RTLPP - State Of REITs: Distress Brings Opportunity

2023-06-01 09:00:26 ET

Summary

• Rates Up, REITs Down? Whether fundamentally justified or not, commercial and residential real estate markets continue to bear the brunt of the Federal Reserve's historically swift monetary tightening cycle.
• Commercial real estate, in particular, has been the boogeyman that bank executives have blamed for unrelated distress. While there are pockets of distress, actual default rates remain historically low.
• The pockets of distress are almost entirely debt-driven, with the notable exception of coastal urban office properties. Nearly every property sector reported "same-store" property-level income above pre-pandemic levels.
• Property-level fundamentals are fine, but some balance sheets are not. Many real estate portfolios- particularly private equity funds and non-traded REITs - were not prepared for anything besides a near-zero-rate environment.
• With commercial property values now 15-20% below 2022 highs, and with interest rates doubling from last year, the tide is just beginning to recede for many highly-levered portfolios or those lacking access to capital. We're beginning to see some REITs with balance sheet firepower start to get aggressive.

State of the REIT Nation

In our quarterly State of the REIT Nation , we analyze the recently-released NAREIT T-Tracker data which focuses on higher-level macro themes affecting the REIT sector at large. This is an abridged version of the full report and rankings published on Hoya Capital Income Builder Marketplace on May 30th.

Rates Up, REITs Down. Whether fundamentally justified or not, commercial and residential real estate markets continue to bear the brunt of the Federal Reserve's historically swift monetary tightening cycle. The ongoing rate hiking cycle – which began in March 2022 – has resulted in the largest increase in the Federal Funds rate in any twelve-month 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 which 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 ( VNQ ) compared to the S&P 500 ( SPY ) since the rate hike cycle began.

While these 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.' An unfortunately timely discussion given the recent passing of Sam Zell - a titan of the U.S. real estate industry and one of the pioneers of the 'Modern REIT Era' - this IPO wave helped to transform the reputation of the public REIT industry from an 'executive-first' structure often riddled with conflicts into a far more 'shareholder-first' governance structure. 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 pushed otherwise distressed highly-levered private portfolios into the public equity markets.

It took several quarters, but private real estate markets are finally "catching up" to the reality of sharply higher interest rates - and expectations that rates may be "higher for longer" - conditions have been reflected in public real estate markets since early 2022. Green Street Advisors' data shows that private-market values of commercial real estate properties have dipped over 15% over the past year 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%. 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 mega-sized loan defaults from Pimco , Brookfield , and RXR. On the upside, residential and industrial property valuations are above 2019-levels as significant property-level Net Operating Income ("NOI") growth has more than offset the uptick in cap rates.

Is this time different? With the scars of the Great Financial Crisis still visible enough to be reminders of more dismal times, most public REITs have been "preparing for winter" for the last decade, perhaps to the frustration of some investors that turned to higher-leveraged and riskier alternatives in recent years - a theme that is certainly not unique to the real estate industry. In doing so, REITs ceded some ground to private market players and non-traded REIT platforms that 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. For many of these highly-levered players, the tide is just beginning to recede, and while many are holding on and hoping for the best, there is likely more distress to come absent a significant downturn in benchmark interest rates. Nareit reported earlier this year that nearly 50% of private real estate debt is priced based on variable rates compared to under 15% for public REITs.

Access to capital 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 have far greater access to longer-term, fixed-rate unsecured debt - which is usually in the form of 5-10 year corporate bonds. This allowed REITs to lock-in fixed rates on nearly 90% of their debt while simultaneously pushing their average debt maturity to nearly seven 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 six years - well above the pre-GFC highs of around four years - and significantly above the weighted average term-to-maturity of around three years for private real estate assets.

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 sharper erosion over the past several quarters from its all-time highs set last year, but still stands at 4.45x, 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.

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.

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. Office REITs remain in the "danger-zone" with a Total Debt Ratio above 50%, while Malls and Hotel REITs have elevated debt burdens above the 40% threshold. As noted in our Losers of REIT Earnings Season report , a significant earnings hit from soaring variable rate interest expense has been the common thread seen across many of these sectors, with a direct earnings hit amounting to 5-10% of Funds From Operations ("FFO") for 2023, and as high as 25% for a small handful of highly-levered REITs.

REITs Remain Hunkered Down, For Now

Unlike the more-highly-levered players with more-limited access to long-term debt capital, the long-term nature of REIT unsecured debt has allowed most REITs to "hunker down" during this period and hope to "wait out" the higher-rate regime and in doing so, recognize only modest increases in interest expenses - a luxury not shared by more high-levered private players. S&P Global Market Intelligence reported this week that U.S. equity REITs raised a total of $3.2 billion in April - below the $5.6 billion raised in March - and well below the $8.3 billion raised in April 2022. The offerings in April brought the year-to-date total to $19.85 billion, about 32.9% lower than the capital raised during the same period last year as REITs have significantly curtailed external growth activity since mid-2022. While we're still waiting on final numbers for this month, it's likely that the twelve-month period from May 2022 through May 2023 will be the slowest period on record for REIT capital raising.

The extended sell-off over the past four quarters has pulled REITs back into "cheap" territory as the "Rates Up, REITs Down" paradigm has weighed on valuations. Equity REITs currently trade at an average Price/FFO multiple of 15.9x 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 P/FFO multiple, which is near the lowest levels since the early 2000s. Neither debt nor equity capital is not cheap, and generally, the REITs that have been raising capital have been doing so to reduce variable-rate debt exposure.

The largest debt offering of the year has come from Uniti Group ( UNIT ), which refinanced its floating rate debt at a significant cost representing a hit to FFO of more than 20%. A handful of other small and mid-cap REITs - many of which would be considered as having a rather strong balance sheet relative to similar private equity portfolios - have incurred similar charges to fix their floating rate debt, underscoring the pain being felt by even more highly-levered portfolios. 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% last September to as high as 6.51% at the October peak and now sits at 5.75%. 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 7.6% for the average REIT, up from a low of 4.4% last year.

Real Estate Property-Level Fundamentals

Commercial real estate, in particular, has been the boogeyman that bank executives have blamed for unrelated distress. While there are pockets of distress, actual default rates remain historically low. As the Silicon Valley Bank collapse unfolded in real-time, some pundits were quick to point the finger at the banks' real estate exposure as a contributing factor to the firm's failure. But unlike in the 2007-2009 crisis period when real estate-backed loans were considered some of the most "toxic" assets on bank balance sheets, the 15% of firm assets that are real estate-backed were actually some of its strongest and most liquid collateral during its unwinding process. Importantly, underlying delinquency rates on real estate loans entered the recent banking turmoil near historically-low levels. Fitch reported last week that the U.S. CMBS delinquency rate decreased 1.70% in April - well below the roughly 3% average from 2015-2018 and the 9% peak in 2011. Notably, over 75% of the new delinquencies were office (36%) and retail (39%).

The pockets of distress are almost entirely debt-driven, with the notable exception of coastal urban office properties. Nearly every property sector reported "same-store" property-level income above pre-pandemic levels. Obscured by the rapidly-shifting macro narrative, REIT property-level fundamentals have been quite strong for most property sectors in recent quarters and - with the exception of office, malls, and some sub-sectors of healthcare and mortgage REITs - entered 2023 with fundamentals that are stronger than before the pandemic. During the depths of the pandemic in 2020, REITs reported a decline in property-level metrics that dwarfed that of the prior crisis, fueled in large part by retail REITs' rent collection woes, but NOI fully recovered by early 2022 and was roughly 9% above pre-pandemic levels in the most recent quarter. The residential, industrial, and technology sectors have been the upside standouts throughout the pandemic with most REITs reporting NOI levels that were 10-30% 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 first quarter, FFO was 25% above its 4Q19 pre-pandemic level on an absolute basis, and roughly 10% above pre-pandemic levels on a per-share basis. Powered by more than 120 REIT dividend hikes in both 2021 and 2022 - and another 55 dividend hikes so far in 2023 - dividends per share rose by 11% from last year in the first-quarter. Total dividend payouts remain roughly 5% below pre-pandemic levels, however, as many REITs have been exceedingly conservative in their dividend distribution policy.

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 93.1% - 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 88.7% in the first quarter.

For many generalist investors - the primary question amid the recent market turmoil is: " what does this mean for REIT dividends? " With FFO growth significantly outpacing dividend growth since the start of the pandemic, REIT dividend payout ratios remained at just 74% in Q1 - up slightly from the 69% last quarter but still 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 around 85%. Notably, other higher-risk sectors have built-up a larger buffer as office REITs payout just 70% of FFO while hotel REITs payout less than 40%.

REIT Valuations & External Growth

REIT external growth comes in two forms – buying and building. REITs have "hunkered down" in recent quarters amid the surge in interest rates, but we believe that opportunities should emerge over time as private players seek an exit. 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 significantly over the past several quarters with net purchases of $4.4B in Q1 - down from a recent peak of nearly $40B in Q4 2021. In fact, the first quarter saw the lowest transactions activity since Q1 of 2010, except for a brief mid-pandemic dip in Q2 of 2020.

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 and into early 2023 to levels that exceeded the prior record set just before the pandemic in 4Q19 at $50.4B. Much of this expansion has been fueled by three property sectors - data center, industrial, and self-storage - which have expanded their pipelines by 86%, 41%, and 27%, 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.

The "animal spirits" - which were very much alive in the REIT world in 2021 and into mid-2022 - have calmed significantly in recent quarters following the spur of activity in early 2022, but the last couple of weeks have seen some renewed activity in the form of six REIT mergers. The largest of these REIT-to-REIT mergers is the deal between ExtraSpace ( EXR ) and Life Storage ( LSI ), which will form the largest storage REIT. Also notable is strip center REIT Regency Centers' ( REG ) deal to acquire Urstadt Biddle ( UBA ) - the first notable example of a public REIT flexing its balance sheet strength to scoop up a smaller, less-capitalized player. Other 'opportunistic' deals in the REIT space have included Ready Capital's ( RC ) acquisition of Broadmark and Ellington Financials' ( 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 - and a similar merger between Diversified Healthcare ( DHC ) and Office Income Properties ( OPI ).

Blackstone ( BX ) has been quiet since last April following a buying spree that included - student housing REIT American Campus , industrial REIT PS Business Parks , and apartment REIT Preferred Apartment , which followed a pair of deals last year for Bluerock Residential and QTS Realty . Absent a significant retreat in interest rates, we foresee many of these assets coming back into the public markets over the next two years as BREIT is forced to unwind its portfolio to meet redemption requests, a wave of withdrawals that is likely to continue so long as BREIT's reported NAV is substantially above that of comparable public REITs. BREIT - which internally determines its Net Asset Value ("NAV") monthly, which is the rate at which sales are sold or redeemed - claims to have generated a positive 8.1% net return since the start of 2022 through the end of April, during which time publicly-traded equity REITs were lower by 28% and private market commercial real estate valuations have declined 15%, per estimates from Green Street Advisors.

Takeaways: Distress Brings Opportunity

In commercial real estate, distress to some spells opportunity for others. Owing to the harsh lessons from the Great Financial Crisis, most REITs have been exceedingly conservative with their balance sheet and strategic decisions, ceding ground to higher-levered private-market players. It took several quarters, but private real estate markets are finally "catching up" to the reality of sharply higher interest rates, and the recent market turmoil may accelerate the distress that loomed over private-market firms and lenders that pushed leverage limits. That said, the pockets of distress are almost entirely debt-driven, with the notable exception of coastal urban office properties. Nearly every property sector reported "same-store" property-level income above pre-pandemic levels, which has fueled a continued wave of REIT dividend hikes this year, which outpaced dividend reduction by four-to-one. Property-level fundamentals are fine, but some balance sheets are not. Many real estate portfolios - particularly private equity funds and non-traded REITs - were not prepared for anything besides a near-zero-rate environment and - absent a quick retreat in interest rates - we could very well see a similar transformative era for commercial real estate as we observed in the early 1990s, a period remembered as a 'Golden Age' for the public REIT industry.

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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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