Putting the recent selloff in U.S. listed REITs into perspective

Putting the recent selloff in U.S. listed REITs into perspective

10 minute read

October 2023

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We’ve argued over the course of this year that markets presented attractive entry points for listed real estate. Recent declines in listed REIT valuations, driven by macroeconomic uncertainty, do not alter this view.

In fact, the tenets of our view on listed real estate remain intact. They are:

  • REIT fundamentals are on strong footing, with same-store net operating income growth of 5% in the second quarter, compared to the average since 2000 of 2.5%.
  • 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 in the near term. This is typically a good environment for listed REITs, which have historically delivered above-average returns after the end of rate-hiking cycles.
  • While past performance does not predict future results, private real estate property prices continue to decline, and we believe this is a contrarian signal that listed REITs are likely to generate positive returns over the next twelve months.

(You can read our analysis on listed REIT entry points, which was published this summer.)

Yet recent listed REIT performance deserves a closer look, and the September decline should be put into perspective.

U.S. listed REITs sold off 7.0% in September; as of the end of the third quarter, they were down 11.7% from their July peak (Exhibit 1). September was the worst month of the year and represents the third-worst September monthly performance since 1995. Listed REITs sold off -3.1% in October, driven by a combination of seasonal weakness that is exacerbated by macro uncertainty. This follows declines of -7.0% in September and -3.3% in August. The asset class is down -14.5% from its July peaks and stands 31.4% below the highs observed at the end of 2021.

EXHIBIT 1
Adjustment to higher for longer rates drove REIT decline in August, September and October

Listed REIT monthly and cumulative returns YTD

Adjustment to higher for longer rates drove REIT decline in August, September and October

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The primary driver of the decline was the Fed messaging that interest rates would remain higher for longer. The Fed raised the projection of its policy rate by 50 bp at each interval through 2026, and it does not anticipate the federal funds rate to fall below 3.0% over that horizon. Without formally doing so, regulators gave investors license to infer 3.0% as the new nominal neutral rate, up from 2.5% last cycle. In the view of Cohen & Steers macro strategist John Muth, that point was the key takeaway from the September FOMC meeting and explains the subsequent selloff in risk assets.

Indeed, real rates rose to as high as 2.3% on September 27 before ending September at 2.2%—representing a 36 bp month-over-month increase. This is the first time real rates have closed above 2% since March 11, 2009, and they reached their highest level since January 5 of that year. Credit spreads, on the other hand, were more resilient, with investment-grade bond spreads modestly widening by 3 bp month-over-month to 121 bp and REIT debt spreads widening 2 bp to 157 bp. Real rates now stand at their highest levels since late November 2008, ending October at 2.5%, while credit spreads widened further.

Bottom line: The markets are returning to an “old normal” of higher rates and higher inflation. These transitions are often hard, especially given the unprecedented amount of central bank intervention that drove markets over the past decade plus. However, with valuations back to levels last seen 7–10 years ago, the sector is screening as attractive, in our view.

While the “higher for longer” messaging was the key factor in recent listed REIT performance, it is important to remember that August, September and October are historically weak periods of the year for listed real estate (Exhibit 2). Average monthly returns since 1995, as measured by the FTSE Nareit All Equity REITs index, have been 0.2%, –0.4% and –0.1%, respectively, while median monthly returns have been 0.1%, –0.1% and –0.1%. Recent years have been particularly bad, with September 2022 returning –12.7% and September 2021 returning –5.9%—the latter noteworthy, given that 2021 was the best full year on record for listed real estate (with full-year returns of 41%).

Coming off such weak months seasonally, returns have historically rebounded in November and December, when historical average monthly returns have been 1.0% and 3.0%, respectively (with median returns of 2% for both November and December). Following September weakness in the past two years, returns over the final three months were 4% in 2022 and 16% in 2021.

EXHIBIT 2
Seasonal weakness historically precedes higher returns at year-end

Avg. Monthly Return

Seasonal weakness historically precedes higher returns at year-end

There are other signposts we are watching that indicate potential strong entry points for listed real estate.

  • Listed REIT returns were negative in 3Q23 at –8.3%. This ends a three-quarter streak in which listed returns were positive and private valuations were down. We’ve previously argued that declines in the NCREIF ODCE index were signaling an attractive entry point for listed REITs, and recent swings in valuations do not alter this view. In fact, history suggests that simultaneous declines in the ODCE and listed REIT indices are not a negative signal. This has occurred in three quarters before (2Q93, 4Q08 and 1Q09), and in each case, next-twelve-month returns for listed REITs were positive. The key signal remains the ODCE index decline, in our view.
  • U.S. listed REITs trade at an approximate 6.25% implied cap rate, as of October 31, versus the historical average since 2010 of 5.7% (ranging from a max of 6.6% to a min of 4.5%). As a result, we believe U.S. listed REITs look to be on the cheap side of fair value. Unlevered IRRs of 8.6% and levered IRRs of 10.4%, also as of October 31, further support this view (Exhibit 3).
  • The “funds available for distribution” (FAD) multiple has declined to 18.1x. This is the lowest level since 2Q15, and it compares favorably to a quarterly average since the beginning of 2011 of 20.4x (ranging from 17.8x to 28.6x) (Exhibit 3).
EXHIBIT 3
Implied cap rates, FAD multiple indicate potential entry points
Implied cap rates, FAD multiple indicate potential entry points

FURTHER READING

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