by Eric Franco
After a sharp five-year rally in US real estate stocks, investors are questioning whether they may be vulnerable to a rise in interest rates. Our research suggests that global real estate stocks may be more likely to weather a changing rate environment.
US real estate stocks, commonly organized as REITs, have been strong performers since the global financial crisis. The FTSE NAREIT All Equity index of US real estate stocks has climbed 20% in 2014 through August. Since March 2009, the index has nearly quadrupled—outpacing both global property stocks and the broader US market. No wonder that US mutual fund investors have pumped $28 billion of net inflows into US real estate stocks over the last three years, in contrast to just $8 billion for their global peers.
Why all the love for US REITs? Despite the recovery in global equities, investors still seem to prefer securities with relatively safe and secure cash flows, including both bonds and higher-yielding stocks such as utilities and REITs.
US REITs have been especially prized for the relative safety of the US and improving cash flows of the stocks, bolstered by steadily improving demand in an environment of limited new supply of commercial properties such as office buildings and retail malls. But while US property market fundamentals remain quite healthy, the valuation of US REITs isn’t nearly as attractive as a few years ago—even when compared with government bonds.
Comparing US and Non-US Real Estate
Outside the US, it’s a different story for two reasons. First, valuations of non-US real estate stocks look relatively attractive. For example, the cash-flow yield for US real estate stocks versus the 10-year Treasury—a widely used valuation metric—is now only slightly above its long-term average, even with interest rates at rock bottom. In contrast, the cash-flow yield for non-US real estate stocks relative to a composite of 10-year sovereign bonds remains well above its long-term average (Display). And, as in the US, fundamentals are generally healthy for property stocks outside the US, with improving demand and limited new supply in most major markets.
More than Just a Bond Proxy
Second, non-US real estate stocks prices have recently been less sensitive to changes in sovereign yields. We analyzed the correlation of changes in sovereign yields with the outperformance of overall equity-market returns relative to real estate stock returns, both inside and outside the US. The trend varies over time. But today, this correlation is near a record high in the US whereas it is about average outside the US (Display). In other words, US REITs recently have reliably outperformed the S&P500 when Treasury rates declined and have reliably underperformed when rates rise, probably because investors are treating US REITs as bond substitutes given their perceived safety. But non-US REITs have generally not behaved as a sovereign-bond proxy in the same way.
Non-US REITs offer another advantage because they are exposed to diverse interest-rate environments. Today, in several major markets like Japan, the euro area and Australia, low rates are still embedded in the financial landscape and are unlikely to rise soon.
So by looking beyond the US, we believe that investors can stay in real estate stocks without returns being too tightly linked to sovereign yields. For those who still want the steady cash flows and dividends that real estate stocks can offer, we think global REITs may be a good way to maintain exposure to the asset class while reducing the vulnerability to rate hikes.