Navigating the Uncertain Terrain of REITs and Commercial Real Estate

The landscape of real estate investment trusts (REITs) and commercial real estate (CRE) has been tumultuous since the onset of the COVID-19 pandemic. For investors who held a broad index of US REITs from February 2020 to the present, the total return, including dividends, stands at a modest 16%. This equates to roughly 3% per year, barely keeping pace with inflation. Despite these tepid returns, recent developments suggest a potential turnaround for the sector. However, significant challenges remain, particularly for commercial real estate.

The Current State of REITs

REITs, often perceived as rate- and inflation-sensitive investments, have demonstrated resilience. The MSCI US REIT index has remained nearly flat, with recent weeks showing a surge due to lowered inflation and interest rate expectations. Notably, the most beleaguered sectors, such as office and retail REITs, have seen a 9% increase in just two weeks. This raises the question: have REITs and the broader CRE market turned the corner?

While the recent uptick is promising, it's essential to consider the broader economic context. A resurgence of inflation could derail expectations for rate cuts, potentially pushing the sector back into turmoil. The speed at which interest rates decline will be crucial, especially for building owners facing imminent loan renewals. The ability to refinance at lower rates will be vital for stabilising the sector and restoring value to properties.

Challenges in Commercial Real Estate

Commercial real estate, despite showing some positive signs, is not out of the woods. Although commercial real estate loan delinquency rates are rising, they remain below 2% at the end of the first quarter. However, trouble in CRE often manifests suddenly, especially when refinancing options dry up. The volume of bank CRE lending fell in both May and June, indicating tightening conditions.

Imogen Pattison of Capital Economics highlights a significant concern: approximately $1.2 trillion in CRE loans are due this year and next. Borrowers might not have the luxury of waiting for lower rates, which could lead to increased distress in the CRE market. Delinquency rates on bonds backed by commercial mortgages are approaching 6%, compared to a financial crisis peak of 10%, suggesting potential trouble ahead.

The Impact of Dollar Devaluation

In a related economic debate, the potential devaluation of the US dollar has sparked discussions about its impact on inflation and the trade balance. A weaker dollar could lead to higher import costs, driving short-term inflation. However, Michael Pettis of Peking University argues that the broader effect on supply and demand could be disinflationary in the long run. The key lies in expanding domestic production and managing the transition smoothly.

Pettis also advocates for a tax on foreign holdings of US assets as a practical approach to closing the trade deficit. Thiswould address the capital account imbalance fueling the US trade deficit. While tariffs are less effective, restricting capital flows could resolve the trade deficit but may significantly disrupt investment portfolios and market valuations.

Conclusion

The REIT and CRE sectors are navigating a complex landscape shaped by economic uncertainty, interest rate fluctuations, and policy debates. While recent gains offer hope, the path to stability is fraught with challenges. Building owners, investors, and policymakers must remain vigilant and adaptive to mitigate risks and capitalise on emerging opportunities. The journey to recovery will require strategic planning, robust risk management, and a keen understanding of market dynamics.