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REIT Fundamentals Remain Positive, But Signs of Softening Emerge

REIT Fundamentals Remain Positive, But Signs of Softening Emerge

Meanwhile, REITs posted positive total returns in March and are down slightly year-to-date.

Publicly-traded REITs eked out a 2.1% gain in funds from operations (FFO) in 2023, according to Nareit’s T-Tracker. While positive, it was much lower than the figures posted in 2022 and 2021 when FFO grew 17.2% and 22.3%, respectively.

The story was similar for net operating income (NOI), with 2.7% growth, down from 11.6% and 14.3% the two prior years.

Meanwhile, the FTSE Nareit All Equity index posted total return growth of 1.78% in March, bringing the index closer to positive territory for the year. Year-to-date, the index is down 1.3% after total returns grew 11.36% in 2023.

Nareit also posted an update on how the 27 largest actively managed real estate investment funds focused on REITs are adjusting their allocation strategies. spoke with Edward F. Pierzak, Nareit senior vice president of research, and Nicole Furnari, Nareit vice president of research, about the T-Tracker, fund research and March’s results.

This interview has been edited for style, length and clarity. Let’s start with the T-Tracker. What did we learn from the full-year results from REITs?

Ed Pierzak: We still have good numbers in terms of operational performance, including FFO growth and NOI growth in the last quarter of 2023. All of that remained positive. One of the things we are starting to see when you look at quarter-to-quarter rather than year-to-year is that we’re seeing more negative numbers. It could be seasonality in the data, but it could also be a softening in operations.

If you look at the strength of the growth we’ve had over the last five or six months, we see this tapering in the strength. It shouldn’t be much of a surprise. By supply and demand measures, there is some softness there. We’re starting to see demand taper off in some sectors. That said, when we look at occupancy rates, we find they continue to be very strong for all property types, excluding office.

If you look at those rates for apartments, retail and industrial, they average between 95% and 97%. These are solid numbers. For office, we have seen a decline but also seen it leveling out. The office occupancy rate is 88%, which is the same as the previous quarter. I would view that as good news as well. Broadly speaking, if we take the T-Tracker and compare it with CoStar’s numbers, which would be a broader indication of the market, we find the T-Tracker occupancy rates are similar to, but higher than, the CoStar numbers. So, operationally I think we are in pretty good shape.

WM: So when you are talking about a softening, what does that entail?

EP: Same-store NOI grew at 3.6%. But in the previous quarter, it was 4.6%, and in the quarter prior to that, it was 5%. It’s a tapering of growth. And likewise, if you look at FFO, the growth levels are also lower. We’re talking about this tapering on a year-over-year basis.

If you look into some of the sectors, industrial year-over-year is negative, but if you think about it, industrial had been so strong for so long that some moderation was inevitable.

WM: Another part of T-Tracker gauges the health of REIT balance sheets. What are you seeing there?

EP: They look really good. In terms of leverage ratio, we’re at 33.2%. This is a level that I would say is akin to a core investment strategy in the private world. In this higher interest rate environment, REITs have done the right things. Their weighted maturity is 6.9 years, and average rates are 4.2%. Compositionally, over 90% of REIT debt is fixed-rate debt, and nearly 80% of it is unsecured debt. Unsecured debt proves to be a competitive advantage, not only in accessing debt but accessing it at an attractive rate.

WM: And this is something we’ve been talking about periodically in our conversations. It seems like balance sheets are largely holding up over time.

EP: We’ve seen the numbers change on the margins, but REITs have been well disciplined and put this strategy in place of longer-term debt, fixed-rate and unsecured and carried it out for the long term. They have a longer horizon focus rather than a short-term one.

WM: Pivoting to the monthly and year-to-date returns, what stands out there for you?

EP: We just finished up the first quarter, and REITs were down modestly. The All Equity index was down a little over 1%. As you look across the sectors, in the broadest sense, most have done OK. Those up were specialty REITs, data centers and lodging. With the monthly numbers, we ended March up a little shy of 2%. One of the things to look at across there is the strength of office, up 4.6%. As much as we hear about office woes, there is a recognition that there is still upside in that sector.

WM: What stands out in the research you’re doing in gauging the activity of the largest active managers? First off, can you remind me of the methodology of who you’re looking at?

Nicole Furnari: It’s based on Morningstar data, and it’s the 27 largest. It is largely mutual funds and ETFs.

The big standout for the fourth quarter was a shift to near parity to what their index would be. In comparing the funds with the FTSE index, for example, telecommunications was very underweight when we started looking. With year-over-year and quarter-over-quarter growth, that underweight level has shrunk and gotten close to zero. It’s also true of gaming and specialty REITs. Specialty REITs posted the largest year-over-year and quarter-over-quarter gains. Active managers are pushing into some of these newer property sectors.

WM: In looking at some of the charts in your piece, residential stands out in terms of managed funds being overweight relative to the all-equity index.

NF: Funds really love residential. And historically, they have been overweight. What’s interesting is if you look at the trend over time, they are easing off the accelerator and shifting allocations. It’s worth pointing out there’s also been an uptick on the retail side. We’re seeing gains in retail and some funds shifting to that sector. It seems like they have a positive outlook on people shopping in stores.

EP: With retail, demand is really outstripping supply. For years, we had heard in the press that the U.S. was over-retailed, but retail supply was curtailed, and developers stopped that supply for a number of years. So it’s not so much that demand has gone through the roof; it’s that it has exceeded supply growth.

WM: We’ve also seen a lot of lower-quality retail properties get removed as well, correct? Some of that has been converted or shut down, so now things are more in balance. Correct?

NF: There’s been a flight to quality, yes. You’ve also seen direct-to-consumer brands like Warby Parker move to build out physical stores.

WM: Right, more retailers are taking omnichannel approaches.

NF: Yes.

WM: Are there lessons for other investors based on what the actively managed funds are doing?

NF: Everyone can take from this what speaks to them. We are providing the information as a way of saying here’s where the active managers are putting their money. When I started this project, I was concerned there would not be much to say quarter-to-quarter. But every quarter a narrative has come out of it. It’s been something interesting to see.

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