The last three years have seen the landscape of work being fundamentally transformed by the rise of remote and hybrid work, a trend that has had significant implications on Real Estate Investment Trusts (REITs), especially those focusing on commercial properties.
The onset of the COVID-19 pandemic in 2020 was a major catalyst, altering traditional office dynamics and ushering in a new era where remote work has a permanence in the work environment.
As of 2023, nearly 35% of U.S. workers with teleworkable jobs are working from home a majority of the time, and 41% have adopted a hybrid work schedule, blending both remote and office work.
Nearly all of the people working remote jobs currently (98%) prefer to continue the mode of work in their career indefinitely, while the number of new workers choosing remote work rose by 24%, with interest in on-site work decreasing correspondingly.
These statistics highlight a shift in work culture, posing a question about the viability of REITs and commercial office spaces. Let us take a look at the impact of remote work on commercial REITs, explore alternative investment opportunities within the sector, and see how REITs are navigating the current high-interest rate environment.
The Rise of Remote Work
For over two decades, remote work was considered a niche option, but since the inception of the Covid-19 pandemic, it has become a mainstream working model.
The rise of remote work was initially sparked due to global health concerns but has had staying power due to the reflection of changing work preferences and technological advancements.
Remote work is thereby altering traditional work culture, with more workers valuing flexibility, work-life balance, and the option to work from anywhere.
With remote/hybrid work being the new norm, the implications for REITs, especially those focused on commercial real estate, are profound and multi-faceted.
Impact on Commercial Property REITs
Remote work has significantly impacted REITs, with a growing number of employees working on remote/hybrid schedules impacting the demand for trading office spaces.
Remote work has directly led to a decrease in expansive office space, with a growing number of companies downsizing their physical office footprints or opting for more flexible, shared workspaces.
As a result, investor sentiment toward commercial property REITs has also subsequently shifted.
Investors are now cautious about the uncertainty and the future of office spaces and occupancy rates, with a growing preference for REITs in sectors less affected by remote work trends, such as industrial or residential real estate.
In response to the reduction in rental income from commercial REITs, investors have shifted their portfolio strategies, focusing on diversification in properties catering to the new work environment.
On the other hand, REITs have adapted to the new environment by investing in properties that support hybrid work models, like co-working spaces, or by repurposing office buildings for other uses, such as residential or mixed-use developments.
Alternative Investment Options in REITs
With the changing landscape of work, alternative sectors within REITs such as data centers and residential properties are gaining traction and emerging as lucrative investment opportunities.
Data center REITs, thriving from increased data traffic since the pandemic, are growing rapidly, with the global data center market expected to expand significantly in the next decade.
Meanwhile, residential REITs, especially those with multifamily units, are experiencing growth due to urbanization and a shift towards renting over homeownership in some demographics.
While traditional commercial REITs have seen a large impact due to remote work, data centers, and residential REITs are capitalizing on the new needs arising from these trends.
Data centers are seeing increased demand due to the increased reliance on digital infrastructure for remote work, while residential REITs have benefited from people spending more time at home and seeking comfortable living spaces.
Impact of High-Interest Rates on REITs
The current high-interest rate environment has presented both challenges and opportunities for REITs. Despite the challenging macroeconomic outlook, REITs have demonstrated resilience due to strong balance sheets and strategic financial management.
REITs have maintained low leverage, with debt-to-market assets remaining below 40% since 2011 and, in recent times, stabilizing in the low to mid-30% range.
This prudent leverage management has been complemented by a strategic shift towards fixed-rate debt, enabling REITs to lock in low-interest rates for longer terms, thus reducing their exposure to variable-rate debt and the impacts of rising interest rates.
Despite this, REITs haven’t been immune to the high-interest rate environment. The cost of new and variable debt has increased, leading to higher interest expenses and a larger debt services burden.
The interest coverage ratio, which measures the ability to cover interest expenses with operating income, began to plateau in late 2022 and then decreased in the first quarter of 2023 as the impact of higher interest rates began to affect REIT margins.
The debt-to-equity for REITs has also seen a slight uptick in the first half of 2023 due to REITs adjusting asset values lower because of upward pressure on capitalization rates.
Despite these challenges, REITs could have a brighter outlook heading into 2024. The Federal Reserve is nearing the end of its rate-hiking cycle; there's a growing expectation for a period of REIT outperformance.
Historically, REITs have typically outperformed both private real estate and equities in post-rate hike periods. Furthermore, the wide valuation divergence between REITs and private real estate presents opportunities for investors, and this gap is expected to narrow as private real estate reprices and REITs recover.
With disciplined balance sheets, REITs are well-prepared for market uncertainty and opportunistic real estate acquisitions, positioning them to navigate a prolonged period of high interest rates effectively.
Future Outlook for REITs
The future outlook for REITs in 2024 and beyond is shaping up to be positive, especially as the sector adapts to evolving work trends and economic conditions.
Following a challenging period marked by high interest rates and valuation adjustments, REITs are poised for a potential period of outperformance.
This optimism is partly due to the expectation that the Federal Reserve is nearing the end of its tightening cycle, which could lead to a more favorable interest rate environment.
A key factor in this optimistic outlook is the solid balance sheets of many REITs, which have been well-managed and are likely to provide a competitive edge in acquisitions and growth, especially over private real estate.
This financial resilience is expected to enable REITs to navigate economic uncertainties effectively.
Moreover, the sector is likely to see a convergence in valuations between public REITs and private real estate in 2024.
The gap between REIT implied and private appraisal-based capitalization rates is expected to close, making REITs an attractive option for investors. This convergence could be driven by further adjustments in private real estate valuations to align with market realities.
Additionally, REITs are expected to continue creating and providing access to new and emerging property sectors, adapting to the evolving economy.
There is particularly strong growth potential in sectors driven by digital advancements, such as data centers and telecommunications towers, fueled by increasing needs for bandwidth and AI-driven demands.
The expansion of e-commerce and trends in onshoring and nearshoring are also likely to present growth opportunities, especially in the industrial sector.
