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In the second quarter, we saw some interesting developments in the year’s key theme, rising interest rates. Early on, markets appeared to be pricing in several rate hikes in 2017. Now, however, it appears that we may experience lower rates for a longer period than anticipated.
Rate outlook moderates
The economy is still performing well overall. Unemployment is at a 16-year low, gross domestic product growth is stable at around two percent a year—as it has been since the start of the recovery—and there are few signs of substantial downside risk. This positive outlook suggests that rates should be on track to rise as expected. However, inflation remains stubbornly below the Federal Reserve’s two percent target despite strong employment growth. In recent testimony before Congress, Fed Chair Janet Yellen reported that the central bank is paying close attention to the weakness in inflation. Her comments suggest the possibility the Fed may slow the pace of interest rate hikes until inflation shows signs of a definitive increase.
Real estate reacts
Traded real estate investment trusts (REITs) have reacted positively to this shift in the interest rate outlook. After a year-end correction in 2016, the FTSE NAREIT Index has trended upward in the first half of 2017.
In our view, last year’s correction was driven largely by a knee-jerk reaction to the shift in monetary policy. The FTSE NAREIT Index’s 2017 performance suggests that the market has now adjusted to the new policy environment and is trading on real estate fundamentals to a greater degree. Those fundamentals look sound: supply growth remains moderate in most markets, rent growth remains positive, and vacancy rates remain low. The overall outlook for real estate is thus largely positive.
A fresh look at retail
Taking a closer look within the broader real estate market, one subsector that has lagged considerably is the retail sector, in particular, regional mall REITs.
Many mall REITs are currently trading at 20 to 30 percent discounts to net asset value. While there are undeniably headwinds facing the sector, in some cases these REITs do look oversold.
As online shopping continues to grow, we have seen a wave of store closures and retail bankruptcies, especially among department stores. These closures have affected malls, which have historically relied on department stores as flagship anchors. Anchor store closures may result in lower foot traffic in malls, which can drive down store earnings. This may mean lower rent growth for mall REITs. However, even within this hard-hit sector, there are bright spots suggesting that retail is not necessarily dead. For example, Amazon’s recent acquisition of the high-end grocer Whole Foods indicates that even the e-commerce giant sees value in physical store infrastructure. And Warren Buffet’s recent purchase of a 9.8 percent stake in Store Capital Corp., a net lease REIT with tenants like Applebee’s and Ashley Furniture HomeStore, suggests that there may be overlooked value in the sector.
Many mall REITs are currently trading at 20 to 30 percent discounts to net asset value. While there are undeniably headwinds facing the sector, in some cases these REITs do look oversold. Thus, within the REIT sector, pockets of value exist that have the potential to drive returns for investors in the long term.
Conclusion
Looking ahead to the second half of the year, the positive outlook for real estate remains intact. Moderating interest rate growth and solid real estate fundamentals suggest that the sector may continue to perform positively for the rest of the year.
