Q1 2023 Public REIT Market Recap
The first quarter was a tale of two halves, with global REIT share prices soaring in January, gaining 9.0% (USD). The script flipped starting in February, with REITs declining 4.4% as Central Banks reiterated the need for more interest rate hikes. This was driven by a resilient labour market delivering robust job gains, despite a pickup in layoffs in the technology sector, along with inflation, although moderating, remained stubbornly high. In March, global REITs declined 3.1% (USD) due to the collapse of U.S. based Silicon Valley Bank and Signature Bank, as well as the forced marriage between Credit Suisse and UBS, in an all-stock deal for CHF 3 billion, negatively influencing share prices.
Confidence in the banking system is crucial for a properly functioning lending environment to facilitate transactions amongst buyers and sellers. Without a properly function banking system, price discovery becomes challenging, thereby making it harder for prospective investors and owners to make investment decisions.
In March, ghosts from 2008 and 2009 awoke with the collapse of Silicon Valley Bank and Signature Bank, marking the second and third largest bank failures in U.S. history. Not to be undone, but Credit Suisse, founded in 1856 with over 167 years of history, was forced to merge with UBS after experiencing as much as $10 billion of deposit withdrawals per day. Fortunately, the government stepped in to prevent a liquidity crisis, and ever since, markets have stabilized, and lending markets have remained liquid.
Current news headlines have been overly negative towards commercial real estate, mistakenly painting the entire real estate market with a broad brush. Media outlets are focused on macroeconomic concerns, such as how higher interest rates and costs of capital are making real estate more costly to own and more costly to operate, which is expected to lead to valuation declines. However, the media is not considering the nuances of various companies, markets, and property types.
However, when we peel back the onion, not all real estate is created equal.
Office markets in the United States are clearly facing significant challenges due to hybrid work schedules that could face permanent impairment. Fundamentals are weak, with direct vacancy rates rising, the amount of sublease space available to lease rising, and tenant inducement packages are increasing. Asset values are lower and hard to peg given the lack of pricing discovery in the private market.
Outside of the United States, however, office fundamentals are better, particularly in Asia-Pacific where culture and the size of residential dwellings lends itself to more people working in an office than at home. Europe is also experiencing higher building utilization rates than the U.S., with demand more consistent and supply lower.
Stepping away from the world of office, commercial real estate (“CRE”) fundamentals in most geographies across most other property types such as in residential, industrial, hotel, self-storage, data centres, cell towers, and convenience-oriented retail, are experiencing strong demand, with landlords feeling emboldened to push rents in a higher inflation environment, which is helping to offset higher operating expenses.
Why are investors bearish on REITs?
If CRE fundamentals outside of the office sector are strong, then why, according to the Bank of America, are investors today the most bearish on REITs since October 2020?
We believe most of the trepidation we hear from investors surrounds the lending environment in the United States and its corresponding influence on real estate values.
Allow us to unpack this further.
According to Morgan Stanley, the size of the CRE market in the United States is $11 trillion, with $4.5 trillion of CRE loans. As a percent of all CRE loans, ~25% constitutes loans collateralized by office properties. Conversations with public and private office landlords suggests that lenders will work with owners to refinance existing debt but may require additional equity upon extending their loans. That’s not to say we won’t see owners hand back their keys like Brookfield and Blackstone have done, but it does NOT imply the real estate apocalypse that we are seeing more of in articles, will come to fruition.
A consequence of the collapse of Silicon Valley Bank and Signature Bank may be more regulation, which leads to tighter lending standards, as banks refocus their efforts on strengthening their own balance sheets. Approximately 29% of all CRE loans in the United States originate from the Top 25 banks, which means 71% are from small, regional, and local banks. Smaller banks are crucial drivers of credit growth, helping to fuel the economy, so it would seem logical that tighter lending standards results in lower availability of debt, at higher loan-to-value ratios and higher rates.
One positive consequence of lenders becoming more selective is less new supply. Over the past few weeks, we have visited with some of the largest owners of commercial and residential real estate in the United States located in San Francisco, Seattle, Austin, Washington D.C., and New York City. A common theme amongst our meetings is that owners are seeing lenders pull back on construction financing, which in turn will result in a more favourable supply outlook 12 months from now. That should then provide existing owners with greater tailwinds to continue to push rents.
How can investors capitalize?
As we mentioned in our 2023 Global Public Real Estate Outlook Report, public REITs are being valued significantly below core stabilized private real estate, a dynamic we saw play out at the onset of the 2008 global financial crisis, as well as the 2020 COVID-19 pandemic. Investors buying in 2008 and 2020, saw returns of 38.3% and 27.2% in the subsequent 12 months (i.e., calendar year 2009 and 2021) and 56.8% in the subsequent 3 years cumulatively after 2008. REITs are trading below their pre-COVID levels, at a ~20% discount to our forward NAV estimates, which already incorporates potential declines in asset values. Public market valuations are disconnected from those in the private market, ultimately lending itself to an attractive reversion to the mean investment opportunity.
Historically, the best long-term returns are generated when REITs are bought at discounts to their intrinsic value, and when investor sentiment is at its lowest, both of which are true today. Despite clouds on the macroeconomic horizon, we see public market valuations as overly disconnected from those in the private market, ultimately lending itself to an attractive reversion to the mean investment opportunity.
All figures are in USD unless noted otherwise. Global REITs index: FTSE EPRA NAREIT Developed Total Return Index.