The real estate sector is in the headlines again amid a nebulous economic outlook and an uncertain path for interest rates. How should investors navigate this landscape? We believe an allocation to listed real estate investment trusts (REITs) offers a compelling solution. 

True, the REITs market won’t be immune to higher interest rates or broader economic uncertainty. However, REITs have evolved since the 2007-08 Global Financial Crisis (GFC) and are more insulated against upheaval than ever before. There are three reasons why we think investors should look again at REITs.

REITs: three reasons to invest

Firstly, REITs have exercised discipline in their balance sheet management since the GFC. This should ensure they’re more equipped to deal with the effects of monetary policy tightening than they were in the past.

Secondly, and linked to the pervious point, REITs have diversified their sources of capital in recent years. We’ve seen a general move away from secured debt (mortgages) towards unsecured debt (bond issuance). The latter provides more flexibility and is usually at a lower interest rate compared with the secured debt alternative.

Finally, REITs valuations have adjusted to the changing market backdrop. By contrast, private real estate valuations have been slower to adapt. Further declines are possible in 2024, especially for those parts of the market facing ongoing structural headwinds, such as the office sector.

Let’s consider each point in more detail.

1. Robust balance sheets

In our view, REITs are well-positioned to withstand volatility in the commercial real estate lending market owing to their robust balance sheets. These have evolved and largely improved across several metrics since the GFC.

Loan-to-values have decreased over the past 10-15 years. They currently average around 36% for the listed real estate market, compared with c.45% before the GFC. Importantly, almost 90% of this debt is at a fixed rate, against c.50% for the private real estate market.

The weighted average maturity of this debt has extended from five years before the GFC to nearly seven years. Refinancing risks for REITs are therefore lower compared to their private market counterparts.

2. Diversified sources of capital

REITs have adjusted their capital structures, moving away from secured debt (mortgages) to unsecured debt (bond issuance). Many have benefited as banks cut back lending. Most REITs have preferred unsecured bonds, which now account for c.80% of total debt issued compared to c.50% before the GFC.

An increase in unsecured bond issuance is one of the benefits of stronger balance sheets. Additionally, this comes with increased flexibility and lower financing costs, thanks to the growing number of investment-grade ratings across the global REITs market.

Access to unsecured debt gives REITs a competitive advantage over many of their private real estate market counterparts.

3. Valuation adjustments

REITs valuations sharply adjusted to the changing macroeconomic conditions at the end of 2022 and into 2023. By contrast, private real estate valuations have been slower to adjust. This makes sense. The public real estate market is often a leading indicator for future private real estate market movements.

Evolving price discovery in the private real estate market might cause bank lenders to assess the capital requirements for their commercial real estate loan books. However, we don’t think this will lead to a systemic problem for the sector.

We anticipate further capital declines over the first half of 2024. The office sector continues to face structural headwinds and deteriorating fundamentals. Borrowers and lenders exposed to this market encounter the biggest financing risks, particularly for poorer quality stock.

It’s worth remembering that offices account for less than 5% of the listed property market. We’d therefore expect REITs to outperform private real estate in the event of further market stress.

Final thoughts…

Today’s REITs model looks markedly different from the 2007-8 GFC. Market participants have learnt from previous cycles and made positive changes that should equip the sector for what lies ahead.

The strengthening of balance sheets, combined with a more robust capital structure, ensures the sector is on a sounder financial footing compared to recent history. REITs also offer exposure to the exciting market sectors that are expected to benefit from structural tailwinds, allowing investors to diversify their portfolios beyond traditional real estate.

For these reasons, we believe the REITs market is well positioned to navigate any economic uncertainty and is – deservedly – back on investor radars for 2024.



Sources: abrdn, FTSE, Nareit T-Tracker as at Q3 2023.