The reversal of fortune in the REIT market will be driven by "resilient corporate earnings" in the face of slower economic growth, declining interest rates and a pronounced shortfall in new real estate supply, the report states.
"The shifting tides of economic and monetary conditions, coupled with compelling valuations, create a canvas for strong performance in the REIT market in 2024," Corrado Russo, managing partner and head of global securities at Hazelview Investments, said in a release accompanying the report.
"Navigating this landscape with precision and seizing the opportunities it presents defines our approach. This is not just a moment — it's an extraordinary market opportunity and we are poised to capitalize on it."
Undervalued REITs offer significant upside potential
The report states REITs are currently priced at a high double-digit discount relative to underlying value (defined as a blend between net asset value and discounted cash flow) which translates to an implied upside potential of approximately 22 per cent.
Hazelview Investments believes this historically rare technical market distortion presents investors with an outstanding opportunity to invest in severely underpriced REITs which are likely to benefit from additional upward momentum from expected central bank interest rate cuts in 2024.
The shift toward a declining interest rate environment follows two years of economic uncertainty and investor confusion in the face of a pronounced spike in global inflation rates and correspondingly hawkish central bank monetary policy.
This produced what the report describes as a "significant disconnect between public REIT and private market real estate valuations."
Similar decoupling dynamics occurred during the 2007-'08 global financial crisis (GC) and the 2020-'22 COVID pandemic.
In both instances, public REIT share prices initially suffered steep declines but subsequently rebounded to outperform the market, corresponding to a narrowing in the valuation gap with respect to the private REIT market.
Policy shift toward lower interest rates to boost REITs
In 2024, the expected slowdown in worldwide GDP growth - the report cites J.P. Morgan's conservative 2.2 per cent prediction, notably lower than the IMF's 2.9 per cent forecast and Goldman Sachs' 2.6 per cent estimate - should give The Fed and other central banks ample room to cut rates further and faster to avoid any possibility of a recession given the lag effect of high interest rates in 2023.
"Looking back at central banks' five waves of interest rate hikes since 1995, REITs were able to deliver the strongest returns in the wake of pauses to those campaigns. This is a key historical point that underlines the opportunity ahead for REITs as an asset class," the report states.
This shift in interest rate policy is also expected to quash bearish investor sentiment with respect to REITs, which saw a marked increase in redemptions in 2023.
Some clients were struggling with higher costs on variable-rate debt, while others sought safer returns on fixed-rate investments paying five per cent returns.
"We're now seeing a pause in interest rates and as we start to look towards potential cuts in central bank rate(s), I think that's going to have a very positive impact on cost of capital.
"Just as the pendulum swung pretty aggressively the other way in 2022 and 2023, there's some significant upside as we head in the other direction," Russo said in an interview with RENX.
That process has already begun in earnest as of November and December when Global REITs registered an impressive gain of 18.9 per cent to end 2023 with an overall increase of 10.8 per cent.
"And even (in the unexpected event) of an economic downturn, if you look at how REITS historically perform during a recession it's not a bad place to be because what you will see (are) capital flows into asset classes that have a very high degree of predictable cash-flow stream.
"That's due to the long-term leases you know you have a legal obligation for tenants to pay you in the real estate sector. (Even a downturn) could be a positive," added Russo.
The report also argues the inflationary environment of the past 18 months has sharply increased construction costs in the face of higher borrowing costs.
The resulting decline in construction activity will decrease supply growth in the residential and commercial real estate sector while demand is expected to remain stable or even rise.
"Fuelled by a resilient global economy and coupled with the forecasted drop in supply growth, (this) would drive REIT values higher," the report states.
"In short: reduced construction will further highlight the imbalance between supply and demand in key regions and property types."
Exaggerated concern over continued high office vacancy
Russo also argues that headline-grabbing reports of major rises in office vacancy rates are overblown with respect to their actual impact on the REIT market.
"Office is going to be challenged, but office is a very, very small part of the real estate universe.
"For example, the U.S. REIT market accounts for 60 per cent of the global REIT market and office only represents two per cent to three per cent of that figure," Russo said.
"Unfortunately, even though office space is basically irrelevant to REITs, that kind of news has generated negative sentiment on real estate overall."
Hazelview Investments is a global real estate investment fund manager and currently oversees $12.1 billion in real estate assets.
Headquartered in Toronto, the company employs an investment and asset management team of over 80 and maintains offices in New York, Hong Kong and Hamburg.
Russo admits the report's 2024 highly optimistic REIT market projections stand in contrast to the company's inherently conservative investment philosophy.
"It's generally in our nature to be more conservative - it's who we are," Russo explained. "When we underwrite, we try not to bank on a lot of growth to justify the prices that we pay for companies.
"But despite rising cost of capital . . . we're seeing many companies trading at attractive valuations.
"I have to say that I'm very highly bullish for 2024. I'm more bullish than I've been in the 30 years that I've been doing this . . .
"When I look at the potential for rental growth in most areas of real estate, the (attractive) valuations, and the underperformance of REITs versus equities that we've seen over the last couple years, and the gap between REITs and private real estate, there are a lot of stars lining up for a good bull run.
"Most of those stars have been aligning for the past 12 months. The only one that was missing was interest rates - the most important negative factor in terms of investor sentiment with respect to REITs.
"But now that extremely harsh interest rate headwind is about to turn into a tailwind over the next 12 to 24 months."