June was another rough month for many property sectors. Lodging/resort REITs had the worst month, with total returns down 19.65 percent. Office REIT total returns were down 15.01 percent and retail REITs were down 9.54 percent with regional mall REITs alone down 16.75 percent for the month.
No property sector finished in positive territory for the month. Residential, self-storage, industrial and data centers posted the smallest losses—in the four percent to five percent range.
WMRE sat down with John Worth, Nareit executive vice president for research and investor outreach, to discuss how REITs stand at midyear and what investors should expect for the rest of 2022.
This interview has been edited for style, length and clarity.
WMRE: June was another rough month for equities in general. How did REITs fare and can you put the results in a broader context?
John Worth: What we’re seeing is in some ways a continuation of what we talked about last month—this dichotomy between stock market performance and REIT operating performance. We’ve seen REIT operating performance be quite good. Q1 earnings for REITs came in over $18 billion. Occupancy rates are up. And FFO overall is above pre-COVID FFO. REIT management teams also say what they are seeing in their internal dashboards is a lot of internal strength in terms of demand. The counterpoint to all of that is that it has been a pretty tough year for stock market performance.
This point/counterpoint of strong operating performance amid market turmoil reflects investors’ concerns about economic growth. But with REITs, while management teams are aware of the risks out there, they believe they are well-prepared and they are not seeing evidence of an economic slowdown in operating performance yet.
WMRE: And where do REITs sit compared with other indices?
John Worth: REITs are outperforming the broader stock market by a little bit. It depends on which index you look at on a year-to-date basis. REITs are outperforming the S&P 500 by about 1 percent and the Russell 1000 by about 130 basis points. So, REITs are outperforming, but not by a wide margin. Early in the year, REITs were significantly outperforming the broader stock market, but they’ve come back and it’s really close to neck and neck on the year. In June, we saw REITs outperform by a full percentage point, but a lot of that outperformance came in the second half of the month. June was a tale of two halves. REITs were down almost 12 percent through June 15 and then were up 5 percent in second half of the month.
WMRE: Over the past year we’ve talked a couple of times about how REITs have performed historically in periods marked by inflation and rising interest rates. Is that something you feel like investors have internalized?
John Worth: Part of it depends on whether it turns out we are truly in real high inflation environment and a true 1970s-style price/wage spiral as opposed to inflation being sustained by energy prices, supply chain issues, and food price shocks. If it becomes the former, people will see REITs hold up in that environment. We have seen REITs have historically outperformed the stock market in periods of high and moderate inflation and when you dig into operating performance, same-store NOI is higher and often beats the rate of inflation. So, we think that underlying operating performance is going to be determined over the long term and should support REIT valuations in a period of high inflation.
WMRE: In looking at operating performance, do you see any divergences developing by property type?
John Worth: There were property types that recovered fast and had tailwinds from COVID and the COVID recovery. Industrial, for example, as well as cell towers and data centers. And residential has performed well. On the other end, office, healthcare that have continued to see lagging performance because of ongoing issues.
With office REITs, we are seeing it in their stock performance but also operational performance is being held back by the uncertainty of the future of work from home and how that will affect demand long term as well as how it’s impacting leasing in the near term. So, there’s definitely some differentiation across sectors, but what we’ve seen in common across all REITs is a lot of recovery. Even sectors where FFO remains below pre-COVID levels there has been dramatic improvement from the COVID trough. Office FFO, for example, is now down just 3 percent from the pre-COVID peak.
WMRE: What should REIT investors be looking at during the second half of 2022?
John Worth: We are in a period of transition. If we think about commercial real estate and where we are, transaction volume has fallen dramatically. We don’t have buyers and sellers on the same page in terms of pricing in a new higher rate regime. What we’re going to see over time is a new equilibrium in cap rates that will be higher. We are not sure they will be so high as to maintain the current level of spread between treasury rates and cap rates. But our expectation is that we will see cap rates rise and see pricing that integrates the current rates and is also pessimistic in terms of economic growth.
That said, this is where the work that REITs have done to increase their resilience, to improve their balance sheets over time, to lower leverage, to lower interest expenses as a percent of NOI and to build business models can really pay off. The consensus of whether we will see a recession in next 12 months has risen to the high 30-percent range. The forecast for GDP is being trimmed meaningfully for the rest of 2022 and into 2023. And while I am a little more optimistic than the consensus, even in a slow growth environment, REITs are set up to find meaningful opportunities that other participants can’t take advantage of.
WMRE: Are there are other features of the current environment that you want to highlight?
Jon Worth: If you look at historical offerings, REITs going to capital markets has really declined in 2022. Total equity and debt capital raised through June 30 was just $39 billion. We’ve seen drops across IPOs, equity issuances and debt issuances. And the second quarter was a particularly low level of issuance. That indicates the degree to which REITs have managed their balance sheets so they can go to capital markets when it’s opportune at a time and a place of their choosing. That’s because they’ve reduced leverage so dramatically and termed out the debt they hold. So they have not been forced to issue new equity or debt while share prices are off. They’ve had the flexibility to have a wait and see moment and see where markets and pricing are going to land.
WMRE: In talking with fund managers that invest in REITs, are there any areas of concern or themes that have come up in recent months?
John Worth: Their focus is in trying to understand what sectors are going to be the best performers and most resilient in a period of slower growth. In June some sectors that were hardest hit included office, lodging, timber, which are sectors that are very pro-cyclical. There’s a lot of attention being paid to different attributes of different sectors and how they are going to react to economic conditions.