Why Most REITs Remain Lean and Liquid: Q&A

March 3, 2021

Insights on how these companies have outperformed during economic disruption, from AEW Capital Management’s Gina Szymanski.

Gina Szymanski, Director & Lead Portfolio Manager, AEW Capital Management. Image courtesy of AEW Capital Management

U.S. real estate investment trusts entered the pandemic better prepared than in past downturns—with less leverage and enough debt capacity to withstand COVID-19-driven economic hardships, according to Gina Szymanski, director & lead portfolio manager at AEW Capital Management.

“Most REITs were able to preserve sufficient liquidity by drawing down lines of credit, reducing common dividends and delaying non-essential CapEx spending,” explained Szymanski, who is responsible for managing AEW’s real estate securities strategies in the U.S. and North America.

In an interview with CPE, Szymanski shared her 2021 outlook for REITs.

How do you see the sector’s position amid the current market unsteadiness?

Szymanski: Because REITs are a capital intensive and levered businesses, they will naturally demonstrate a certain degree of volatility during times of economic distress. That said, REITs went into the pandemic with less leverage than in past recessions and with sufficient debt capacity to withstand the current economic downturn. Additionally, both the Fed and Washington were quick to provide significant stimulus, which prevented the capital markets distress witnessed during the Great Financial Crisis.

How do U.S. REIT valuations look at this point?

Szymanski: REITs have fared much better during this downturn compared to the Great Financial Crisis. While property closures caused some retail and hotel companies to breach debt covenants over the past 12 months, most REITs were able to preserve sufficient liquidity by drawing down lines of credit, reducing common dividends and delaying non-essential CapEx spending.

REITs are currently inexpensive compared to equities and bonds on a relative basis. Based on our current models, we believe that REITs can provide investors with strong returns over the next two years, stemming from both attractive dividend yields and accelerating cash flow growth.

How has the low interest rate environment impacted REITs’ debt and net operating income?

Szymanski: The low interest rate environment is a meaningful tailwind for REITs. Companies have been able to issue debt at historically low coupons recently. For those who need payment relief, this helps reduce the cost of carry. For those who are less impacted by the pandemic, refinancing to cheaper debt provides an incremental source of earnings growth going forward while acquisitions become much more accretive.

What is your take on the health of the real estate capital markets at this stage?

Szymanski: Real estate capital markets are functioning remarkably well. There was a brief period early in the pandemic where credit spreads widened, but they have since narrowed back down to historically tight levels. The Fed along with the other major central banks around the globe were all too familiar with the playbook from the Great Financial Recession. They knew that to be successful, they had to act swiftly and significantly and that is exactly what they did.

What is AEW’s strategy for building a balanced portfolio?

Szymanski: There are many ways that REITs can de-risk their balance sheets. Reducing leverage, having untapped debt capacity and staggering debt maturities are more obvious examples. However, it is also important for REITs to think about diversification of funding sources. Companies have frequently benefited from having access to a variety of capital markets such as secured and unsecured debt, CMBS and preferred equity. Some companies have also found it helpful to have life insurance companies or sovereign wealth organizations as capital partners since these institutions typically have deep pockets and long-term investing horizons, which is important when riding out economic cycles.

Our approach to building a balanced portfolio relies on strong risk analysis at both the company and portfolio levels. AEW has a disciplined approach to risk assessment, which includes property quality, capital allocation, liquidity, earnings visibility and ESG. The goal is not to avoid risk altogether, but to build a portfolio of intended bets that offer sufficient return for the risk being taken. AEW has a long-term track record of generating outperformance with below-average volatility.

How would you describe REITs’ approach to prospective investments/acquisitions since the onset of the health crisis?

Szymanski: Any time there is a disruption in the economy, it is a reminder that having strong capital partners is key. REITs whose balance sheets were less levered and who maintained a strong cost of capital throughout the pandemic were able to continue investing. AEW has a reputation for underwriting conservatively and continued investing during the pandemic. There have been opportunities to invest in property types demonstrating resilience such as cold storage, properties that address structural economic needs such as affordable housing, as well as COVID-19-impacted sectors such as senior housing.

As related to cash flow disruptions, what can REITs expect going forward? How long do you see recovery unfolding?

Szymanski: Investors may not realize this, but several real estate property types have already fully recovered. In fact, they never experienced a slowdown. For example, data centers were deemed essential services by the government and never shut down. Online traffic and data streaming increased significantly as everyone was forced to work and learn from home. Many industrial assets also benefited as more goods were purchased online and shipped directly to consumers from distribution centers. Single-family rentals also benefited as people departed for the suburbs, no longer needing to live close to work. Why stay cooped up in an apartment when you could rent a house for the same price, have your own backyard and extra space for a home office?

For property types that were negatively impacted by the pandemic, we expect the recovery to follow the pace of vaccine rollouts and their efficacy against new variant COVID-19 strains. For life to return to normal, herd immunity must be reached, and travel bans and lockdowns must be lifted. Once the need for social distancing is eliminated, capacity utilization will improve. Currently, this is expected by end of 2021; meanwhile, we are already seeing some green shoots such as improved rent collections for retail, increased leasing demand for apartments, and a strong pace of future group bookings at hotels in anticipation of herd immunity. There are reasons to believe that pent-up demand exists, especially for social experiences and travel. Everyone deserves a vacation after what we’ve all been through.