After starting the year on a high note with total returns up more than 10 percent in January, publicly-traded REITs gave back some of those gains in February with the Nareit All Equity REIT Index down 5.9% for the month.
Infrastructure REITs (down 11.7%) and office REITs (down 10.8%) were the worst performing segments, but all property types with the exception of self storage (up 1.7%) posted declines for the month.
At the same time, REITs have reported strong operational results so far in in their fourth quarter earnings reports, indicating a gap remains between operating fundamentals and current REIT stock valuations.
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 February numbers.
This interview has been edited for length, style and clarity.
WMRE: Start us off on the high level. What do the month’s results tell us?
Ed Pierzak: The good news in February is that REITs are still up for the year despite the drop. Total returns for all equity REITs are up 3.6 percent year-to-date. The decline in February follows the trend with the overall market.
The REIT sectors that had the worst performance were office and infrastructure. For the office sector, it’s a familiar story—the uncertainly created by work-from-home.
On infrastructure there’s a more interesting story. As we have been working on the preliminary T-Tracker of the quarterly results in infrastructure, we are seeing some of that negative performance is attributable to non-U.S. operations. So it’s not reflective of the U.S. real estate market.
Overall, REITs saw a little falloff in February. But take a look at the backdrop of the U.S. economy. We’ve had a number of things going on. You start off with jobs. As we start with the latter part of 2022, we did see the job gains waning. Gains were good, but less good than at the beginning of the year. The expectation was that this trajectory would continue in 2023. In January, instead we got hit with strong job numbers.
When looking at inflation, it’s been an issue. It’s been declining. But if you look at the PCI or PCE it’s still at levels that are pretty elevated. There was a thought that with some softening in rents, particularly in housing, it would flow through in the overall inflation numbers. It has not happened yet.
And then if you look at the 10-year Treasury, rates are still going up. Started 2022 at 1.5%. By the end of the year, it was 3.6%. At the end of February it was 3.75%. And today’s [is] touching 4%. What we are recognizing is that it can prove to be a challenging environment for real estate. But when you look at results and operational performance, we still think REITs are well-positioned.
WMRE: A big theme I’ve been hearing is that the gap between REIT fundamentals and stock prices presents an attractive opportunity for investors.
Ed Pierzak: We are in full agreement. Touching on the T-Tracker more specifically, operations year-over-year are solid. We have seen some softening quarter-to-quarter. But year-over-year FFO is up over 10%, NOI is up 6.8% and same-store NOI is up 6.5%. It’s keeping up with inflation. Occupancy rates actually increased to 93.6%. When you look at those numbers, you’re seeing operations are holding. And I think one of the nice things for REITs is when you look at balance sheets, I would characterize them as strong. Leverage ratios, at 34%, are still low. And the type of debt they have is predominantly fixed-rate debt with an average weighted term to maturity of about seven years. The weighted average cost of capital is now at 3.7%. So, on one hand, REITs are not immune to uptick in rates. But over that same period, the cost of capital started at 3.3% and ended at 3.7%. Meanwhile, you have the 10-year Treasury at 4.0%. It’s attractive debt and they are well positioned to handle what 2023 has to hand out.
WMRE: You published a new piece examining the divergences between public and private real estate markets historically. Can you talk about that?
Ed Pierzak: This divergence between public and private markets started in 2022. When you look at the third quarter of 2022, that was the largest dislocation between public and private markets, at 38.4 percent, that we’ve measured. The natural question is, what happens next?
We went ahead and looked at the historical experience. What happens when we see these troughs? The big takeaway from this is when you look at the performance of REITs four quarters after a trough, they outperformance private real estate by a large margin. When you look at the total return difference, it’s at 31.3% on average. … Furthermore, we see this REIT performance about 82% of the time. … Lastly, we looked at the history of these troughs and divvied them up in three buckets. The most shallow is -10% to -20% divergence and the deep troughs are -30% to -40%.
We see REIT outperformance in all instances, but as the trough gets deeper, REIT returns get higher and private market returns get lower. You get this relationship that average REIT total return spread tends to get larger as troughs are more severe.
WMRE: It makes sense if public real estate is at a discount to private markets and the underlying assets are fundamentally similar, it’s something investors would want to take advantage of.
Ed Pierzak: We took a look at the duration of these dislocations. … When you look at historical experiences, for less severe throughs, we found the divergence tended to last about four quarters. For more severe throughs, the historical experience has been that it has lasted for nine quarters. … As of the end of 2022, we would have been in this current dislocation already four quarters. If we go ahead and if the differences go to zero by the end of the year, this dislocation would end up being eight quarters, which is consistent with the historical experience.
John Worth: As we’ve been out talking to investors about this valuation gap and the opportunity this creates, nobody is disagreeing. A lot of folks are looking at this and coming to the same conclusion. The difference is going to be at end of 2023 or in the middle of 2024 is whether you were nimble enough to execute. Could you get some money out of private vehicles or allocate new resources to public markets? That’s going to be big question looking back. Did you execute on it?