From a share price perspective, the real estate sector has been a laggard year-to-date, as bearish investors moved away from riskier assets such as REITs amid rising interest rates and a worsening economic backdrop.
Although the real estate market, as represented by the FTSE EPRA/Nareit Global Real Estate index, rebounded in July with a return of 6.7%, the index has lost 19.2% year-to-date as of 31 August, according to Nareit.
REITs have historically provided natural protection against inflation as real estate rents and values tend to increase when prices rise, but this has not happened this year, despite what investors and property fund managers expected.
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Andrew Rees, associate in investment companies research at Numis, said that markets were "somewhat misguided to think that property would protect perfectly against inflation in the current environment".
He added: "When the inflation is being caused by supply-side constraints and is occurring against the backdrop of a stagnating economy, as is the situation in which we have found ourselves in 2022, real estate is unlikely to deliver the same level of inflation protection."
Kevin Brown, equity analyst for REITs at Morningstar, explained that the assumption that REITs provide inflation protection is based on flawed evidence.
"Inflation helps REITs push higher rent growth and some sectors have seen high single-digit or low double-digit rent growth over the past few quarters. However, for sectors with long-term leases, the impact of inflation will take years if not decades to fully trickle through the full portfolio," he said.
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If interest rates have to be raised even higher than the implied 4.1% that the futures market is currently forecasting for the middle of next year, further share price volatility could be very likely for REITs, Rees said.
Nick Britton, head of intermediary communications at the AIC, agreed, noting that if interest rates go much higher, a negative effect on risky assets such as property would be expected.
That said, Brown believes that investors should view this as an opportunity to acquire REITs at discounts to their long-term fair values, arguing that the disruption caused by income-orientated investors moving out is temporary.
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"While we believed that many sectors were overvalued during periods of low interest rates as the higher level of external growth was unsustainable, we believe that the market has now overreacted and that REITs in most sectors are trading at discounts to their long-term valuations," he said.
"Therefore, while more interest rate hikes are possible and that may send REIT share prices down in the short-term, over the long term we like the discounts most REITs are currently trading at and would recommend investors consider adding exposure to REITs to their investment portfolios."
Michael Gobitschek, portfolio manager of the real estate equity fund SKAGEN m², said that a lot of bad news is already priced into valuations, such as the effects of inflation, interest rate hikes and potential recession on asset prices and vacancy rates.
"It might get worse before it gets better, but for long-term investors REITs have rarely looked as attractive as they are now," he said.
Dividend outlook
Jason Yablon, head of US real estate at Cohen & Steers, said that slowing economic growth and high inflation temper the near-term outlook for real estate, particularly for sectors lacking pricing power, but noted that fundamentals for the underlying properties remain robust.
In fact, the first half of 2022 was one of the strongest periods for REIT fundamentals in memory, Brown noted, with many real estate companies reporting historic levels of revenue and net operating income growth.
"Guidance coming from management teams seem to indicate that the back half of 2022 will slow a bit, but that is coming off a historic peak and compared to nearly any other period should be considered a very high level of growth," he said.
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Despite strong fundamentals for some real estate sectors, dividends are still below 2019 levels after approximately two-thirds of REITs cut or eliminated their dividend during the pandemic.
"We think the continued revenue and net operating income growth the companies will see in 2022 and beyond should allow them to restore their full dividends within a few quarters," Brown said.
According to data by the AIC, out of all 24 investment company REITs investing in UK property, 15 increased their dividend in their last complete financial year, four held it steady, and only five cut dividends.
Numis' Rees said that sustainable rental growth will be key to determining the trajectory of dividend growth, adding that "sectors with attractive fundamentals and a high degree of index-linked rents should perform well in this regard".
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Specialist REITs, which include logistics, healthcare and residential sectors, now make up just over half of the assets invested in UK direct property through investment companies, according to the AIC.
While they outperformed during the pandemic as shops and offices struggled, the tables have since turned, with a relative bounce back for more generalist property this year.
The mainstream UK commercial property sector has delivered a total return of 0.3%, but the logistics and residential sectors have suffered losses of 22.6% and 7.6% respectively, according to data from the AIC.
However, given that record low vacancy in the industrial sector continues to support rental growth, Rees said he believes the share price weakness in Q2 for industrial-focused REITs was overdone.
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Matthew Norris, investment adviser at Gravis Advisory, said that specialist REITs that can grow rental income are likely to outperform compared to traditional REIT sectors. This is likely to include the built-to-rent, self-storage, purpose-built student accommodation and urban logistics sub-sectors.
When it comes to the laggards, Josef Licsauer, investment analyst at Hargreaves Lansdown, said that the retail and office sectors could continue to struggle.
"Hybrid working has sapped the demand for prime and in some cases secondary office real estate. It is recovering but it is likely to take time. A similar story can be said with retail property. Traffic volume is returning, but the sector is facing headwinds," he noted.