2023-05-23 08:05:00 ET
Summary
- There are certainly some issues facing REITs right now.
- REITs also enjoy many advantages and strengths that the market seems to be ignoring.
- It's time to be contrarian and selectively buy REITs.
Co-produced by Austin Rogers for High Yield Landlord
There's blood on REIT street.
As of this writing, real estate investment trusts ("REITs") ( VNQ ) are down over 30% from their all-time high, almost as much as the depths of their selloff during the initial stages of the COVID-19 pandemic.
The original saying of "buy when there's blood in the streets" came from Baron Rothschild in the 18th century when a war (or at least the rumor of one) caused a sharp selloff in asset prices.
It's the kind of principle that's easy to say and hard to practice. It's called " contrarian " for a reason!
It's rare to see any stock or asset drop sharply in price when absolutely nothing is going wrong with it. Sometimes a stock price can simply get ahead of its fundamental value and require a rationalization process bringing the two back into alignment. But typically, a 30%+ selloff indicates the market's perception that a stock's risk has increased.
For REITs, the risks are numerous right now:
- REITs, like almost all real estate investment strategies, use substantial debt in order to leverage returns on equity.
- High debt is a huge liability when interest rates have surged as high as they have as fast as they have.
- A wall of debt maturities in the coming years is going to cause big jumps in interest expenses, at best, or defaults, at worst, for some REITs.
- REIT stock prices are down, which hinders their ability to raise equity capital for growth purposes.
- Office buildings are seeing occupancy and rental revenue decline amid entrenched hybrid-remote work arrangements.
- Recessionary conditions appear to be setting in, which should ding rent growth and occupancy across many sectors of real estate.
One of the biggest issues for REITs right now is capital scarcity .
What does that mean?
It means that since stock prices are low and debt prices are high, REITs have a very hard time raising capital at low enough costs to make growth investments profitable.
As a result of these higher capital costs, REIT capital raising activity is collapsing.
In April, REITs raised over 60% less equity and debt capital than the same month in the year prior and around 43% less than the previous month. A 40%+ drop in capital raising activity month-over-month is incredible and indicates the severity of the capital scarcity problem for REITs.
The problems that REITs (especially certain ones like office REITs) face are real. We don't deny them.
But looking only at the problems without considering the strengths and opportunities is like placing a bet on a boxer without knowing who they will be fighting in the ring!
Put differently, it would be like placing a bet against a boxer having heard that they lost their last fight without knowing anything else about them.
So, let's look at some of REITs' strengths in order to get a fuller picture.
REIT Strength #1: Higher Capital Costs = Less Future Supply of Buildings
As explained in a previous article , higher costs of capital create short-term pain but long-term gain for REITs.
Why?
Because the same high capital costs hindering REITs' growth investments today is also causing developers to pull back on new construction. Significantly less new construction today means significantly less new supply of buildings in a few years.
As with everything in economics, it's all about supply and demand. Rent rates, like all prices in the economy, are determined by supply and demand. Less new construction starts today means less competition for REITs' existing property portfolios in a few years.
Paradoxically, however, REIT development pipelines are collectively at their highest level in history. This is partly due to the higher cost of construction, but it also indicates that REITs, on the whole, have better and more extensive access to capital than other developers.
Notice also that about 1/3rd of REITdom's entire development pipeline is for office properties. While many of those projects likely will be postponed or canceled, it's still important to point out that developments for other property sectors remain modest.
Meanwhile, outside of the office sector, demand for commercial real estate space remains strong.
Multi-tenant retail (shopping centers) offers a particularly striking example of this.
While US retail real estate enjoys one of its lowest vacancy rates in decades, completions of new shopping centers remain muted. And surely with the increased capital costs, developers will pull back on construction of new retail space even further.
More good news for retail REITs is that cap rates have been ticking up recently, and transactions have veered toward centers in smaller markets that feature higher cap rates anyway.
Many of these smaller markets have nothing wrong with them. Many are growing and offer strong demographics. Being able to buy at higher cap rates is a strong opportunity.
To give one example, Sunbelt shopping center landlord Whitestone REIT ( WSR ) recently acquired a property called "Lake Woodlands" in the Woodlands, TX, a suburb of Houston, at a 7% cap rate.
It's a well-located center in a growing market, even if the address doesn't show a major metro city like Houston.
REIT Strength #2: Tenant Demand Remains High
Sticking with the subject of retail real estate, it's notable that even in Q1 2023, amid high interest rates and consumer price inflation still moderately high, retail real estate enjoyed perhaps its highest occupancy rate on record.
While office occupancy tanks, apartment and industrial occupancy remains very high -- near their all-time highs, in fact.
Remember the point about supply and demand?
Well, low supply of available space translates into higher prices, which in this case are rent rates.
Thus, rent rates continue to climb higher at a faster rate than operating expenses, which results in strong growth in same property (or "same store") net operating income for REITs:
This level of organic rent growth has not been seen in decades, and for most types of REITs it makes up for the higher cost of capital making external growth through acquisitions harder.
As an example of how high occupancy and strong tenant demand for space leads to rent and NOI growth, see the examples of these REITs:
Occupancy | Rent Growth | Same-Store NOI Growth | |
Alexandria Real Estate ( ARE ) | 93.6% | 24.2% | 9.0% |
AvalonBay Communities ( AVB ) | 95.5% | 9.5% | 10.7% |
Camden Property Trust ( CPT ) | 95.3% | 4.5% | 8.1% |
EastGroup Properties ( EGP ) | 98.1% | ~20% | 11.0% |
Mid-America Apartment Communities ( MAA ) | 95.5% | 12.6% | 12.5% |
Prologis ( PLD ) | 98.0% | 41.9% | 11.4% |
STAG Industrial ( STAG ) | 98.1% | 23.8% | 5.9% |
Admittedly, these are some of the strongest examples of organic rent and NOI growth.
The point is that the tailwinds of organic growth are outweighing the headwinds of higher interest expenses.
REIT Strength #3: Debt Maturities Are Well-Structured
From 2020 to the first half of 2022, REITs took advantage of very low interest rates to refinance long-term debt at low, fixed rates.
In fact, REITs learned a lot of lessons from the Great Financial Crisis in 2008-2009, when the REITs most badly damaged were highly leveraged with an abundance of short-term or floating rate debt. Since then, REITs have extended their debt maturity ladders out further and further.
Today, the weighted average term to maturity of REIT debt sits at just under 7 years.
Plenty of REITs can be found with weighted average debt terms to maturity even higher than that.
Take, for example, the high-quality single-tenant retail REIT, Agree Realty ( ADC ). The REIT's weighted average debt term sits at about 8 years, and very little debt matures until 2028.
What's more, ADC came into 2023 with over $500 million in forward equity at locked-in prices, which gives the REIT enviable liquidity in the current environment of fewer and fewer buyers and thus less and less competition for properties.
Hence we find that ADC's average acquisition cap rate jumped from 6.2% in Q4 2022 to 6.7% in Q1 2023.
Next up, take a look at NNN REIT ( NNN ), formerly known as National Retail Properties. This is another single-tenant retail REIT, albeit with a different investment focus than ADC.
Although NNN has an even amount of debt maturing in the coming years, the REIT took the opportunity to issue 30-year bonds over the last few years that mature as late as 2052.
NNN Presentation
Notice that NNN's weighted average debt maturity is over 13 years.
There's another REIT that can boast the same 13+ year weighted average debt maturity metric, and that is Alexandria Real Estate Equities.
Although ARE has laddered its debt maturities very evenly, it has no maturities in 2024. What's more, like NNN, ARE took the opportunity to lock in low fixed-rate debt for 30 years as recently as February 2023.
This kind of farsightedness from REIT management teams is what separates the best from the rest.
Takeaway
There are problems and headwinds facing REITs right now. There's no doubt about that.
But to focus solely on the headwinds while ignoring the tailwinds is a foolish way to invest. You have to balance the two. And you have to consider how other investors are balancing the two.
Right now, there's blood on the streets of REITdom as panicky investors sell in order to get away from "commercial real estate," which the media continues to claim is problematic.
But while office buildings certainly have some significant problems right now, commercial real estate as a whole continues to perform well from high organic growth, well-structured balance sheets, and the promise of less future supply of new properties amid the capital scarcity.
At High Yield Landlord, we are taking advantage of this opportunity and buying REITs when there's "blood in the streets."
Many REITs are today for sale at up to 50% discounts relative to the fair value of their properties, net of debt. We think that this is a fantastic opportunity if you are long-term oriented.
For further details see:
Buy REITs When There's Blood In The Streets