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 Q2 results on a company-by-company level, but this report will focus on higher-level macro themes affecting the REIT sector at large.
Rates Up, REITs Down: Commercial and residential real estate markets remain an easy transmission mechanism – or “punching bag” – 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 eighteen-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 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 (VNQ) compared to the S&P 500 since the rate hike cycle began.
Higher For Longer? The business models of many private equity funds and non-traded REITs were not simply designed for a period of sustained 5%+ 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 16% 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%. 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 flip side, 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 capitalization rates (“cap rates”).
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. 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 10% above pre-pandemic levels in the second 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.
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 51 basis points to 4.41%, which was the highest level since December 2021. Office delinquencies rose another 46 basis points to 4.96%, which is up sharply from just 1.63% a year ago. 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 (PSA), 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 nine public REIT-to-REIT mergers thus far this year. The largest of these REIT-to-REIT mergers is 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 earlier this month, while Kimco Realty (KIM) announced this week that it will 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) acquisitions of Arlington Asset (AAIC) and Great Ajax (AJX). 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 Properties Income (OPI).
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.
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 that REIT capital raising activity slowed in July after a relatively strong two months of activity in May and June. REITs have collectively raised a year-to-date total of $39.7 billion, which is 12.7% higher than the capital raised during the same period in 2022. The majority of the capital raised this year have through debt offerings, which have accounted for 82% of the total capital raised this year – well above the historical average of around 50%. The single largest common equity offerings this year came via Welltower’s (WELL) at-the-market offering program, which has raised $2.2B through July. American Tower (AMT) has raised the most capital year to date at $5.5B 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. Capital is not cheap, and generally, the REITs that have been raising capital have been doing so to reduce variable rate debt exposure.
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 4.51x, 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.
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% last September to as high as 6.51% at the October peak and now sits at 5.94%. 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 second 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 65 dividend hikes so far in 2023 – dividends per share rose by 9% from last year in the second quarter.
Total dividend payouts remain roughly 1% below pre-pandemic levels, however, as many REITs have been exceedingly conservative in their dividend distribution policy. With FFO growth significantly outpacing dividend growth since the start of the pandemic, REIT dividend payout ratios remained at just 64% in Q2 – 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 payout just 70% of FFO while hotel REITs payout 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 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 400 basis points below pre-pandemic levels at 88.4% in the second quarter.
Deeper Dive: REIT Valuations & Growth
The extended sell-off since mid-2022 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 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. The average equity REIT pays a dividend yield of 3.9% on a market-cap-weighted basis.
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 significantly over the past several quarters with gross purchases of just $7.7 in Q2 – the lowest 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.
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, industrial, and self-storage – which have expanded their pipelines by 82%, 45%, and 20%, 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: 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 outpace 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.
For an in-depth analysis of all real estate sectors, 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.