Total returns for the Nareit All Equity REIT Index rose 2.00% in July—the second consecutive monthly gain following a 5.36% rise in June—and while there were strong performances across most property types, much maligned office REITs led the way for the index, with a 13.32% gain in total returns for the month.
For the year total returns for the all equity index are now up 5.03% year-to-date. Office REITs have total returns of -5.01% for the year.
WMRE spoke with Edward F. Pierzak, Nareit senior vice president of research, and John Worth, Nareit executive vice president for research and investor outreach, to discuss the July numbers and Nareit’s Mid-Year Report.
This interview has been edited for style, length and clarity.
WMRE: If we start with your midyear report, one section that caught my eye looked at actively-managed funds focused on REITs. Can you walk us through some highlights of that analysis?
Ed Pierzak: It gives us a good sense of what active mangers are doing today. One thing that you see through time is the movement from the traditional four property types [office, multifamily, retail and industrial] to the modern economy sectors. If you take a look through that movement, it’s consistent with the evolution of the REIT indices overall. In 2000, the four traditional property types accounted for over 75% of the index. Now they are 40%. Managers are moving with the market and what it shows us is that REITs are a cost-efficient way to access high quality properties and best-in-class operators for traditional and modern property types.
John Worth: This is something we plan on doing as a quarterly feature in terms of tracking active managers. Their decisions of underweighting or overweighting compared with the overall REIT index is really interesting information. These are some of the most dedicated, smartest REIT investors in the world. The ability to see where they are positioning themselves gives some direction on the future of real estate markets generally.
WMRE: When you say actively-managed funds, what does that entail? These are primarily mutual funds, not ETFs, correct?
John Worth: Yes. These are all actively-managed U.S.-focused REIT funds, typically 40 Act Funds. It’s tracking mutual funds where there is a disclosure of holdings. These are the managers going to REITweek, going to REITworld, meeting with REIT management teams, participating in that process. They are knowledgeable in real estate markets, but also with the individual REITs. We would be happy to include active ETFs, but today REIT ETFs are primarily passive and tracking the overall REIT index.
WMRE: Are there other major takeaways you want to highlight from your mid-year report?
Ed Pierzak: We’ve talked a lot about the divergence in our previous conversations. It’s been an ongoing theme. We have new preliminary data on the private side. We had put out a commentary that described the valuation process as making progress, but that the wheels of progress are turning slowly.
If we look at the NCREIF numbers and total returns for Q2 2023, the appreciation component was negative again. But it’s a modest 3.6%. If you look at progression over the last four quarters, it started with a barely negative number and then to 5% to 4% and now to the mid 3s. As expected, the process is a little bit slow.
On the transaction side, we saw cap rates decline a bit, but that likely is a function of the mix of assets more than anything else. It’s not a real large sample. On the appraisal side, that cap rate is edging upward as well.
WMRE: Where does that leave the spread between private and public markets today?
Ed Pierzak: For transactions on the private side, the cap rate is at 5%. Last quarter’s implied cap rate from the NAREIT T-Tracker was 5.85%. We expect that 5.85% may come down a little bit in the third quarter. So, the spread is under 100 basis points on transactions.
But the NCREIF appraisal ODCE cap rate is at 4.23%. There was a pretty material jump by 20 basis points. But if you look at the last quarter implied Nareit cap rate, you are looking at a gap of around 160 basis points. There’s still work that needs to get done.
WMRE: Pivoting to July results, what stands out from the month?
Ed Pierzak: What pops out for the month of July is that we see that office has performed quite well. And I think we’ve had the discussion before of the challenges in the office sector. We’ve had a material bounce. If you go from the trough in late May this year through the end of July, office REITs are up nearly 29%. That’s a very substantial bounce.
Part of the story here is the recognition that perhaps as people have talked about the challenges, all REITs have been painted with the same brush. Everything was treated the same, but in fact, within the office sector we have seen a bifurcation in the performance of certain types of properties. Newer, highly-amenitized office buildings have done quite well and REITs are owners of a lot of those properties. The market is recognizing that REITs do own those assets.
WMRE: What about with some other property types for the month?
Ed Pierzak: Regional malls are up quite a bit as well—jutst over 8%. Retail in some ways is a similar story to office. There’s a recognition that retail REITs have been operating well and one of the things that is not often recognized—if you go to the true supply/demand fundamentals of retail—is that it is one of the sectors that has curtailed new supply for years. Even as we’ve seen new supply of office come on, retail development has effectively shut down. That’s been to the sector’s benefit. Now there’s good demand and limited new supply and that’s starting to run through to performance numbers.
WMRE: We’ve also had the removal of some retail inventory as well, correct? And we’ve seen some companies divest weaker parts of their portfolio to focus on stronger assets.
Ed Pierzak: Owners have assessed their portfolios and the assets they deemed the best assets are getting a lot of reinvestment dollars.
WMRE: Does anything stand out for other sectors? Were any segments down for the month?
Ed Pierzak: One in particular that stands out would be the cell tower sector. Ultimately there lies some potential of sorting out the supply/demand dynamic. The underperformance is tied to the fact that the pace of signing of new leases has been off.
John Worth: Another [sector] to point out on the positive side is data centers. They have been the best performing on a year-to-date basis. Data center REITs were up a little over 5% in July and are up 25.6% for the year. They are among the leaders. We’ve likened it to the e-commerce influence on the warehouse/distribution space. The demand of any new developments with AI are likely to have a similar effect on data centers. There’s a lot of excitement within the sector on future developments.