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The role of REITs in a new post-COVID-19 world

INSIGHT ARTICLE  | 

Public real estate investments via real estate investment trusts (REITs) have long been a core part of diversified portfolios. Over the long term, REITs have provided competitive risk-adjusted returns in many market environments (Figure 1), attractive incomes and a hedge against inflation. However, the structural challenges more acutely affecting sectors such as office space, regional malls and shopping centers are leading some investors to question whether an allocation to REITs still makes sense. We believe the evolving composition of the broad REIT landscape will help to sustain these attributes.

However, the pandemic has some investors asking whether an allocation to REITs still makes sense when work-from-home (WFH) trends are likely to have a negative and long-lasting impact on office space. Add in the headwinds from online shopping on retail and reduced travel on hotels, and surely,

REITs face insurmountable damage, correct?

It is likely that demand for office space will face headwinds for some time, as WFH offsets natural demand growth and “dedensification” (less density due to wider distancing practices increases square footage demand).

 

Nonetheless, while WFH flexibility may be a more common way of life going forward, our view is that the business imperative for in-person collaboration and teamwork will spur a gradual return to offices as vaccine numbers increase.

More significant for investors, the REIT market has evolved over the past decade as growth in “new economy” businesses and sectors has changed the landscape of the broader real estate market. The real estate needs of businesses related to e-commerce, wireless telecommunications and health care, plus trends toward distributed workforces, has led to growth in alternative—or nontraditional—sectors of the REIT market, while traditional sectors typically associated with REITs have shrunk as a proportion of the market. By some measures, alternative sectors now account for almost two-thirds of the REIT market (Figure 4).

The role of REITs in a new post-COVID-19 world figure 4

Moreover, in our view, many of the alternative segments—data centers, industrial (e-commerce warehouses) and infrastructure (cell towers)—are likely to be beneficiaries of trends such as distributed workforces and e-commerce that were already in place, but accelerated due to the pandemic. Other sectors may get a tail wind from the post-pandemic economic recovery, as well as vaccine progress (Figure 5).

The role of REITs in a new post-COVID-19 world figure 5

To be sure, certain sectors do face structural headwinds that likely were exacerbated by the pandemic. However, as noted above, those currently represent a smaller portion of the market than they have historically. To that point, office represents only 7% of the index despite its prominence in many investors’ view of the asset class.

Near term, headlines for REITs may remain challenging, especially as pandemic recovery efforts ebb and flow. Stories about WFH, vacancies and rent collection challenges in major cities, and retail store closures may be headwinds and sources of volatility. Nonetheless, considering all of the points discussed above—growing importance of sectors benefiting from secular trends, cyclical recovery potential, attractive long-term risk/return potential across market cycles—we continue to believe that a modest allocation to REITs may play an important, positive role in a well-diversified investment portfolio.

RSM CONTRIBUTORS


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