter. Are there other themes to look back at or things to look forward to for the final quarter?
John Worth: We’re up to $54 billion in M&A deals pending or completed, year-to-date. About $38 billion of that is attributed to REIT-to-REIT transactions.
WMRE: Can you talk a bit about the new Morningstar research on portfolio construction?
John Worth: The research used portfolio optimization techniques and concluded that REITs should make up between 4 percent and 13 percent of an investor’s portfolio. That’s very consistent with our view and is aligned with a wide body of literature supporting an allocation to REITs and real estate in the five percent to 15 percent range. And although we’ve seen this before, it’s important to see it from yet another researcher.
In general, we want to make sure financial advisors understand how to use REITs. REITs are a diversifier and an income-based total returns driver. When you look at the broad-based investment market basket, you find that 15 percent of that is allocated to commercial real estate. So it stands to reason that you would find a well-diversified portfolio [somewhat] similar to that market weight.
The role of advisors and a number of us in the industry is to describe how you can get to that allocation in an efficient way. A piece so many investors and advisors misunderstand is what constitutes commercial real estate. There’s a perception that it’s predominantly retail and office. But if you look at the REIT index, retail and office are each only about 10 percent of the index. The diversity of commercial real estate is something that individual investors sometimes don’t understand.