Is 2025 over yet? It feels like enough has happened in markets so far this year that it should be. Back in early January, following a strong December jobs report, some Wall Street economists were hinting at no rate cuts and even the possibility of US Federal Reserve (US Fed) rate hikes in 2025.

It feels like a long time ago, but equity markets had a healthy start to the year, with the S&P 500 up 4.6% through its year to date high on 19 February. Fast forward and the S&P 500 has fallen 10% from these highs and markets are pricing in three rate cuts before year-end with “fast money” investors like hedge funds unwinding positions at the quickest pace since COVID.

Clear air turbulence

The root cause of the recent downdraft in markets appears to be the escalation of rhetoric around tariffs and the potential economic impact of workforce reductions in the US federal government.  As real estate specialists, we aren’t particularly qualified to opine on the global balance of trade or government spending, but we can attempt to answer the question, “What does this have to do with commercial real estate fundamentals?” The answer, we believe, is likely very little.

Of course, we don’t believe CRE (Commercial Real Estate) fundamentals are completely immune from an economic recession. In this scenario, we’d expect to see an uptick in tenant defaults and a slowdown in tenant decision making, which would likely result in lower occupancies and rents over time. However, we do think CRE has some benefits vis-à-vis other sectors of the economy that are worth revisiting.

Lower levels of uncertainty

As real estate investors we don’t need to estimate how many units of our product consumers will buy this year, whether our suppliers will increase input prices for the goods we produce, whether our key drug will be approved, or whether new tech will come along that makes our hardware or software obsolete. CRE operates based on legally contractual leases where future cash flows are highly predictable. High quality real estate typically attracts high quality tenants, which tend to meet their obligations – we saw this even during COVID when tenants continued to pay rents even when they weren’t there. This dynamic is borne out in the standard deviation of real estate investment trust (REIT) earnings, which is roughly one third that of the S&P 500.

Incumbent landlord strength

Tariffs might weigh on the economy, but the number one enemy of a high quality CRE landlord is new supply that tries to poach tenants. If building materials like steel and lumber become more expensive, and if deportations shrink the construction labour force, making labour more expensive, the cost to build will go up. This creates an additional hurdle for developers, which is good news for incumbent landlords like the listed REITs we invest in. The supply backdrop was already looking supportive (Chart 2), with the brakes having been hit on new construction in many sectors in 2022/23. This benefit should feed into landlords pricing power in the years ahead, notably in sectors such as industrial/logistics and apartments.

Flexibility to reposition

A benefit that is only enjoyed by listed REIT managers and not by their private real estate brethren is the ability to seamlessly reposition portfolios in response to new information. We track 17 different property types within CRE. Some of these are longer duration and more defensive in nature (think healthcare, net lease, data centers), while others see their fundamentals respond much more quickly to changes in the economy (hotels, storage, apartments). We can reposition our portfolios in a matter of days, which is a deeply underappreciated benefit of the listed REIT asset class.

Opportunity in volatility

What is an investor to do with the seemingly conflicting ideas that CRE fundamentals are stable, but equity markets are volatile? We believe volatility creates opportunity for investors – with the investors we serve having time frames measured in years rather than weeks or quarters. With this in mind, the current situation in equity markets creates two specific types of opportunities:

1) Although REITs have outperformed the S&P 500 year-to-date, they too have declined, and they started the year at close to historically large discounts to the broad market. Investors seemingly haven’t had much interest in “defensive growth” for several years, but perhaps this will now begin to change. In our opinion, REITs’ relative valuations makes them attractive in a healthy macro environment, but maybe their defensive characteristics make them even more attractive in an uncertain one.

2) The current market sell-off appears to be somewhat technical in nature, especially as it relates to the idea of hedge fund “de-grossing”. As a recent report from Bloomberg News stated: “While the ability to summarily dismiss underperforming traders and liquidate positions helps [hedge fund] firms manage risk and produce steady returns, it exacerbates market selloffs when they do it in unison.” To us, this sounds like an inefficiency in the market. We believe it is happening in REITs, and, in our view, presents an opportunity to take advantage of by acquiring shares of high-quality REITs at discounted prices.

Seatbelts should remain securely fastened

The pace of news flow and swings in equity markets this year have been frenetic, bordering on exhausting, and it’s only March. Real estate can sometimes be seen as a slightly boring asset class, lacking the headline-grabbing attention of other sectors. But against the current backdrop of a more volatile and uncertain macro environment, perhaps being steady and boring is a positive quality to have.

So, while it’s tempting to get caught up in the daily excitement of the news cycle and accompanying market turbulence, we would advise not turning the plane around, but instead focusing on the destination and looking for a less bumpy route to get there.

IMPORTANT INFORMATION

REITs or Real Estate Investment Trusts invest in real estate, through direct ownership of property assets, property shares or mortgages. As they are listed on a stock exchange, REITs are usually highly liquid and trade like shares.

Real estate securities, including Real Estate Investment Trusts (REITs), are sensitive to changes in real estate values and rental income, property taxes, interest rates, tax and regulatory requirements, supply and demand, and the management skill and creditworthiness of the company. Additionally, REITs could fail to qualify for certain tax-benefits or registration exemptions which could produce adverse economic consequences.