U.S. REIT Valuations Offer an Attractive Entry Point for Patient Investors

The share prices of U.S. real estate investment trusts have fallen by approximately 30% from their 2021 highs because of higher interest rates and stress in some commercial real estate sectors. We think that the correction is overdone and the current valuations offer an attractive entry point for patient investors. Our core REIT coverage is trading at a discount of approximately 25% to our fair value estimate. We estimate that the average REIT within our U.S. coverage is currently trading at a dividend yield that is 126 basis points higher than the historical average. We see marked differences in valuation across different REIT sectors in the United States. For instance, the industrial sector is fairly valued, with stock valuations already accounting for future growth, but other sectors like offices, hotels, and malls are trading at attractive discounts.

Since 2000, REITs’ relative performance has shown a strong negative correlation with interest-rate movements. REITs are required to pay dividends to shareholders, so many investors seek REITs for high dividend yields. However, as the risk-free rate increases, those investors rotate out of the sector. Additionally, higher interest rates reduce the value that management teams can create for shareholders through external growth. Rising interest rates in 2022 have led to the sector underperforming the broader U.S. equity market.

Stable net operating income growth for most REITs and relatively stable interest rates from 2012 to 2019 led to stable cap rates during this period. Lower interest rates after the pandemic led to contracting cap rates in 2021, but the cap rates for commercial real estate have continued to inch upward over the past year, partly because of higher interest rates. In the long run, we anticipate steady NOI growth for U.S. CRE given the supply/demand dynamic and interest rates lower than they are today, which should lead to average commercial real estate cap rates of around 6.5%.