After a turbulent and somewhat difficult year for real estate equities, we believe the sector is poised for a rebound in 2021. Our positive view is somewhat predicated on life returning to a more normal state, but mostly focuses on real estate specific attributes, namely; discounted valuations for the sector, strong financial positions for real estate investment trusts (REIT), an abundance of capital looking for real estate investments and a very favourable interest-rate environment.
While REITs rebounded throughout the year from the March lows, with a particularly good bounce after the news on vaccines in November, the sector is still trading at close to a 10% discount to net asset value overall. Sectors which have proven to have a better fundamental outlook during COVID-19, such as industrials, data centres and single-family rentals, are trading at higher valuations, but should be supported by strong growth profiles. We think asset classes such as apartments, necessity-based retail and well-positioned office space, have been unduly punished by the market and should come back in 2021. Historically, this level of overall net asset value discount has resulted in good buying opportunities, and we expect that relationship to continue.
Since the global financial crisis of 2008-09, REITs have made a concerted effort to improve their balance sheets. They have brought down leverage and payout ratios, and improved liquidity and access to capital. This put them in a good position to weather the COVID-19 storm and take advantage of opportunities coming out of it. While we have seen some distribution cuts to the hardest hit sectors, for the most part, distributions have been resilient with even a few increases. There have not been any emergency equity raises. In fact, any REITs that have raised equity over the past few months have done so from a position of strength to take advantage of opportunities. This should bode well for growth in 2021.
Not surprisingly given the uncertain economic environment, 2020 saw a decrease in real estate transactions compared to prior years, although there were a few notable deals (i.e. Blackstone Infrastructure Partners in the life sciences and self-storage space). There is still significant capital on the sidelines from pension funds, institutional investors and private equity, all of whom are looking to increase their real estate weightings to boost returns. We believe that with public real estate generally being valued at a discount to private real estate, there is the increased likelihood for mergers and acquisitions, which should be supportive for valuations.
One reason real estate is such a sought-after asset class is that it provides a solid yield in this ultra-low interest rate environment. With central banks likely on hold for the foreseeable future, lower yields should continue. This may put downward pressure on cap rates and lead to increased valuations as investors search for yield outside traditional fixed-income assets. REITs should also benefit from lower borrowing costs.
With growth returning to the REIT sector in 2021, attractive valuations and smart money looking to real estate in a low-interest rate world, we believe 2021 is shaping up to a healthy one for investors in the space.
4 Source: Bloomberg Finance L.P., as of December 22, 2020. Gross dividend yield minus Government of Canada 10-year yield.