With the sharpest increase in interest rates in more than 40 years, it’s hardly a surprise that the share prices of commercial property REITs have been hit hard. Yet, for some investors, that spells opportunity.

Global listed property expert, Andrew Parsons of Resolution Capital, has told Morningstar’s Wealth of Experience podcast that he’s turned from property bear to optimist:

“We’ve come from a period of ridiculously easy money. We had this extraordinary period of QE, also negative interest rates, and that distorted investor perceptions of the space. It also encouraged a huge amount of development activity in certain sectors. Well, that’s been cleansed and what we have now is a much healthier situation and the prices in many respects don’t look overly demanding.”

Wealth of Experience podcast

Parsons says there are three reasons to be positive on the outlook for listed REITs:

  1. Better capitalization rates. So-called cap rates – a property’s net operating income as a percentage of asset value – have risen sharply because of higher interest rates. In the heyday of near zero rates, many commercial property segments had cap rates of 3-4% which offered little reward for the risks involved. Parsons says those days are over.
  2. Restricted supply. Parsons believes that rising rates mean credit to property developers has shrunk and that will continue to limit property supply. That’s bullish for the sector.
  3. Healthy balance sheets. Parsons says the balance sheets of commercial REITs are in good shape. Most REITs didn’t take on more debt when rates were low as they’d learned their lessons from the GFC – when many struggled due to carrying high leverage into an unprecedented economic downturn. Now, loan to value ratios are 30-35%, and most have extended debt duration where they aren’t required to pay back loans in the short term.

Parsons stresses that REIT valuations don’t offer ‘deep value’ yet are reasonable enough to positive on returns over a 5–10-year timeframe.

He thinks some real estate markets are more challenged than others. For instance, REITs in Germany and Sweden are suffering after increasing their debt when rates in Europe turned negative a few years ago.

However, Parsons believes outlook is better for the US REIT market. The office market there has its difficulties. But the residential market has held up well, with prices only going down 4% from peak to trough. And that bodes well for retail property too as consumer balance sheets are healthy, helped also by low unemployment, and fuel prices being down over the past 12 months.

Parsons says most investors remain bearish on US retail property given the rise of online shopping. Yet, the evidence is that retail is not only surviving, but thriving. For instance, vacancy rates at strip malls are at 15-year lows, as seen in the chart below.

US mall vacancy rates

There are two reasons for that. First, supply has been almost non-existent for the past decade. Second, demand has held up well as even online retailers have realized that they need physical stores to grow their brands.

In Australia, consumers are more stretched because most mortgages have variable rates rather than fixed rates like in the US. That means as rates increase, it has an immediate impact on those people with variable rate mortgages. However, Parsons sees plenty of value in retail REITs here too.

To find out more about the opportunities that Andrew Parsons sees in Australian commercial property, you can tune into the Wealth of Experience podcast here.

James Gruber is an assistant editor at Firstlinks and Morningstar.com.au