Q2 2023 Public REIT Market Recap
What happened and where do we see the opportunities
Historically, recessions and bear markets tend to occur unexpectedly rather than when widely anticipated, and such surprises often tip economies into a downturn. However, during the first half of 2023, key markets such as the U.S., Canada, Japan, Australia, and Singapore are proving to have more resilient global economic growth than anticipated. These markets are witnessing job gains and improvements in productivity. In contrast, the Eurozone entered a recession in Q2 2023, primarily driven by Germany's manufacturing contraction. A growing divergence is evident worldwide, with manufacturing sectors in countries like Germany and China struggling, while service-based economies like the U.S. are expanding.
Traditionally, the most favourable long-term profits have been achieved by purchasing REITs below their actual value and during times when investor sentiment towards this asset class is at its lowest. The current situation aligns with these circumstances, as REITs are currently available at a reduced cost.
Inflation continues to exhibit resilience, potentially adding pressure on central bankers to implement rate hikes during the latter half of 2023. This pressure is particularly evident in the U.K., where headline inflation remains persistently high. Although credit has become more expensive, we anticipate that lenders will collaborate with current borrowers rather than resorting to property foreclosure and hastening a short sale at a discounted price.
Real Estate Fundamentals
Real estate fundamentals are displaying remarkable resilience, with solid performance observed across various property types, excluding the office sector.
In numerous cities and regions, industrial vacancy rates are at near-record lows, granting landlords the ability to raise rents significantly as leases expire and space becomes available. Although demand for industrial space is returning to pre-pandemic levels, the industry remains robust as tenants continue to expand their supply chains.
Data centre rents are witnessing an increase for the first time in over a decade, driven by strong demand for space and a dwindling supply of new projects, amplifying the value of existing space. Escalating labour, land, and construction costs make data centre development challenging, resulting in higher rents. This trend is further propelled by the growing demand for space driven by artificial intelligence requirements.
The demand for housing has reached unprecedented levels as households seek reasonably priced accommodations. We anticipate continued rent growth in the multifamily, single-family rental, and manufactured housing sectors, with high occupancy rates expected across the rental spectrum.
The self-storage sector remains solid, with household penetration rates surpassing pre-pandemic levels. While occupancy rates are moderating closer to pre-COVID levels and new customer rents are lower, existing customers are unphased by rent increases. Consistent demand for storage units and a decline in new supply due to unfavourable construction cost financing contribute to the sector's stability.
Lastly, the demand for retail space exhibits resilience, fueled by strong consumer spending patterns and the eagerness of retailers to establish new stores. Market rents are also increasing, allowing landlords to benefit from positive mark-to-market adjustments upon lease expiration.
Attractive REIT Valuations
With stable commercial and residential real estate fundamentals and consistent cash flows, coupled with stock prices remaining relatively unchanged since the beginning of the year, REIT valuations have become appealing.
Presently, REITs are trading at significantly discounted prices compared to public equities. From the second quarter of 2022, when central banks began raising interest rates, up until the end of the second quarter of 2023, global REITs have performed approximately 20% worse than global equities.
Moreover, REITs are currently trading at substantial discounts compared to our forward-looking intrinsic valuation estimates. Considering the current increase in the cost of capital that REITs are experiencing, we observe that global REITs are trading at a discount of around 22% to intrinsic value, which combines net asset value and discounted cash flow. This suggests a potential upside of over 27%.
Furthermore, REITs are presently trading at a 21% discount to the stable core private real estate market. If REIT valuations were to revert to the levels currently observed in the private real estate market, it would indicate a potential upside of approximately 27% from current levels. Although there can be discussions about whether the private market has experienced a sufficient decline or if the public market is being excessively penalized, the valuation gap is presently at historically wide levels, surpassing those seen during the 2008-2009 financial crisis and the start of the pandemic in March 2020.
REITs are cheap and on sale, and typically, the best long-term returns are generated when REITs are bought at discounts to their intrinsic value and when investor sentiment for the asset class is at its lowest, both of which are true today.