CONTRIBUTORS
Daniel Scher
Portfolio Manager, Research Analyst
Franklin Equity Group
Blair Schmicker, CFA
Portfolio Manager, Research Analyst
Franklin Equity Group
In his recent article “Quick Thoughts: Five surprises for 2024,” Head of Franklin Institute, Stephen Dover, opines that 2024 could mark the return of secular stagnation, where economic growth slows, inflation falls, and nominal rates revert to the lows present in the 2010s. If this assessment proves correct, real yields would be anticipated to return to a level below long-term real growth, where they resided from 2009-2022.
It is possible that this trend reversal has already begun. The yield on 10-year Treasury Inflation-Protected Securities (TIPS) fell significantly from ~2.5% to ~1.7% in the last two months of 2023.1 This is a notable correction, but real yields remain much higher than the ~0.5% average that prevailed after the European debt crisis in 2013 through the start of the pandemic in 2020.2
How does this affect real estate? As long-lived, fixed assets with inflation-protective characteristics, quality real estate can be viewed as an equivalent to TIPs plus a risk premium. This is seen empirically through the relationship between the average Adjusted Funds from Operations (AFFO) yield (the AFFO relative to the REIT share price) and a 10-year TIPS bond yield plus the BBB credit spread, as shown in Exhibit 1. As such, the recent return benefit of the rally in TIPS has extended to real estate. In fact, real estate was the best-performing sector in the S&P 500 Index from the peak in real yields at the end of October through the end of 2023 (See Exhibit 2). Notably, this phenomenon has not been US-specific; real estate was also the best-performing sector in Europe (as measured by the STXE 600 Index) from the peak in German real yields at the beginning of October through year-end.3
Exhibit 1: Average AFFO Yield and 10-Year TIPS Yield + BBB Credit Spread
Average Adjusted Funds from Operations Yield and 10-Year TIPS Yield + BBB Credit Spread
July 2011–December 2023
Source: Bloomberg, as of December 2023. Past performance is not an indicator or guarantee of future results. See www.franklintempletondatasources.com for additional data provider information.
Exhibit 2: S&P 500 Sector Performance
S&P 500 Sector Performance
November 1, 2023–December 31, 2023
Source: Bloomberg. As of December 2023. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses, or sales charges. Past performance is not an indicator or a guarantee of future results.
Mean reversion is not guaranteed in financial markets, but it does have an enviable track record. Real estate was the worst-performing asset class in 2020 amid the pandemic and repeated the feat in 2022, as tightening monetary policy was discounted. By contrast, it was among the best-performing asset classes in 2021, as markets contemplated recovery from the worst of the COVID pandemic.4 This year could be poised to offer similar respite from the contagion of rising interest rates, which would make the recent retracement in Treasury yields a compelling entry point.
We understand warnings about systemic risk posed by commercial real estate—a valid concern for leveraged assets amid higher capital costs. We view this as a “wall of worry” to climb, particularly for publicly-traded real estate. As we discussed in our article in October, "REITs: Providing visibility in an age of uncertainty,” REITs have evolved since the global financial crisis; leverage is lower, and quality has improved. Moreover, the relevance of legacy assets with uncertain futures like offices and malls has diminished while technology-adjacent properties like towers, data centers and logistics have experienced robust secular growth. We also believe the cash flow outlook for the sector is resilient and that a forthcoming decline in new supply—a consequence of the tighter monetary policy that led to the downdraft in valuation—points toward accelerating rent growth as we approach 2025 and beyond.
Finally, publicly traded real estate, as more dynamically valued assets, can thrive even if private real estate, which may not have been efficiently repriced to reflect the new cost of capital environment, remains challenged. As shown in Exhibit 3, REITs have historically outperformed equity averages and private real estate in particular following a Fed tightening cycle.
Exhibit 3: Average Total Return During and After Fed Tightening Cycle
Average Total Return Before and After Fed Tightening Cycle
Sources: Nareit, Federal Reserve Board, NCREIF, FactSet, Raymond James Research. Fed tightening cycles include 1994-1995, 1999-2000, 2005-2006, 2015-2018, and 2022-2023. Public Real Estate represented by All Equity REITs Index and Private Real Estate by NCREIF Fund Index-Open End Diversified Core Equity. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
As such, publicly traded real estate began to outperform once markets interpreted that the Fed was pivoting away from a tightening bias. If this does indeed signal the return of a dovish Fed and secular stagnation, we believe publicly traded real estate could positively surprise investors in 2024.
Endnotes
- Source: Federal Reserve Economic Data (FRED). As of December 31, 2023.
- Ibid.
- Source: Bloomberg, as of December 30, 2023. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
- Ibid.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Equity securities are subject to price fluctuation and possible loss of principal. Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
Alternative strategies may be exposed to potentially significant fluctuations in value.
Real estate investment trusts (REITs) are closely linked to the performance of the real estate markets. REITs are subject to illiquidity, credit and interest-rate risks, and risks associated with small- and mid-cap investments.
Privately held companies present certain challenges and involve incremental risks as opposed to investments in public companies, such as dealing with the lack of available information about these companies as well as their general lack of liquidity.
Active management does not ensure gains or protect against market declines.