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Q3 2017 Real Estate Report: Time to Focus on Details

real estate interest rates outlook

As interest rates gradually rise, it is becoming increasingly important to understand the unique factors driving specific real estate subsectors. To outperform, a traded real estate portfolio must focus on those managers and sectors that are positioned to thrive in this changing environment.

Looking back, we have seen some clear trends within sectors. Industrial real estate investment trusts (REITs), for example, have performed well over the last eighteen months while retail REITs have struggled.real estate interest rates outlook industrial subsector performance

Industrial REITs have benefited from two primary drivers. First, steady economic growth has created increased demand for industrial space. Second, the rapid growth of ecommerce has led to significant demand for specialized warehouse space and last-mile facilities. As consumers have switched to online shopping, rapid delivery has become a key differentiator for companies like Amazon. To fulfill customer orders quickly and ensure one- or two-day delivery, online retailers need sophisticated warehouses and last-mile facilities that are located close to their core customer base in urban areas.

Demand for ecommerce-appropriate industrial space has thus grown rapidly. However, supply is restricted, both due to the specialized nature of the space and to the limited urban land available. As a result, some industrial REITs have broken ground on new facilities, in addition to purchasing existing square footage.

Looking ahead, we believe ecommerce is likely to continue to grow, providing ongoing support for industrial real estate. However, industrial REITs have experienced significant price growth and there may be limits to the runway these REITs have left.

The story of retail REITs offers a stark contrast.

real estate interest rates outlook retail subsector performance

As ecommerce has grown, many traditional retailers have come under pressure. There have been high-profile bankruptcies such as Toys R Us as well as a significant number of store closures. Major department stores such as J.C. Penney and Macy’s have closed thousands of underperforming stores nationwide. As a consequence, REITs focused on retail, particularly regional malls that have traditionally relied on department stores, have underperformed the REIT sector overall.

However, while the sector seems to be out of favor, there is reason to think that the sell-off may be overblown.

Tenancy remix is a normal part of a mall’s lifecycle. On average, malls see tenant turnover of around 25 percent over five years as customers’ tastes change and they demand new experiences and options. While the loss of anchor department store tenants may lower sales and foot traffic in the short term, new stores will move into that space and attract customers over time.

Furthermore, not all malls are equally affected by the changing retail mix. A-grade malls in high-density, affluent areas are performing well, and B-grade malls, which are often anchored by non-discretionary retail outlets, such as a large grocery store, are also generating stable income. We believe that most of the impact of the retail rebalancing will affect C-grade malls located in less-dense, less-affluent areas. These malls are typically not held in traded REITs, so we do not believe their potential closure will affect the sector overall.

[Related:Hear portfolio manager John Snowden’s audio summary of this Commentary]

Looking ahead, it is important to identify key drivers that will determine sector performance. As interest rates rise, any weaknesses in traded REIT portfolios will be exposed. Understanding what drives performance and how different sectors and managers are reacting to the changing environment is vital for building an effective portfolio. REITs and real estate sectors are not created equal and in this environment, an experienced investment manager may be able to identify opportunities even in maligned sectors.

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