As of now, it seems that the odds are clearly stacked in favour of commercial real estate going into 2024. The key driver of this is the expected change of Fed’s direction in the monetary policy.
Starting from 2024 and onwards, the FOMC’s median estimate plots a rather consistent convergence in SOFR back to ~3% level by 2026.
The market seems to disagree a bit on the exact timing of first interest rate cuts, but by mid-2024, the consensus stands close to 100% on experiencing a first decrease.
This is a combination of several factors why the market is so aligned on the future trajectory of Fed Fund’s rate; such as clear disinflationary data, weakening job reports, and slowing economy all of which contribute to a meaningful basis for interest rate cuts.
In the context of REIT investing, the following is what matters:
- It is highly likely that the interest will fall in 2024; the extent or number of cuts is not that crucial.
- When first cuts materialize and the market will start to price additional moves with more certainty, duration-heavy assets will respond as if there was a more major decline in SOFR.
So, given the above, REITs, which carry a huge exposure in duration factor (where the cash flows are back-end loaded and resemble characteristics of fixed income) should perform extremely well in 2024.
Here are two duration-loaded REITs, which should definitely be considered in portfolios by investors who also believe that the rates will be going down in 2024.
#1 SAFE – unique ground lease REIT
Safehold (NYSE:SAFE) is a very unique REIT with operations in a ground lease segment and with a market cap of around $1.5 billion. The way how SAFE creates value is by taking off some of the CapEx pressure for property developers through purchasing land and leasing it out on a long-term basis to these developers.
Through this mechanism, SAFE enables developers to effectively back-end load their CapEx requirements over (typically) 100-year period with some embedded mark-ups and periodic lease escalators.
For SAFE, this warrants very reliable cash flows, which are similar to long-dated fixed income instruments. For example, as of now, SAFE has over 90 years of remaining life for the contracted leases, where these cash flows are underpinned by a rather sound underwriting policy (e.g., rent coverage over 3.8x).
All of this translates to a heavy exposure to duration factor as the cash flows are relatively fixed for an extremely long period of time (e.g., even for longer periods than jumbo bonds).
In the chart below, we can clearly see how SAFE has lost a ton of value since the FED started its restrictive monetary policy. Most of this is explained by the sensitivity towards duration.
We can confirm this by looking at how SAFE has responded to the recent news in relation to an increased disinflationary environment.
It is very obvious that SAFE responds in a magnified fashion to each move in the interest rates. It is also evident that SAFE is still ~70% below the level before the Fed began its hiking cycle, implying that there is still a lot of room for upside.
Finally, by experiencing some interest rate cuts, SAFE will also be relieved from the fundamental perspective.
Because of higher interest rates, SAFE’s cash spreads have declined to just a couple of basis points. In case the interest rates would continue to climb higher, the underlying cash flows of SAFE would be underwater.
Now, once it is rather clear that the interest rates will most likely not move higher and instead be subject to a gradual normalization, there could be additional upward pressure on the SAFE’s share price that is associated with the disappearance of negative cash spread risk.
#2 O – reliable dividend aristocrat
Realty Income (NYSE:O) is considered one of the best-managed REITs and well-known REITs that is preferred by many retail investors.
It is classified as a dividend aristocrat and after acquisition of Spirit Realty Capital, Inc. (SRC) it will become the 4th largest REIT.
On top of the compelling duration play, O embodies many other interesting characteristics such as:
- Upper grade investment credit rating. Currently, O carries an upper medium investment grade credit rating of A3, which is not that common for equity REITs. A3 rating comes in handy during times of economic uncertainty to get optimal access to financing at reasonable terms that could be utilized in, for example, accretive M&A moves, while other more distressed REITs (or developers) are selling.
- Defensive portfolio. O carries also a portfolio of durable properties, which are mostly leased under net lease principle. More than 90% of rents come from rather defensive and countercyclical economic sectors, which again render the underlying cash flows more stable and predictable just as for fixed income instruments. Moreover, the overall rent coverage and the state of O tenant balance sheets are at very healthy levels, thereby further strengthening the defensive characteristics of O cash flows.
In O’s case, the drop in share price has not been that considerable since early 2022. Nevertheless, as opposed to SAFE, during this period O has delivered improved results by strengthening the like-for-like FFO performance. At the same time, O has managed to acquire a notable volume of properties on top of acquiring SRC.
So, all things being equal, O should experience a more pronounced bounce back relative to the decrease when the interest rates start to tick higher.
The most important aspect contributing to a more elevated duration profile is the structure of weighted average leases. As of Q3, 2023, O had close to 10 years as weighted average lease term.
After the merger with SRC, this component will improve or get more extended as SRC carries an even longer weighted average lease term profile (10.2 years).
The bottom line
In my opinion, the odds are clearly stacked in favour of having lower interest rates in 2024. While it is impossible to predict specific levels, the notion of declining rates and some initial cuts over the foreseeable future is sufficient to contemplate duration-loaded real estate investments.
Companies such as SAFE and O, which carry similar cash flow patterns to the fixed income securities should be able to deliver alpha performance relative to the overall REIT space, which itself will generate solid returns under a falling interest rate environment.