An Opportunity for REITs To Shine in 2024

The REIT sector has faced many challenges over the past few years, including COVID-related closures and tightening monetary policy. Franklin Equity Group Portfolio Managers Blair Schmicker and Daniel Scher discuss how a return to pre-pandemic monetary policy could mean a promising 2024 for publicly traded real estate.

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 AFFO Yield and 10-Year TIPS Yield + BBB Credit Spread

Exhibit 2: S&P 500 Sector Performance

S&P 500 Sector Performance