State of the REIT Nation
This is an abridged version of the full report published on Hoya Capital Income Builder Marketplace on November 18th.
Following the decade of “Lower for Longer,” investors remain split on whether the pandemic-era regime of persistent inflation and higher interest rates is genuinely a “New Normal” or a passing pandemic-related disruption. Just as policymakers are seemingly going “all-in” in a fight against inflation, the current regime of synchronized fiscal expansion and persistently elevated inflation is under siege by the deflationary effects of deteriorating global economic conditions across major developed markets and synchronized fiscal contraction. After soaring by 43% in 2020 and expanding another 3.4% from there in 2021 – a level of fiscal intervention that exceeded that of WWII and fueled the highest inflation rates in four decades – the growth rate of government spending is doing something that’s rarely seen in U.S. history – decline. Federal spending dipped 20% through Q3 – 8x the next steepest six-month contraction in U.S. history.
As expected, we have indeed seen a moderation in inflationary pressures in recent quarters from extreme levels to simply elevated levels, but where the ultimate “trend level” of inflation end up has a significant impact on asset values. One camp expects to see a return to the 2-3% level seen in 1950s, 1960s, 1990s, 2000s, and 2010s, while the other camp expects inflation to remain in the 4-6% levels seen in the 1970s and 1980s, citing the inflationary forces of potential de-globalization, rising energy prices through a “green” transition, and other regulatory frictions that impede perfect competition. For the highly “rate-sensitive” and domestic-focused sectors including residential and commercial real estate, this uncertainty has fueled a return of the “Rates Up, REITs Down” correlations as these assets appear particularly “cheap” if inflation and nominal “risk-free” interest rates will return to the 2-3% range – but less so with the nominal “risk-free” rate in the 5%+ range.
This active debate has been playing out across the U.S. real estate industry – a unique “dual market” structure with both an active public and private market. Of note, 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” – which have been reflected in public real estate markets for several quarters. Green Street Advisors’ data shows that private-market values of commercial real estate properties have dipped nearly 13% over the past six months following a historically sharp 8% decline in October alone. By comparison, the peak-to-trough drawdown in this valuation index during the Great Financial Crisis was 30%. Overall private market real estate values have now returned to pre-pandemic levels with some property sectors still in the green during this period while other more disrupted sectors – notably office and hotels – are lower by double-digit percentages.
The effects of sharply higher interest rates on REITs have been far more muted than they would have been in decades past, as the industry has been exceedingly conservative with their balance sheet and strategic decisions over the past decade. REITs have been able to lean more heavily into shorter-term credit facilities for funding needs rather than tapping longer-term bond markets, hoping to “wait out” the spike in interest rates this year. REITs entered this period of volatility with a “war chest” relative to their position in 2008 as REITs raised more capital from 2019-2021 than in any prior three-year period on record with most REITs able to lock in low-interest rates on long-term debt while still maintaining a relatively “equity-rich” capital stack.
REITs had taken full advantage of lower interest rates in prior years to lower their average long-term interest rate to around 3.50% – the lowest level on record. Much like the cost of essentially all other goods and services in 2022, however, the incremental cost of capital has no doubt become far more expensive this year. 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 around 5.87%. Unlike many private market players with more-limited access to long-term debt capital, the long-term nature of REIT 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.
With the scars of the Great Financial Crisis still visible enough to be reminders of more dismal times, 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 debt. Perhaps most critically, publicly-traded REITs have far more ample access to longer-term, unsecured debt that has allowed REITs to push their average debt maturities to over 7 years, on average, thus avoiding the need to refinance during these highly unfavorable market conditions.
Public REITs entered 2022 with historically strong balance sheets across essentially every metric. Even when incorporating the recent 30% drawdown in 2022, 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. Meanwhile, interest coverage ratios have remained near all-time highs as strengthening cash flows in recent quarters has more-than-offset the impact of higher interest expenses. Per NAREIT, an interest coverage ratio of 3x is often considered a benchmark for being able to cover fixed charges (coverage ratio is calculated by dividing EBITDA over interest expense).
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. As we’ll discuss throughout this report, while REITs enter this 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 more short-term borrowing and continuous equity inflows to keep the wheels spinning. Much the opposite of their role during the GFC, we believe that many well-capitalized REITs are equipped to “play offense” and take advantage of compelling acquisition opportunities if we do indeed see some degree of distress in private markets from higher rates.
That said – not all REITs are created equal, and the broad-based sector average does mask some of the ongoing issues in several of the more at-risk sectors and among REITs that have been more aggressive in their balance sheet management. While all REIT sectors are now out of the Debt Ratio “danger-zone” above 50%, a pair of REIT sectors – hotel and office REITs – still operate with debt ratios above 40% while roughly two dozen REITs – primarily in the retail and hotel sector – operate with debt levels above 50%. On the flip side, many of the “essential” property sectors – housing, industrial, and technology – continue to operate with debt ratios below 20%.
REIT Sector Fundamentals
Obscured by the macro narrative, property-level fundamentals have been quite strong – and strengthening – for most property sectors in recent quarters. REIT company-level metrics have exhibited a substantial rebound since mid-2021 as REIT FFO (“Funds From Operations”) has now fully recovered the sharp declines from early in the pandemic. In the third quarter, REIT FFO was 20% above its 4Q19 pre-pandemic level on an absolute basis, and 12% above pre-pandemic levels on a per-share basis. Driven by a 7.1% rise in same-store Net Operating Income (“NOI”), FFO/share rose 13.6% year-over-year from 3Q21, led once again by REITs in the more COVID-sensitive property sectors.
Powered by more than 125 REIT dividend hikes in 2021 and another 120 so far in 2022, dividends per share rose by 18.5% from last year, but total dividend payouts remain roughly 10% below pre-pandemic levels as many REITs have been exceedingly conservative in their dividend distribution policy. With FFO growth still significantly outpacing dividend growth since the start of the pandemic, REIT dividend payout ratios declined to just 73% in Q3 – up from record lows last quarter but still well below the 20-year average of 80%. With a historically low dividend payout ratio, we believe that REITs have significant ’embedded’ dividend growth that will be unlocked over the coming quarters – or will at least serve as a buffer to protect current payout levels if macroeconomic conditions take an unfavorable turn.
During the worst 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’ difficulty in collecting rents. Driven by the normalization in rent collection across the hardest-hit sectors, same-store NOI fully recovered in early 2022 and was roughly 5% 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. On the other hand, most shopping centers, office, and mall REITs – with some exceptions – are now roughly even with pre-pandemic property-level cash flows.
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 93.4% – 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 350 basis points below pre-pandemic levels at 89.4% in the third quarter.
As discussed in our REIT Earnings Recap & Ratings Updates, third-quarter earnings results were generally better than expected with roughly 85% of equity REITs beating consensus FFO estimates while nearly two-thirds of the REITs that provide forward guidance raised their full-year outlook, reflecting a high degree of confidence among REIT executives that the growth momentum will be sustained beyond the initial post-pandemic recovery and amid the rising rate environment. Earnings results from Shopping Center, Industrial, and Net Lease REITs were most impressive – accounting for exactly half of the 58 guidance hikes. Residential and technology REIT results were more hit-and-miss – accounting for half of the 14 downward guidance revisions.
REIT Valuations & External Growth
While the sell-off in 2022 has pulled REITs back into “cheap” territory as the “Rates Up, REITs Down” paradigm has weighed on valuations, much of the sector traded at premium valuations throughout 2021 which revived the “animal spirits” and facilitated external growth opportunities that were relatively few-and-far-between over the last half-decade. Equity REITs currently trade at an average Price/FFO multiple of 15.6x 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 13.4x P/FFO multiple, which is near the lowest levels since the early 2000s.
Favorable valuations in 2021 sparked a wave of external growth through M&A, IPOs, development, and property acquisitions. REITs have “pumped the brakes” amid the surge in interest rates, but we believe that opportunities should emerge over time as private players seek an exit. 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 development. REITs had again become active buyers in 2021 – acquiring more assets in 2021 than in any year prior – but have slowed this activity rather dramatically in recent quarters with net purchases of $12B in Q3 – down from nearly $40B in Q3 2021.
At the property-sector level, net lease REITs have been far-and-away the most active acquirers in recent quarters – benefiting, in part, from the aforementioned effects of private market players seeking an exit due to the more-challenging financing conditions. Self-storage REITs have also remained quite active in recent quarters with similar dynamics at play given the relatively large quantity of “mom and pop” investors in the private market. Major REIT portfolio acquisitions over the past twelve months incorporated in the chart below include Independence Realty’s (IRT) $5.6B acquisition of Steadfast Apartment REIT, Ventas’ (VTR) $2.3B deal to acquire New Senior, Welltower’s (WELL) $1.6B portfolio acquisition from Holiday Retirement, Public Storage’s (PSA) $1.8B acquisition of ezStorage, CubeSmart’s (CUBE) $1.7B acquisition of Storage West, and Sun Communities (SUI) $1.3B acquisition of Park Holidays UK.
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 in Q3 to levels that exceeded the prior record set just before the pandemic in 4Q19 at $50.4B. Retail REITs have seen their pipeline well the most significantly on a percentage basis – but from a nearly-nonexistent base last year. Self-storage REITs have also remained among the most active REIT developers with a pipeline that is nearly 30% higher from last year. Office REITs – which remain the most active developers in the REIT sector on an absolute basis – are the lone sector with a shrinking development pipeline amid questions over office space needs and the ultimate persistence of the “Work From Home” era.
REIT M&A and IPOs Have Cooled
The “animal spirits” – which were very much alive in the REIT world last year – have calmed significantly in recent quarters following the spur of activity in early 2022. Blackstone (BX) has been quiet since April following a buying spree that included – student housing REIT American Campus (ACC), industrial REIT PS Business Parks (PSB), and apartment REIT Preferred Apartment (APTS), which followed a pair of deals last year for Bluerock Residential (BRG) and QTS Realty (QTS). Other major deals earlier in the year included Prologis‘ (PLD) merger with Duke Realty and Healthcare Realty’s (HR) merger with Healthcare Trust of America. Since the end of May, we’ve seen just one major M&A deal – the acquisition of STORE Capital (STOR) by private equity firms GIC and Oak Street. In addition to the STOR deal, Veris Residential (VRE) received a takeout offer from private equity firm Kushner Companies which was rejected.
REIT IPOs have also been essentially non-existent this year following a notable uptick in 2021 – a year that saw seven public listings, the most since 2013. In September, Strawberry Fields went public through a direct listing on the OTC markets under the ticker symbol STRW. Strawberry Fields is a healthcare REIT with a portfolio of 79 properties located primarily in the U.S. Southeast. Also in September, American Healthcare REIT filed a registration statement with the SEC, proposing a listing on the NYSE under the ticker symbol “AHR.” The REIT was formed in 2021 from the merger of two Griffin-American portfolios and owns 313 medical office buildings, senior housing, skilled nursing facilities, hospitals, and other healthcare facilities, in 36 states and the UK. A handful of recent REIT IPO filings have been either postponed or canceled including the listing for office owner Priam Properties, net lease REIT Four Springs Capital, cannabis-focused Freehold Properties, and self-storage operator SmartStop Self-Storage.
Takeaways: REITs Hunker-Down Amid Rate Storm
REITs have “hunkered down” over the past several months and can afford to “wait out” the Fed due to the strength of their balance sheets – a luxury that’s not shared by more highly-levered private players. To private owners’ credit, property-level fundamentals have actually strengthened across most property sectors this year despite stagnant economic growth. Public REITs have rewarded investors with a historic wave of dividend hikes over the past two years, and with a still-historically-low dividend payout ratio, we believe that REITs have significant ’embedded’ dividend growth that will be unlocked over the coming quarters – or will at least serve as a buffer to protect current payout levels if macroeconomic conditions take a more unfavorable turn.
For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Apartments, Homebuilders, Manufactured Housing, Student Housing, Single-Family Rentals, Cell Towers, Casinos, Industrial, Data Center, Malls, Healthcare, Net Lease, Shopping Centers, Hotels, Billboards, Office, Farmland, Storage, Timber, Mortgage, and Cannabis.
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.