As private real estate sells off, our conviction in REITs grows

As private real estate sells off, our conviction in REITs grows

Rich Hill

Rich Hill

Head of Real Estate Strategy & Research

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24 minute read

June 2023

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Recent market events, including a downturn in private real estate, give us greater conviction in our analysis showing favorable entry points emerging for global listed REITs.

KEY TAKEAWAYS

  • REIT fundamentals are on strong footing. We believe recessions create strong entry points for listed REITs, and our analysis shows the best entry points have historically been during early-cycle recoveries.
  • The U.S. Federal Reserve and some other central banks are expected to stop hiking interest rates sooner rather than later. This is typically a good environment for listed REITs, which have historically delivered above-average returns after the end of rate-hiking cycles.
  • For just the third time in history, the U.S. has seen consecutive significant quarterly declines in private real estate. Meanwhile, the performance gap between European private and listed real estate has narrowed. We believe this is a contrarian signal that listed REITs are likely to rebound.

Three factors that suggest an attractive entry point

Late last year, we wrote a report arguing why we see favorable entry points emerging for listed REITs. Recent market developments give us further conviction in this view.

Three key factors underscore our prior analysis, which we review and update below.

First, we continue to believe that commercial real estate fundamentals are on strong footing. Consider that listed REITs generated same-store net operating income (NOI) growth of 7.2% in 1Q23, compared with the historical average since 2000 of 2.4%. Fourth-quarter rolling NOI growth stood at 7.4%, compared with an average of 2.7% (since 1983), according to NCREIF.

Listed REIT fundamentals are decelerating but will remain resilient. In fact, we have lowered our growth expectations amid the slowing economic backdrop (Exhibit 1). But REITs have entered the economic slowdown in relatively healthy positions due to favorable supply-demand dynamics amid tight supply. Listed REIT earnings have historically been stable, particularly compared with equities, due to their in-place leases, limited supply and high operating margins.

EXHIBIT 1
Cash flow growth for REITs have been strong and should remain resilient

Global REITs(a) cash flow growth estimates (%)

Cash flow growth for REITs have been strong and should remain resilient

Second, we believe that recessions create strong entry points for listed REITs. We have seen historical returns in recessionary periods (on a next-12-month basis) of greater than 10% for U.S. and more than 14% for European listed REITs (Exhibit 2). However, the best entry points for REITs have come early cycle, when next-12-month returns have historically been around 20% for both U.S. and European REITs. By comparison, U.S. listed REITs have declined 0.2% and European listed REITs have returned 7.2% on a next-12-month basis after late cycle periods, leading into recessions.

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EXHIBIT 2
Recessions create potential entry points

Average 12-month forward total returns based on U.S. conference board indicator(a)
January 2000–December 2022

Recessions create potential entry points

Average 12-month forward total returns based on Euro Area business cycle indicator(e)

January 2000–December 2022

Recessions create potential entry points

Third, we believe that we are transitioning from a stagflationary environment to a stagnationary environment, which has historically been more accommodative for REITs. With inflation backing off, we believe the Federal Reserve will stop hiking interest rates sooner rather than later. Inflation is higher and more persistent in Europe and many other global markets, but the Fed is typically a leading indicator for central bank actions in international markets.

And the end of a rate-hike cycle is typically a very good environment for listed REITs. In fact, U.S. listed REITs have historically produced returns above 15% over the six months following the end of a Fed hiking cycle (Exhibit 3). That’s also important for global listed REITs, not only because the U.S. is typically a leading indicator for international markets, but also because U.S. REITs compose nearly two-thirds of global REIT assets under management.

EXHIBIT 3
On average, listed REITs have historically outperformed broader equities following hikes to the federal funds rate

Average returns during hiking period cycles(a)

On average, listed REITs have historically outperformed broader equities following hikes to the federal funds rate

At March 31, 2023. Source: Cohen & Steers calculations, Bloomberg, and Federal Reserve.

Lead/lag in listed and private real estate may signal near-term listed REIT outperformance

There are additional market developments that we believe are important to understand.

First and foremost, we have long argued that listed REITs are a leading indicator for the private market. Recent market activity supports this view: We have seen the spread between listed and private real estate returns, both in the U.S. (Exhibit 4A) and in Europe (Exhibit 4B), narrowing from the significant divergence the two asset classes had in 2022.

EXHIBIT 4A
We believe further declines in private real estate are likely over the next 18 months as the spread narrows
We believe further declines in private real estate are likely over the next 18 months as the spread narrows
EXHIBIT 4B
We believe further declines in private real estate are likely over the next 18 months as the spread narrows
We have long argued that listed REITs are a leading indicator for the private market.

In the U.S., listed REITs were up for each of the last two quarters (4Q22 and 1Q23), while the NCREIF ODCE index, a widely followed index of open-ended funds that own core assets, was down over the same periods.

Indeed, over the two quarters, U.S. REITs outperformed the ODCE index by more than 10 percentage points. This is especially noteworthy because private U.S. CRE valuations have declined for two consecutive quarters (or more) only twice before—in 4Q90–4Q92 and in 3Q08–4Q09. We see this occurrence as a contrarian “buy” signal for REITs. And if listed REITs lead private valuations on the way down, we expect them to do so on the way up as well.

It’s not just the timing of the ODCE index decline that’s significant; it’s also the magnitude. The 4Q22 return of around –5% was the fifth-greatest quarterly decline since 1978. The return in 1Q23 of around –3% was the eighth-greatest decline since 1978 (Exhibit 5).

EXHIBIT 5
Listed real estate has delivered attractive total returns following declines in private real estate

Top private real estate quarterly declines since 1978(a)

Listed real estate has delivered attractive total returns following declines in private real estate

Our analysis of the previous 10 largest declines in the NCREIF ODCE index shows that U.S. listed REITs have never been down on a next-12-month basis after those drops; they’ve been up anywhere from 15% to more than 100%. We don’t believe it is reasonable to expect returns in the higher end of this range, but we do believe this is a strong market signal that we may be at an attractive entry point for REITs.

We see a somewhat similar dynamic playing out in Europe, where the INREV index (from the European Association for Investors in Non-Listed Real Estate Vehicles) has posted negative total returns for three consecutive quarters (–1.3% in 3Q22, –6.2% in 4Q22 and –1.0% in 1Q23). These were the first negative quarterly returns for European private real estate since a small decline during the height of the pandemic (–0.6% in 4Q20) (Exhibit 6).

EXHIBIT 6
European private real estate returns turn negative

INREV Index total Return

European private real estate returns turn negative

By comparison, European listed REITs, as measured by the FTSE EPRA Nareit Developed Europe Index, are potentially showing signs of bottoming. After dropping significantly to start 2022 (–7.2% in 1Q, –28.2% in 2Q and –21.6% in 3Q), European REITs rebounded in 4Q of last year, returning 14.4% before then dropping moderately in 1Q of this year (–2.9%).

Following this period of repricing, we believe listed REIT valuations look attractive relative to history (Exhibit 7), and discounted valuations have historically marked favorable entry points. In particular, we believe European listed REITs, which have lagged their U.S. peers in recent performance, offer attractive upside potential, while we see opportunities in Asia Pacific from reopenings and China’s supportive monetary policy stance.

EXHIBIT 7
REIT valuations appear attractive, though selectivity remains key

Premium/discount to NAV by region(a)

REIT valuations appear attractive, though selectivity remains key

Common concerns about REITs may be misplaced

Yet investors might be wondering: If this is such an attractive environment, why are listed REITs underperforming the S&P 500 so far this year? For one, we believe the recent banking headlines have created concerns that are weighing on listed REITs.

In particular, there is now increased focus on tightening lending conditions, especially in the office sector. However, contrary to common misconception, office exposure within listed REITs is less than 3.5% of the index’s market cap.

Further, there is a view that commercial real estate is a highly levered asset class. In the case of REITs, this simply isn’t true. On average, REITs have leverage less than 35%, and 86% of their debt is fixed (for an average term of around six years).

These attributes, which appear not to be well understood among the general investor population, may help insulate listed REITs against looming market pressures as growth slows and lending conditions tighten.

Finally, we challenge the comparison with the S&P 500 for one primary reason: The S&P 500 is no longer a diversified index. The majority of YTD gains in the index have been driven by a small subset of stocks; in contrast, the U.S. listed REIT universe comprises 18 different subsectors and is therefore much more diverse, with different characteristics and market dynamics. As of the end of May, the MSCI US REIT Index was just -0.5% below the equal-weighted S&P 500 index, with several subsectors producing meaningfully higher returns, including single-family rentals, data centers, and industrial.

Is the stage set for a REIT rebound?

We don’t claim to be market timers. But when uncertainty abounds in markets, as it does today, we believe that often indicates an environment in which strong returns can be generated over the medium term.

Given continued healthy listed REIT fundamentals and our view of the signals that the private CRE market is now sending, we do believe historical precedent points to the possibility of a strong rebound for the asset class— lending further conviction to our assessment that 2023 may be a favorable entry point.

ABOUT THE AUTHORS
Author Profile Picture

Rich Hill, Senior Vice President, is Head of Real Estate Strategy & Research, responsible for identifying allocation opportunities in both listed and private real estate and related thematic and strategic research.

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