Q4 2023 Public REIT Market Recap
What happened and where do we see the opportunities
REITS are ready for Takeoff
As we enter 2024, we believe REITs are ready to takeoff after two years of sitting on the runway. We believe the current economic and capital markets environment is meaningfully more favourable today than it has been in the past two years, especially concerning the outlook for interest rates.
According to the Bank of America, central banks around the world are forecasted to cut interest rates 152 times in 2024 – the first time in three years where interest rate cuts will outpace hikes. In December, the U.S. Federal Reserve made a significant pivot, signaling the possibility for 75 basis points of interest rate cuts in 2024, responding to the anticipation of inflation reaching 2% by year-end. Similarly, the European Central Bank also suggested potential interest rate cuts, revising down its 2024 inflation forecast. China is also contemplating reserve requirement ratio and/or interest rate cuts to counter weak domestic demand and the risk of deflation.
Looking back almost 30 years to 1995, when central banks paused their interest rate hiking campaigns, REITs emerged as the strongest asset class, delivering substantial returns over the subsequent six-month period, and over a nine-month period, REITs generated a 15%+ total return.
Where does this leave us?
Looking ahead to the investment opportunity landscape in 2024, we believe REITs that can deliver attractive earnings growth, retain pricing power in a slowing economic climate, grow margins, and trade at an appealing valuation with a higher-than-average expected return, will outperform. As it relates to valuation, despite the flurry of gains experienced in November and December, we believe REITs are cheap relative to public equities, private real estate, historical valuations, and where we see valuations going over the next two years.
Relative to Public Equities
Over the past two years, real estate fundamentals around the world, excluding the office sector, have been very good, characterized by better occupancy rates, rising market rents, higher net operating income margins, and releasing spreads on expiring leases and the reletting of vacant space.
Since the beginning of 2022, the robust recovery in operating fundamentals has resulted in cumulative earnings growth of over 15% for the global REIT industry. However, global REITs have underperformed global equities by over 18.6% during this period, with roughly 13.6% of that underperformance taking place in 2023.
REITs are currently trading 1-standard deviation below their historical mean relative to the general equity market. Over the past 20+ years, the only time periods where REITs have traded at such depressed valuations has been the tech-wreck in 2001, the global financial crisis (“GFC”) in 2009, and the COVID-19 pandemic in 2020.
Relative to Private Real Estate
Economic uncertainty and capital market volatility in 2022 and 2023, caused by tighter central bank monetary policy, created a significant disconnect between public REIT and private market real estate valuations. The current discount implied between public REIT and private market pricing is -30%.
We believe the gap between public and private real estate valuations has started to close and will continue to close in 2024, as seen in the prior cycles. If public REIT valuations were to revert to where the private real estate market is currently priced, that would imply a 43% upside.
Relative to Historical Valuations
Global REITs are presently trading at nearly a 12% discount to spot NAV, cheaper than their 30+ year long-term average. As recently as November, REITs were trading at a 20%+ discount to NAV.
As seen in prior cycles, it’s common for discounts to NAV to exceed 20% for short periods of time. Historically, when REITs traded at a discount to NAV exceeding 20%, the sector has consistently reverted to NAV, often surpassing it.
Relative to Hazelview Valuations
Due to poor performance in 2022 and 2023, we believe REITs are cheap and the attractive valuations are a big part of the REIT story entering 2024. Our valuation models suggest that REITs are priced at a high-teen discount to intrinsic value (defined as a blend between NAV and discounted cash flow), which implies ~22% upside in price from today.
Should interest rates decline consistent with third party forecasts and central bank guidance, it could lead to higher asset values over the next 12 months. However, our forward-looking valuation models do not currently reflect potential cap rate compression. For illustrative purposes, a 25-basis point change in cap rates could result in a ~7% increase in NAV.
In addition to a more favourable interest rate environment in 2024, expected to serve as a positive catalyst for REITs, we believe there are further tailwinds that could assist REITs in closing the current valuation discount. These include resilient corporate earnings despite slower economic growth, and rapid declines in new supply, enabling real estate owners to exert greater pricing power for sustained rental rate increases.
For 2024, we are spotlighting a select number of companies that we believe are poised to create value and distinguish themselves from the pack. While we provided only a few examples, we think the underperformance of REITs in 2023 have provided us with the opportunity to build an entire portfolio of companies that we expect to deliver outsized returns in the next two to three years.
Our top investment opportunities for 2024 are as follows:
- United States: American Tower
- Canada: Chartwell Retirement Residences
- Europe: Montea and CTP NV
- Asia-Pacific: SUNeVision, Mirvac and Ingenia Communities
With our optimistic outlook for a more favourable interest rate and macroeconomic landscape in 2024, we anticipate that REITs will finally gain the momentum we have eagerly awaited over these past two years.