Real Estate Sector Rating: Neutral

The fallout from the COVID-19 pandemic continues to be a source of uncertainty for the Real Estate sector, but mass vaccinations and relaxed restrictions on public gatherings have reduced investor pessimism. The outlook for office REITs is likely to be uncertain until it becomes clear whether there will be an enduring shift toward remote working—although the recent trend appears to be for most workers to eventually return to the office. Nevertheless, increases in office building inventories are likely to weigh on lease prices and potentially property valuations.

Warehouse/distribution center demand remains strong, resulting in rising rents. And with the rapid rise in home prices amid low interest rates and de-urbanization, REITs specializing in single-family home rentals and manufactured homes have benefited; this is translating into higher multi-family rents, as well. If the economic expansion continues, workers return to offices, and interest rates stay relatively low, the Real Estate sector could do very well. In a generally still-low interest rate environment combined with renewed demand for office and retail space, investors' search for yield and moderate valuations could be a strong tailwind for the sector. However, this sector is very sensitive to rising interest rates, and historically underperformed most other sectors when the Fed begins raising interest rates.

The Russian invasion of Ukraine in late February, and the ongoing political response, has clouded our outlook on equity sectors. Due to the unprecedented and volatile series of events, the economic and market landscape has become highly uncertain.

Until there is more clarity on how the sharp rise in commodity prices, tightening of financial conditions, and likely Federal Reserve interest rate hikes might impact the economy and underlying fundamentals that drive relative sector performance, we think it’s prudent to maintain sector allocations that are in line with the overall market.

Positives for the sector:

• Low interest rates are positive for funding, and make REITs’ traditionally high dividends more attractive to investors
• Warehouse, data center and telecom towers are benefiting from technology and e-commerce trends
• Single-family residential REITs segments are seeing strong demand and rising rents, which is translating into higher multi-family rents
• Long-term demographics support recovery in extended-care and assisted-living facilities

Negatives for the sector:

• Higher interest rates are a significant headwind for this highly leveraged sector
• Long-term shift to e-commerce from brick-and-mortar stores puts retail REIT revenues at risk
• Short-term uncertainty exists about workers returning to the office
• Traditionally defensive characteristics in a rising market

Risks for the sector:

• A quicker-than-expected rise in interest rates could be a sharp headwind
• A permanent rise in work-from-home could reduce demand for office real estate