Publicly-traded REITs have had a rough go of things in 2022, with total returns down more than 25 percent for the FTSE All Equity REIT index as of the end of October. (That was after the same index posted gains of more than 40 percent in 2021). But last month did see the sector recover some ground, with total returns up 3.38 percent for the month led by particularly strong performances among retail REITs and lodging REITs.
For the year, REITs are ahead of the Nasdaq Composite (down 29.32 percent year-to-date through Oct. 31), but trail the S&P 500 (-17.70 percent), The Russell 2000 (-16.86 percent) and the Dow Jones Industrial Average (-8.42 percent). Last week, the Fed raised interest rates another 75 basis points in its bid to tame inflation, which could deal another blow in the short term.
But October was also marked by REITs reporting third quarter numbers, which showed fundamentals remain solid. Publicly-traded REITs also continue to boast strong balance sheets marked by low leverage levels and debt maturities that are termed out for multiple years.
WMRE spoke with John Worth, Nareit executive vice president for research and investor outreach, to discuss the latest monthly results.
This Q&A has been edited for length, style and clarity.
WMRE: Let’s start as always with the big the picture. REITs were up for the month. What were some of the highlights?
John Worth: REITs posted their first positive monthly performance since July. In part, it was driven by markets pricing in an expectation that the Federal Reserve might slow the pace of monetary tightening. After last week’s 75-point hike we saw the markets give back some of those gains. But for the month of October, REITs were up 3.4 percent.
Among that, we had some interesting leaders. Lodging/resort REITs were by far the best performing sector (up 19.65 percent). Retail was up over 12 percent, driven by regional malls with a 22.2 percent gain.
There were positive results nearly across the board. Residential (-2.85 percent), healthcare (-0.75 percent) and infrastructure (-4.67 percent) stood out as not having positive returns. But overall, for the equity market it was a positive month and that was true for REITs.
WMRE: We are into REIT earnings season now. What have you been seeing in those reports?
John Worth: A preliminary look suggests that we will see FFO up again this quarter and that we will see an all-time high in aggregate FFO for REITs. And metrics like same-store NOI are going to show strong performance at or around the rate of inflation. The solid REIT operational performance underpins some of that inflation protection that REITs can provide.
At the sector level, as we saw last quarter, the majority of property types are going to have FFO in excess of their pre-COVID FFO. Last quarter, nine pure-play sectors had FFO exceeding pre-COVID FFO and I expect to see similar results this quarter.
One other piece on operating results, since the Fed has telegraphed they are not done with rate increases, is that it raises more questions on the impact of rising rates on real estate generally. We’re seeing the degree of preparation REITs have in place for rising rates. Leverage will continue to be quite low and the tenure of debt continues to be an average of more than seven years and the majority of that is fixed-rate debts. Interest rate expense as percent of operating incomes also remains near all-time lows. All that means REITs remain well-prepared for a period of higher interest rates.
WMRE: Outside the monthly numbers, what other topics in the REIT space are you looking at right now?
John Worth: We’ve got some upcoming work in a market commentary where we’re starting to ask the question, “How do REITs perform coming into, during and coming out of recessions?” There are interesting patterns where REITs, compared with private real estate, tend to underperform coming into recessions. That is consistent with what we are seeing now. REIT valuations are below private real estate and REITs have priced in a recession. But within recessions, REITs tend to outperform and coming out of recessions REITs also outperform.
That speaks to the different valuation cycles for REITs vs. private real estate. That question has been coming up a lot with our discussions with investors. If we are headed into recession, what should we expect from commercial real estate generally?
The other piece that’s been on my mind that stems from some traveling and talking to some global investors, is the degree to which investment managers are thinking about “completion” portfolios. Investors are looking at their real estate portfolio, comparing it to the shape of the modern economy and saying, “Maybe this doesn’t map as well by property type as it did 10 years ago.”
So, they are using listed real estate to pair with their existing private real estate for diversification in multiple ways. They are diversifying public/private and by geography. And they are using listed real estate to get to property sectors they may be underexposed to in their private portfolios.
WMRE: There was also a Wall Street Journal piece pointing out a disconnect between publicly-traded REIT share prices and non-traded REIT valuations. It seems like that is related to what you’re talking about in terms of private and public real estate having different valuation cycles.
John Worth: Our sense is that fundamentally, real estate is real estate. But different types of real estate in different structures have different cycles for valuations. So, you can get these gaps over the short-term in terms of what the values look like. Public markets react more quickly. But, over time, the long-term valuations tend to converge.
Different investors are going to find different wrappers for real estate investment work for different reasons. Ultimately there is different timing to the valuation cycle and that’s just part of the overall dynamics in how listed and non-listed REITs can work together.
WMRE: We’re closing in on the end of the year. What are some themes you are looking at for 2023?
John Worth: One of the big questions is where are we going to land in terms of long-term interest rates? And as a part B to that question, where are long-term interest rates going to land in 2026, 2027 and further out? Are we going to see a reversion to a low-for-long environment or are we going to see higher equilibrium rates after this normalization cycle?
Related to that, when are we going to see cap rate adjustments? With 10-year Treasuries over 4 percent, there’s a real sense that cap rate adjustments are more of a “when” than an “if” question. But we need to see some transactions and what cap rates are.
A third question is there are now some cracks in the labor market. The unemployment rate ticked up in the latest report and the pace of job creation slowed over the last 10 months. The other thing we’ll be watching is if we are going into a recession with a weakened job market and weakened demand for goods and services.
WMRE: If we do head into a recession, do you anticipate much of a distressed real estate cycle? As you’ve pointed out, REITs seem positioned well. But there may be other more highly-levered investors in the market or ones that bought late in the cycle that may have some issues.
John Worth: It’s hard to say. If it is going to happen to anyone it would be to investors with high leverage and with short-term maturities. That would be the recipe for distressed dispositions. Those are always case-by-case. But higher rates and slower growth are two other ingredients for seeing some distress. I don’t think those will come out of the REIT space given the way they’ve managed their balance sheets. In fact, for REITs it could be an opportunity for growth.