Steve Hentschel
CHICAGO – After one of the strongest years on record, the REIT market is in relatively good shape despite recent volatility. JLL’s Strategic Transactions Monitor details issues driving the REIT market, including a constructive outlook amid soaring interest rates, an increase in take-private activity and the unwinding of COVID-19-driven trends.
REITs are down 20% year-to-date along with broader markets on rising inflation, Federal Reserve rate hikes and broader geopolitical risks. Although market participants have focused on short-term underperformance, longer-term REITs have outperformed. Since January 2021, REITs have outperformed the S&P 500 by over 14%, driven by 43% total shareholder returns generated by REITs over the year. Self-storage and industrials sectors led the outperformance, up 59% and 45% respectively in 2021.
“There is an increasing correlation of REITs’ trading performance with broader equity markets, currently 92% compared to the S&P 500 on a rolling three-month basis, exacerbated by the increase in quantified trading activity and the emergence of passive equity investors such as index funds in the REIT space.” said Steve Hentschel, Head of M&A and Corporate Advisory Group at JLL Capital Markets. “The correlation was even more pronounced during times of extreme volatility like the global financial crisis and COVID-19, and we see it today. The overall trend is that REIT trading prices are becoming more and more decoupled from property values.”
REITs trade at an average discount to net asset value (NAV) of over 15%. An ongoing dislocation in public and private values could herald opportunities for fundamentals-driven private market participants and lead to take-private M&A. In addition, discounts to NAV have resulted in an unfavorable cost of equity, resulting in follow-up issuance of just 8 billion a year.
The growing “firmness” of the core inflation index, currently above 8.5%, has prompted the Fed to hike rates significantly this year, pushing rates down an average of 150 basis points on both the longer and shorter parts of the curve drifted above. This, in turn, has led to the aforementioned underperformance of REITs, which in turn has caused the implied trading capitalization rate of REITs to increase by over 60 basis points.
“While current cap rate yields are the closest they’ve ever been compared to fixed income yields, it’s important to consider the tremendous growth prospects for REITs, which are projected to average 20% NOI growth over the next three years will generate the same business.” Hentschel adds. “Fundamentals still support a positive longer-term outlook for REITs despite today’s volatility in capital markets.”
The Rise of Take-Privates
The proliferation of non-traded REITs is triggering a paradigm shift in the REIT stock and M&A markets. REITs’ take private equity volume has totaled $86 billion since 2018, more than 17 times larger than IPO equity volume. Since there have been no IPOs since the beginning of 2022, there have been five take privates with an equity volume of over US$ 21 billion. This continues a trend that started a few years ago.
“The tremendous amount of capital raised in the non-traded REIT space has necessitated the execution of larger transactions,” said Sheheryar Hafeez, managing director of the M&A and Corporate Advisory Group at JLL Capital Markets. “M&A transactions are an efficient way to deploy this capital and we could see the trend continue as productive fundraising stays on track, new players for non-traded REITs begin to raise significant capital and the continued dislocation on the public and private market.
“In many ways, untraded REITs have supplanted the public REIT market as a form of growth capital, as investors seeking real estate returns that are uncorrelated to public stock markets are reallocating capital to the untraded REIT space,” he continued away
Inflation leads to rotations into safer REITs
As inflation accelerated to an annualized rate of 8.5% in May, public REITs, which offer greater inflation protection, have outperformed the market and other REITs. REITs with longer weighted average lease terms (WALT) had previously outperformed REITs with shorter WALT since December 2019, but the relationship flipped in mid-2021, causing shorter WALT REITs to boom of late.
“As the market appears to be anticipating a slowdown in economic activity, a rotation towards what is considered ‘safe’ is now at play,” Hafeez added. “The two largest REITs in the major sectors analyzed have outperformed their peers by 5.5% since December 2021, compared to the same two REITs, which have outperformed their sectors by just 2.0% between December 2020 and 2021.”
The impact of COVID-19 on REIT performance may be diminishing
A silver lining in recent performance data has been the thawing of the impact of COVID-19 on REIT performance. Beneficiaries of COVID-19 such as sub-sectors linked to the e-commerce boom had outperformed during the pandemic compared to retail REITs that struggled during physical store closures. Similarly, gateway-focused REITs had underperformed in 2020 compared to non-gateway-focused REITs. These trends are reversing today.
“While COVID-19 will remain a fact of life that we will all have to live with for the foreseeable future, we are seeing the ‘laggards’ of COVID-19 starting to recover strongly, which is encouraging to see and reflects the broader one US psyche that wants to move forward,” Hentschel said.
Debt market-driven asset repricing in private housing markets was mitigated by significant dry powder
Asset revaluations in private capital markets were initially driven by rising interest rates; However, bond markets remain liquid, albeit volatile. A more comprehensive risk assessment of new acquisitions is currently underway and investors are testing their models based on an inflationary environment, future rate hikes and the potential for an economic slowdown, but with the significant dry powder on the side (closed-end funds alone). have more than $240 billion in dry powder today), the risk of a significant revaluation can be mitigated.
Neighborhood centers benefit from changed behaviors
Neighborhood retail centers, which account for 953 million square feet of US inventory, are experiencing significant tailwinds. Neighborhood centers are generally defined as those with 10,000 to 100,000 square feet of leasable area and generally do not contain large tenants. Therefore, they bring together a consumer base in close proximity for shopping and service needs. Nearly 90% of all consumption today occurs within 15 minutes’ drive of a consumer’s home, and this shift in consumer habits towards shopping close to home has driven the overall performance of these assets.
Additionally, shorter average lease terms compared to traditional big-box retailers, along with few new developments, have allowed owners to be more proactive when it comes to rent increases, making these assets top targets for investors.
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