LAND - Rates Down REITs Up

2023-11-29 09:00:00 ET

Summary

• Rates down, REITs up? Two years of persistent rate-driven pressure on residential and commercial real estate markets appears to finally be abating as the worst of pandemic-era inflationary pressures subside.
• This 'light-at-the-end-of-the-tunnel' comes as commercial property values were approaching the critical 20% drawdown level, a level that can result in cascading distress that extends beyond the weakest players.
• Not out of the woods, yet. Expectations of "Higher for Longer" are merely shifting to "High for Long" in which benchmark rates will remain materially above pre-pandemic levels into 2025.
• The 'unwind' is just beginning for the "Zero-Rate Heroes." The business models of many private equity funds and non-traded REITs are contingent on cheap and plentiful debt, which counteracted the drag from higher fees, inefficient structure, and often poor governance.
• Macroeconomic conditions are aligning in an ideal manner for low-levered entities with access to "nimble" equity capital - conditions that maximize the true competitive advantage of the public REIT model, which these entities have been unable to exploit in the "lower forever" environment.

State of the REIT Nation

In our quarterly State of the REIT Nation , we analyze the recently-released NAREIT T-Tracker data. Last week, we published our REIT Earnings Recap which analyzed Q3 results on a company-by-company level, but this report will focus on higher-level macro themes affecting the REIT sector at large.

Rates down, REITs up? Two years of persistent rate-driven pressure on the residential and commercial real estate market appears to finally be abating as the worst of pandemic-era inflationary pressures subside. Commercial and residential real estate markets have been an easy transmission mechanism - or "punching bag" - of the Federal Reserve's historically swift monetary tightening cycle, which resulted in the largest increase in the Federal Funds rate in any two-year period since 1981 on an absolute basis and the single-most significant increase on a percentage basis. Concern about real estate is warranted given that the two prior rate hike cycles that exceeded 400 basis points - the late 1980s cycle that sparked the Savings & Loan Crisis and the mid-2000s cycle that sparked the Great Financial Crisis - resulted in significant distress and disruption within in the real estate industry. This concern has resulted in a nearly one-to-one correlation between REIT valuations and benchmark long-term interest rates, and has resulted in a roughly 20 percentage-point underperformance from the Vanguard Real Estate ETF compared to the S&P 500 since the rate hike cycle began.

This 'light at the end of the tunnel' comes as commercial property values were approaching the critical 20% drawdown level - a level that can result in cascading distress that extends beyond the weakest players. The business models of many private equity funds and non-traded REITs were not simply designed for a period of sustained 4%+ benchmark rates, nor for a period of double-digit percentage point declines in property values. Green Street Advisors' data shows that private-market values of commercial real estate properties have dipped over 19% from the peaks last April and have now given back all of their pandemic-era gains. By comparison, the peak-to-trough drawdown in this valuation index during the Great Financial Crisis was 30%. We've noted that the 20-25% drawdown level is a critical "capitulation threshold" - a level that matches the maximum Loan-to-Value ("LTV") ratio accepted by conventional commercial real estate lenders. Far more than the prior crisis, however, we've seen a greater divergence between property sectors over the past several quarters, with office valuations now about 30% below 2019 levels, which has sparked a wave of office loan defaults.

On that point, it's critical to stress that this valuation pressure - and the pockets of distress that have become more visible in recent months - remain almost entirely interest-rate-driven (with the notable exception of the office sector). Property-level fundamentals remain solid-to-strong across nearly every property sector, with the notable exception of coastal office properties and some sub-segments of healthcare. Public REITs reported that "same-store" property-level income, on average, was 11% above pre-pandemic levels in the third quarter. The residential, industrial, and technology sectors have been the upside standouts throughout the pandemic with most of these REITs reporting NOI levels that are over 20% above 2019 levels. Even the battered office REIT sector has posted positive 10% growth in property-level cash flows since 2019 as tenants in long-term leases continue to pay rents. Retail REITs - which had seen sharp declines in property-level cash flows early in the pandemic due to missed rent payments - have posted some of the more impressive property-level performance in recent quarters, while Senior Housing REITs have also enjoyed a swift NOI rebound this year.

Of course, the interest rate headwinds become very "real" when the underlying properties are financed with debt - particularly copious amounts of variable rate debt. With the scars of the Great Financial Crisis still visible, most public REITs were "preparing for winter" for the last decade, often to the frustration of some investors who turned to higher-leveraged and riskier alternatives in recent years. Private market players and non-traded REIT platforms were willing to take on more leverage and finance operations with short-term and variable-rate debt - a strategy that worked well in a near-zero rate environment but quickly crumbles when financing costs double or triple in a matter of months. Nareit reported earlier this year that nearly 50% of private real estate debt is priced based on variable rates compared to under 10% for public REITs. We've observed significant pain inflicted on the handful of public REITs that entered this period with variable rate debt loads in the 20-30% range - still relatively low compared to typical private equity firms - resulting in double-digit percentage point drags on Funds from Operations ("FFO").

Access to long-term debt is perhaps the most distinct competitive advantage of the public REIT model, but it's an advantage that hardly gave public REITs much of an edge when debt capital was cheap and plentiful in the "zero-rate" economic environment of the 2010s. Compared to private institutions, publicly-traded REITs had far greater access to fixed-rate unsecured debt - which is usually in the form of 5-10 year corporate bonds. This allowed REITs to lock-in these fixed rates on 90% of their debt while simultaneously pushing their average debt maturity to nearly 7 years, on average, thus avoiding the need to refinance during these highly unfavorable market conditions. Even with the significant pullback in financing activity in recent months, the average term-to-maturity for public REITs is still over 6 years - well above the pre-GFC highs of around 4 years - and significantly above the weighted average term-to-maturity of around 3 years for private real estate assets. Hence, for many of the highly-levered players that lacked access to long-term capital, the trends observed in the chart below are magnified by a factor of 2-3x.

"Hope" has been the only strategy for many highly-levered property owners amid a dearth of buying interest and limited capital availability - "hope" that interest rates recede before their "debt clock" expires. The Mortgage Bankers Association's 2022 Loan Maturity Survey showed that roughly a third of commercial mortgages mature by the end of 2024 - a relatively manageable sum for the broader real estate sector - but the clock is ticking ever louder for the firms sitting on a significant pool of variable rate debt, and it's beginning to show-up in delinquency rates. Trepp reported this month that the overall commercial real estate delinquency rate rose to 4.64% - up 50% from last year to the highest level since December 2021. Office delinquencies have accounted for the vast majority of this increase, however, surging nearly 3x from a year ago to 5.75% from the record-lows last year of 1.75%. Apartments are the only other sector that has seen a material increase in delinquency rates, a direct result of the high variable rate debt utilization rate given its relative ownership skew towards smaller "mom and pop" investors.

Distress for some is an opportunity for others, and we're beginning to see the public REITs with balance sheet firepower start to take advantage of capitulation from highly-levered players - a trend that will gather steam if debt markets remain tight. There's been no better example of these trends than Blackstone's flagship fund, BREIT, which has been forced to offload its best-performing assets this year as it seeks to raise capital to meet investor redemptions while simultaneously seeking to avoid a "mark-to-market" on many of its other assets - including five public equity REITs - that it acquired for significant premiums at the peak of the market in 2021. Since last December, BREIT has sold nearly $10B in assets to public REITs including its $5.5B sale of two Las Vegas casinos to VICI Properties (VICI), an $800M sale of a Texas resort to Ryman Hospitality (RHP), a $2.2B sale of Simply Self-Storage to Public Storage, and a $950M partial sale of The Bellagio casino to Realty Income (O). Of note, these deals have closed within four weeks, on average, a remarkably swift transaction timeline that few other entities besides public REITs could pull-off. This trickle of deal flow into public REITs should continue if benchmark interest rates remain elevated, but would accelerate significantly if public REIT valuations rebound while debt availability remained limited.

Concurrently, we've seen a revival of M&A activity from within the public REIT sector itself, with a record-setting pace of ten public REIT-to-REIT mergers thus far this year. Over the past month, we've seen two additional large-scale mergers, with net lease REIT Realty Income acquiring Spirit Realty , and healthcare REIT Healthpeak (PEAK) acquiring Physicians Realty (DOC). This pair of mergers follows a handful of significant mergers earlier this year, the largest of which was the deal between Extra Space (EXR) and Life Storage , which combined to form the largest storage REIT. We've seen two mergers in the strip center space: Regency Centers (REG) closed on a deal to acquire Urstadt Biddle (UBA), while Kimco Realty (KIM) announced in August that it would acquire RPT Realty (RPT). Other 'opportunistic' deals in the REIT space have included mortgage REIT Ready Capital's (RC) acquisition of Broadmark and Ellington Financial's (EFC) acquisition of Arlington Asset (AAIC). We've also seen a pair of mergers that are done more out of necessity rather than from a position of strength, including the merger between Necessity Retail (RTL) and Global Net Lease (GNL) - a pair of externally-managed REITs advised by AR Global.

Bottom line - macroeconomic conditions are aligning in an ideal manner for low-levered entities with access to "nimble" equity capital - conditions that maximize the true competitive advantage of the public REIT model, which these entities have been unable to exploit in the "lower forever" environment. And while past periods of significant tightening were remembered as those of distress, they can rightfully also be remembered as periods of a significant revolution and rebirth that spanned many of the public REITs that exist today. The S&L Crisis of the late 1980s - which resulted in the failure of nearly a third of community banks and resulted in significantly constrained access to debt capital - spawned the dawn of the 'Modern REIT Era.' A second wave of REIT IPOs followed in the aftermath of 9/11 and again after the Great Financial Crisis as the limited access to (and high cost of) debt capital, combined with a lift in equity market valuations of public REITs - pushed otherwise distressed highly-levered private portfolios into the public equity markets, a theme that we could very well see repeat over the coming quarters. On cue, Bloomberg reported this week that Lineage Logistics - one of the largest cold-storage logistics property owners - is considering an IPO next year at a valuation of more than $30B. Lineage operators over 400 cold-storage units in North America and Europe, and competes with Americold Realty Trust ( COLD ), which has more than 240 facilities.

Deeper Dive: REIT Balance Sheets

The ability to avoid "forced" capital raising events has been the cornerstone of REIT balance sheet management since the GFC - a time in which many REITs were forced to raise equity through secondary offerings at "firesale" valuations just to keep the lights on, resulting in substantial shareholder dilution which ultimately led to a "lost decade" for REITs. While REITs entered this tightening period on very solid footing with deeper access to capital, the same can't necessarily be said about many private market players that rely on the short-term borrowing or continuous equity inflows to keep the wheels spinning. Much the opposite of their role during the Great Financial Crisis, many well-capitalized REITs are equipped to "play offense" and take advantage of compelling acquisition opportunities if we do indeed see further distress in private markets from higher rates and tighter credit conditions.

S&P reported last week that REIT capital-raising activity is trending at levels that are about 10% above 2022 levels, but still 40% below the record-setting pace from 2021. REITs have collectively raised a year-to-date total of $56 billion, the majority of which has been through debt offerings, which have accounted for roughly 80% of the total capital raised this year - well above the historical average of around 50%. The single largest common equity offering this year have come via Welltower's (WELL) at-the-market offering program, which has raised $3.6B in new equity this year - accounting for roughly a third of the total equity capital raised in the REIT sector this year. American Tower (AMT) has raised the most capital year to date at $7.0B through a series of debt offerings, followed by industrial REIT Prologis (PLD) at $5.4B. Uniti Group's (UNIT) $2.6B bond offering is the largest debt offering of the year. We've seen a small handful of preferred equity offerings this year: Bluerock Homes (BHM) issued $500M of unlisted Series A preferred stock, while Gladstone Land (LAND) issued $200M of new Series C preferred stock.

Even as benchmark interest rates doubled from a year earlier and even with market values of REITs lower by 20-30% during that time, REITs balance sheets remain very healthy by historical standards, merely giving back the incremental pandemic-era improvement. Debt as a percent of Enterprise Value still accounts for less than 35% of the REITs' capital stack, down from an average of roughly 45% in the pre-recession period - and substantially below the 60-80% Loan-to-Value ratios that are typical in the private commercial real estate space. Interest coverage ratios (calculated by dividing EBITDA over interest expense) have seen a shaper erosion over the past several quarters from its all-time highs set last year, but still stands at 4.54x, which roughly matches the coverage ratio at the end of 2019 and compares very favorably to the 2.75x average in the three years before the Great Financial Crisis.

Credit quality is even stronger on the residential-side. Owing to years of tight mortgage lending conditions and a generally slow post-recession recovery in homeownership, the residential real estate market has undergone a period of significant deleveraging over the last decade. At of the end of Q3, the mortgage debt service payment ratio as a percent of disposable income remained near the lowest level on record at 3.99%. By comparison, this level was at 7.13% in Q4 2007 before the GFC recession. Importantly, subprime loans and adjustable-rate mortgages - the dynamite that led to a cascading financial market collapse in 2008 - have been essentially non-existent throughout this cycle. Adjustable-rate mortgages - which would be most "at-risk" from the surge in rates have accounted for less than 5% of mortgages originated since 2009, down from nearly 30% at the peak in 2005.

That said - not all REITs are created equal, and the broad-based sector average does mask some of the intensifying issues in several of the more at-risk sectors and among REITs that have been more aggressive in their balance sheet management. A handful of small and mid-cap REITs - some of which would be considered as having a rather strong balance sheet relative to similar private equity portfolios - have incurred significant charges to "fix" their floating rate debt exposure, while others have continued to roll the dice by maintaining a sizable chunk of variable rate debt. The BofA BBB US Corporate Index Effective Yield - a proxy for the incremental cost of real estate debt capital - has surged from as low as 2.20% in late 2021 to as high as 6.67% at the October peak and now sits at 6.01%. On a percentage basis, this represents a nearly 200% increase in interest costs on variable rate debt. The cost of equity - which we compute based on average FFO yields - is now 7.9% for the average REIT, up from a low of 4.4% last year.

Deeper Dive: REIT Fundamentals

As noted, the pockets of distress are almost entirely debt-driven, as nearly every property sector reported "same-store" property-level income above pre-pandemic levels. REIT company-level metrics have tracked this rebound in property-level performance relatively closely throughout the pandemic - with the exception of the highly-levered REITs that expect sharp FFO declines this year even as property-level cash flows continue to increase. REIT FFO ("Funds From Operations") has fully recovered the sharp declines from early in the pandemic and in the third quarter, FFO was 25% above its 4Q19 pre-pandemic level on an absolute basis, and roughly 18% above pre-pandemic levels on a per-share basis. Same-store Net Operating Income, meanwhile, was roughly 11% above the pre-pandemic level in the third quarter.

Powered by more than 120 REIT dividend hikes in both 2021 and 2022 - and another 70 dividend hikes so far in 2023 - dividends per share have finally fully recovered from the wave of pandemic-era dividend cuts in 2020. With FFO growth significantly outpacing dividend growth since the start of the pandemic, REIT dividend payout ratios remained at just 66% in Q3 - its second-lowest level ever and well below the 20-year average of 80%. With a historically low dividend payout ratio, the average REIT has built up a significant buffer to protect current payout levels if macroeconomic conditions take an unfavorable turn. As always, the sector average does mask some elevated payout ratios across several sectors: Mortgage REITs currently pay out about 95-100% of EPS, on average, while Cannabis REIT payout ratios are also elevated. Other higher-risk sectors have built up a decent buffer as office REITs pay just 70% of FFO while hotel REITs pay less than 40%.

After recording the largest year-over-year decline on record in 2020 which dragged the sector-wide occupancy rate to 89.8%, REIT occupancy rates have rebounded since mid-2020 back to 933% - towards the upper-end of its 20-year average. By comparison, occupancy levels dipped as low as 88% during the Financial Crisis and took three years to recover back above 90%. Residential and industrial REITs have continued to report near-record-high occupancy rates in recent quarters while retail REITs noted a solid sequential improvement as the "retail apocalypse" trends subside. Office REIT occupancy, however, has seen substantial declines since the start of 2020 and remained 400 basis points below pre-pandemic levels at 88.3% in the third quarter.

Deeper Dive: REIT Valuations & Growth

The extended sell-off from late-2021 through late-2023 - combined with the nearly 20% increase in FFO during this time - has pulled REIT valuations to the lowest level since the end of the Great Financial Crisis. Equity REITs currently trade at an average forward Price/FFO multiple of around 15x using a market-cap weighted average. The market-cap-weighted average, however, is somewhat distorted by the massive weight of richly-valued technology REITs, and on an equal-weight basis, REITs trade at a 13x median P/FFO multiple, which is near the lowest levels since the early 2000s. The average REIT also trades at an estimated 20% discount to its Net Asset Value, as implied by current private market valuations. Equity REITs pays a dividend yield of 4.0% on a market-cap-weighted basis, but this dividend yield climbs to over 5.5% on an equal-weight basis, and roughly 8.0% when including mortgage REITs.

Equity valuations can and do play an important role in the ability of REITs to grow accretively, given the usage of secondary equity offerings to fund major acquisitions. So naturally, REITs have "hunkered down" in recent quarters as stock price valuations remain low by historical standards and in relation to private market-implied valuations. REIT external growth comes in two forms – buying and building. Acquisitions have historically been a key component of FFO/share growth, accounting for more than half of the REIT sector's FFO growth over the past three decades with the balance coming from "organic" same-store growth and through ground-up development and redevelopment. With a historically large "bid-ask" spread for private real estate assets, REITs have slowed their acquisitions over the past several quarters with gross purchases of $35B in over the past six months - the lowest six-month volume since 2010 - but as noted above, we believe that opportunities should emerge if debt markets remain tight if and when public REIT stock prices rebound.

Nearly all of the M&A activity this year has been through the dozen REIT-to-REIT mergers discussed above - a total sum that is somewhat distorted by the sizable merger between Extra Space and Life Storage. At the property-sector level, net lease, industrial, and casino REITs have been far-and-away the most active acquirers of private market assets in recent quarters - accounting for more than half of total net purchases across the REIT industry - with some taking a surprising "business as usual" approach to external growth despite the shifting interest rate environment. We noted in our Earnings Recap that net lease REITs reported an average increase in acquisition cap rates of only around 100 basis points between Q4 2021 and Q3 2023, during which time the benchmark 10-Year Treasury Yield increased by roughly 230 basis points. Most other REIT sectors have been more reluctant to "hit the bid" on slow-to-adjust private market valuations. Data Centers and Office REITs have been the most significant "net sellers" over the past year.

REITs have become some of the most active builders in the country over the past decade and - despite the pressure from higher rates - REITs expanded their pipeline throughout 2022 to levels that exceeded the prior record set just before the pandemic, but new groundbreaking have been few-and-far-between over the past quarter given the unfavorable rate environment. Much of this expansion has been fueled by three property sectors - data center, self-storage, and industrial - which have expanded their pipelines by 123%, 37%, and 25%, respectively, since the end of 2019 - and some of this inflated pipeline is the result of higher construction costs and lingering supply chain delays that prolong the development timeline. Retail REITs, on the other hand, have engaged in minimal development activity over the past several years - which has fueled the recent occupancy increases - while the pipeline in residential, office, and healthcare REITs is roughly even with 2019-levels.

Takeaways: Patience Will Be Rewarded

Two years of persistent rate-driven pressure on the residential and commercial real estate market appears to finally be abating as the worst of pandemic-era inflationary pressures subside. This 'light at the end of the tunnel' comes as commercial property values were approaching the critical 20% drawdown level - a level that can result in cascading distress that extends beyond the weakest players. But we're not out of the woods, yet: Expectations of "Higher for Longer" are merely shifting to "High for Long" in which benchmark rates will likely remain materially above pre-pandemic levels into 2025. The 'unwind' is just beginning for the "Zero-Rate Heroes." The business models of many private equity funds and non-traded REITs are contingent on cheap and plentiful debt, which counteracted the drag from higher fees, inefficient structure, and often poor governance. Macroeconomic conditions are aligning in an ideal manner for low-levered entities with access to "nimble" equity capital - conditions that maximize the true competitive advantage of the public REIT model, which these entities have been unable to exploit in the "lower forever" environment.

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Disclosure : Hoya Capital Real Estate advises two Exchange-Traded Funds listed on the NYSE. In addition to any long positions listed below, Hoya Capital is long all components in the Hoya Capital Housing 100 Index and in the Hoya Capital High Dividend Yield Index . Index definitions and a complete list of holdings are available on our website.

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