ESG
Equity

Why REITs Now?

By Mike Rode, CFA
APR 21 | 2022
Motion blurred photo of crowd using escalators.

Key Takeaways

REITs have historically outperformed the market during periods of moderate and high inflation.

REITs delivered exceptional returns in 2021 as part of a COVID recovery story and may likely continue to benefit from the gradual return to normal work patterns and leisure activities.

The environmental, social and governance (ESG) aspects of REITs may help manage risks and support investor interest in this asset class.

With inflation making headlines and interest rates moving higher, the risks of investing in bonds are increasing. In addition, stock market volatility has been unsettling, particularly in the tech sector and other growth stocks where many investors have substantial exposures. Supply chain issues and worker shortages have challenged growth estimates for many sectors, including automotive, food and beverage and retail.

Overall, investors face a great deal of uncertainty when evaluating whether to put money into stocks or bonds. Given this environment, we believe it is an opportune time to consider investing in real estate through REITs.

REITs trade like stocks but hold various types of real estate assets. They invest in office buildings, apartment buildings, industrial facilities, data centers, self-storage facilities and cellular towers. Many REITs specialize in specific property types and diversified REITs invest in more than one type of commercial property. Some may also invest in the mortgage loans used to finance various properties.

Why Consider REITs Now?

REITs may offer an inflation hedge.

As shown in Figure 1, REITs have historically generated higher average returns during periods of moderate and high inflation than in low inflation periods.{sup}1{/sup}

Figure 1 | REITs Have Outperformed During Periods of Moderate and High Inflation

REITs Have Outperformed During Periods of Moderate and High Inflation.

Data from 1/1/1972 – 12/21/2020. Sources: Nareit analysis of returns for the FTSE Nareit All Equity REIT Index and S&P 500 Index. “Low” refers to periods when inflation was lower than 2.5%; “moderate” to periods when inflation was 2.5% – 5.9%; and “high” to periods when inflation was 6.0% or higher. Inflation was measured using the Consumer Price Index for All Urban Consumers (CPI-U). 

Why would this be the case? Rising inflation often signals a robust economy, as healthy consumer and business spending and a strong employment picture tend to push up prices. This scenario creates demand for real estate, as tenants seek to rent more office and industrial spaces, apartments, retail locations and other types of space. In addition, REITs often include rent escalation provisions in tenant lease agreements. Furthermore, during the pandemic, rising construction costs impacted by supply chain snarls limited the supply of new buildings, which supported the property values of REITs’ holdings.

REITs may benefit from the pandemic recovery.

After declining sharply in the early days of the pandemic, apartment rents are now nearly 5% above pre-pandemic levels. As workers return to offices, at least part-time, the demand for office space is expected to improve. And retail store closings that reached a record high in 2020 declined sharply in the second quarter of 2021, a positive development for retail REITs. These trends have pushed net effective rents (i.e., the actual amount of rent paid after any landlord-provided promotional discounts to attract new tenants) higher than before the pandemic.

REIT dividends have the potential for attractive growth.

The return investors earn from holding REITs is a combination of dividend income and long-term capital appreciation. REITs must distribute at least 90% of their taxable income as dividends, so when rents rise those dividends increase. REITs’ earnings and dividend growth accelerated strongly in 2021, and earnings are forecasted to grow at around 14% in 2022. (Source: National Association of REITs.)

REIT yields compare favorably to those in the stock and bond markets.

As of December 2021, the yield on the FTSE Nareit All Equity REITs Index, a frequently cited benchmark for U.S. REITs, was 2.6%.2 This compares to a 1.2% dividend yield for the S&P 500. The yield on the 10-year Treasury, while increasing, remains below 2%.

REITs have historically offered diversification benefits.

Returns from REIT investments typically do not move in lockstep with returns from stocks and bonds, as shown in Figure 2. Therefore, incorporating REITs into a portfolio that includes stocks or bonds may reduce risk through diversification.

Figure 2 | Asset Class Correlations From 1996-2021

Table of correlation coefficients between US REITs, the S&P 500, US Mid-Cap Stocks, US Small-Cap Stocks, International Stocks, Investment Grade Bonds and High-Yield Bonds. Correlation between REITs and the other asset classes ranges from 0.19 and 0.67.

{sup}1{/sup}Russell Midcap® Index, {sup}2{/sup}Russell 2000® Index, {sup}3{/sup}MSCI EAFE Index, {sup}4{/sup}Bloomberg U.S. Aggregate Bond Index, {sup}5{/sup}BAML U.S. High Yield Bond Index, {sup}6{/sup}FTSE Nareit All Equity REIT Index. Data from 1/1/1996 - 12/31/2021. Source: FactSet.

These correlations show that returns for U.S. large-, mid- and small-cap stocks as well as international stocks tend to move together most of the time, as their correlations are above +0.75 (note that +1.0 is the maximum possible value and would mean returns from two asset classes always move in the same direction over time).

In contrast, REITs have a lower correlation to stocks, which means they diversify risk when included in a portfolio containing stocks. Investment-grade bonds also offer diversification benefits, but investors must consider the interest rate risk bonds represent in a rising rate environment.

ESG – An Often Overlooked Aspect of Investing in REITs

In our view, in addition to the many reasons to consider REITs noted above, integrating ESG factors into an investment analysis also supports the argument in favor of many REITs. An economy’s long-term well-being depends on key ESG themes embedded in the REIT opportunity set, including access to health care, sustainable living practices, protecting environmental resources and supporting technological advances.

  • REITs help finance affordable housing, student housing and apartment complexes, all of which can help alleviate the housing shortage many U.S. cities are experiencing.

  • REITs finance health care and medical research facilities that are essential to supporting a healthy population and workforce.

  • REITs provide financing for data centers and cell towers that support the global digital economy. These facilities are critical to everyday life and essential to education in the digital era. Access to digital services helps increase financial inclusion by expanding mobile payment capabilities to underserved populations globally and can be life-changing for micro-business owners in emerging market countries.

  • Urban planners are focusing on electrification, including electric vehicle charging stations and rooftop solar panels. A 2020 Brookfield Properties case study indicated that EV charging stations would become standard at all its future developments and major business parks. With significant rooftop space available, U.S. REITs could greatly expand their solar generation.

  • According to Nareit’s 2021 REIT ESG dashboard, 37% of the top 100 REITs by equity market cap reported using on-site renewable energy sources, compared to 23% just one year earlier.

Why Should a REIT’s ESG Credentials Matter to Investors?

Sustainability issues are important when evaluating REITs, but the reasons are not always obvious. In general, choices about a facility’s design and operations affect the environment and communities where it is located. Those choices also affect the property owner’s ability to retain desirable tenants and charge attractive rents. This directly affects REIT investors’ returns. Other reasons why we think investors should care about a REIT’s ESG qualities include: 

Environmental

Integrating environmental practices into a building’s design and operations can be a differentiator, and REIT managers should consider this in their investment process.

Green building certifications for energy efficiency and reducing greenhouse gas emissions may translate into greater profitability by reducing the cost of operating a building. Notably, some tenants are willing to pay premium rents for space in these buildings because green programs (a) align with their own sustainability goals and (b) help save money in the long term.

Research published by Cushman & Wakefield in 2021 shows LEED-certified buildings command higher prices and have higher occupancy rates than older buildings. This ability to command higher rents can increase cash flow and boost property values for investors.

What Is LEED Certification?

LEED (Leadership in Energy and Environmental Design) is the most widely used green building rating system in the world. Available for virtually all building types, both new construction and renovations, LEED provides a framework for developing efficient green buildings that offer cost savings. The LEED rating system covers location and planning, sustainable site development, water savings, energy efficiency, materials selection, waste reduction, and indoor environmental quality.

Source: U.S. Green Building Council.

Social

One aspect of the “S” pillar of ESG that is critically important to REITs is protecting tenants’ data security and privacy. A strong commitment to cybersecurity is a selling point in attracting tenants, while weak protections can be costly. For example, some years ago Marriott hotels suffered a major data breach that was expensive to address and had a negative impact on customer loyalty. Its competitors used the opportunity to persuade frequent travelers to switch their hotels rather than trust Marriott.

Governance

Good governance is important to REIT managers, as poor governance can harm a REIT manager’s reputation. A management team that loses investors’ trust will find it hard to raise new capital. Given that REITs need new capital to invest in more properties, good governance is essential to a REIT that wants to grow.

Snapshot of a REIT with Strong ESG Credentials

Equinix (EQIX) is the world’s largest data center operator. A fundamentally strong business, the company’s practices align with core ESG themes integrated across American Century’s investment practices.

Environmental

  • 72% of Equinix assets are LEED-certified and adhere to internationally recognized standards for quality with respect to managing overall environmental impacts and/or energy management. Its long-term goal is to have 100% of its assets meet these qualifications.

  • 92% of the energy used to power Equinix’s data centers came from renewable sources in 2019, up from 77% in 2017.

  • Greenhouse gas emissions intensity has declined by approximately 3% annually over the past three years.

Social

  • 91% of Equinix assets are certified under international standards for information security and comply with the European Union’s General Data Privacy Regulations.

  • With data privacy growing in importance, the reassurances these certifications represent are essential to every company that uses a data center for its cloud computing and data storage needs.

Social

  • 91% of Equinix assets are certified under international standards for information security and comply with the European Union’s General Data Privacy Regulations.

  • With data privacy growing in importance, the reassurances these certifications represent are essential to every company that uses a data center for its cloud computing and data storage needs.

{sup}Source: Equinix Investor Relations governance materials.{/sup}

American Century’s Real Estate Team and How We Invest in ESG

The American Century Global Real Estate team has been working together to invest in REITs for over 12 years.

ESG principles are fully integrated into our process, and material ESG factors are incorporated into our bottom-up research using American Century’s proprietary ESG scoring system.

Every holding in American Century’s ESG Global Real Estate Portfolio corresponds to at least one of the following themes: Sustainable Living, Health Care, Technology Advancement or the Environment. 

Author
Mike Rode, CFA
Mike Rode, CFA

Vice President

Senior Client Portfolio Manager

Read more about American Century’s approach to ESG and investment stewardship

Nicole Funari, “Inflationary Pressures and REIT Performance,” REITs & Inflation Outlook 2022: What to Know,” Nareit, December 7, 2021. 

REIT Industry Monthly Data for December 2021, Nareit, accessed January 23, 2022.

When portfolio managers incorporate Environmental, Social and Governance (ESG) factors into an investment strategy, they consider those issues in conjunction with traditional financial analysis. When selecting investments, portfolio managers incorporate ESG factors into the portfolio's existing asset class, time horizon, and objectives. Therefore, ESG factors may limit the investment opportunities available, and the portfolio may perform differently than those that do not incorporate ESG factors. Portfolio managers have ultimate discretion in how ESG issues may impact a portfolio's holdings, and depending on their analysis, investment decisions may not be affected by ESG factors.

References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.

No offer of any security is made hereby. This material is provided for informational purposes only and does not constitute a recommendation of any investment strategy or product described herein. This material is directed to professional/institutional clients only and should not be relied upon by retail investors or the public. The content of this document has not been reviewed by any regulatory authority.

The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.