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

Transcript

Hi, late last year, we wrote a report saying that it was an attractive entry point for REITs. Four key points underscored our views.

First, we argued that commercial real estate fundamentals were on strong footing.

Second, we believe that recessions create strong entry points for REITs with historical returns on a next 12-month basis of greater than 10%. And in fact, the best entry points historically for REITs come early cycle when they produce more than 20% next-12-month returns. So those are the first two points.

The third point is that we believe that we are transitioning from a stagflationary environment to a stagnationary environment, which is usually much more accommodative for REITs historically.

Why do we think that’s occurring? Well, the Fed’s medicine is beginning to work. And as the Fed’s medicine begins to work, we believe that the Fed will stop hiking interest rates sooner rather than later. And that is typically a very good environment for REITs where they produced plus-15% returns over the next six months following the end of a Fed hike. We believe all of those factors are very much still in place, increasing our conviction.

However, there’s a couple other things that have occurred as well, that we think are important to understand. First and foremost, we have long argued that listed REITs are a leading indicator for the private market. What’s played out over the past two quarters is very textbook, especially that listed REITS are up for the past two quarters in 4Q22 and 1Q23, while the NCREIF ODCE index, which is widely followed index of open-ended mutual funds that own core assets, is actually down over the prior two quarters.

So net net, listed REITS have outperformed the NCREIF ODCE index by more than 10 percentage points. That’s a big move. And mind you, for REITs being up for two quarters and the NCREIF ODCE index being down for two quarters that typically doesn’t occur.

But it’s just not the timing of these changes, it’s the magnitude of these changes as well. The decline in the NCREIF ODCE index in 4Q22 of around 5% or so was actually the fifth greatest decline since 1978. The decline in 1Q23 of around 3% or so was the eighth greatest decline since 1978.

Why do I say this? Well, if we look at the prior 10 greatest declines in the NCREIF ODCE index, REITs have actually never been down on a next 12-month basis. They’ve been up from 15% at a minimum to more than 100% as a maximum. I don’t think they’re going to be 100% this time, but we do think that REITs providing an attractive entry point while listed is down is an important tell that the market is signaling right now.

So it begs the question, why are REITs underperforming the S&P 500 if this is such an attractive environment? We think a lot has changed since banking headlines came into view about 45, 60 days ago. What do I mean by that? Well, there’s a lot more focus on lending and tightening lending conditions, especially for office.

But we think REITS provide a unique set of circumstances that insulate them from some of these concerns. What are those concerns? Well, there is a view that commercial real estate is a highly levered asset class. That’s not true for REITs. REITs have less than 35% LTVs. They’re 86% fixed for an average term of around six years.

And what about office exposure? Well, remember office exposure as a percent of market cap for listed REITs is only around three and a half percent. So we think any weakness that comes because of concerns about lending conditions for REITs or office exposure for REITs actually leads to a buying opportunity.

So what about valuations? Well, we think REITs look attractive relative to themselves. And they look as attractive as they have to the IG corporate bond market in a long time. But we do think they still look a little expensive relative to the real estate debt markets. So one of the key catalysts we’re looking for the near term is stabilization of real estate debt markets, or maybe even tightening in real estate debt spreads. We think as this occurs, REITs will begin to rally again.