US REITs underperformed the broad market again in March, for the third consecutive month. Moreover, it was the 12th time of weaker dynamics vs the broad market over the last 14 months. On an absolute basis, REITs ended the month in the green again, for the second time in a row but just for the 4th time over the last 8 months.
EXECUTIVE SUMMARY
US REITs underperformed the broad market again in March, for the third consecutive month. Moreover, it was the 12th time of weaker dynamics vs the broad market over the last 14 months. On an absolute basis, REITs ended the month in the green again, for the second time in a row but just for the 4th time over the last 8 months. Thus, BBREIT index increased by 0.9% MoM in March vs +3.1% MoM of SPX index. Absolute March performance was +0.1 std from the mean monthly performance, and it was in the top 49% of absolute monthly performance in the index history. In turn, March relative performance was -2.2% MoM. It is -0.4 std from the mean monthly performance, and it is in the bottom 31% of relative performance vs SPX index since BBREIT index inception. Moreover, the first half of April remained weak for US REITs either. So, the index decreased by 7.3% ytd vs +9.0% ytd of SPX index as of April 11, 2024. 1Q24 was the worst start of the year for BBREIT index since 2009. Moreover, on a relative basis, REITs tumbled by 15.9% yoy in 2023 vs a median FY figure of just -0.4% since 1995 year, underperforming in 7 of the last 8 years. US REITs dynamics remained quite volatile in the first two months of the year, driven by the 4Q23 earnings season, but a range of variability decreased significantly in March. Thus, a difference of monthly price changes of the best and the worst performers among top 50 REITs from BBREIT index was just 18.8% in March vs 50.3% in February. So, dynamics of CRE subsectors were also mixed in March.
As a result of weak both absolute and relative performance yoy, valuations continue going down even despite a notable reverse movement in 4Q23. Moreover, relative valuations vs SPX index still kept going down, staying near the lowest levels over more than 20 years. On the other hand, absolute valuations don’t look extremely cheap vs historical averages, given still elevated rates, especially after their significant growth ytd in 2024. Thus, P/B of BBREIT index was 2.23x as of April 11, 2024, -0.2 std from the mean since April 2002 of 2.32x, and -0.1x since the end of February. P/Sales of BBREIT index decreased by 0.2x from the end of February to 5.8x as of April 11, 2024 vs an average since May 2002 of 5.6x. In turn, a discount to SPX on P/B index was 53% as of April 11, 2024 vs an average discount since 2002 of just 21%, -2.0 std. As for P/Sales, the current premium to SPX index is 110% vs an average premium of 225%, -1.7 std. On P/FFO basis, a median figure of REITs was 16.1x as of April 11, 2024 vs a historical average of 17.9x, or -0.6 std. In turn, median dividend yield of 50 largest BBREIT index members was 4.1% as of April 11, 2024 vs a historical average of 4.05%, or just -0.04 std. On EV/EBITDA basis, a median figure of REITs was 19.8x as of April 11, 2024 vs a historical average of 19.8x, or -0.02 std. Interest coverage ratio of US REITs remained strong, at 4.9x at the end of 4Q23 vs a historical average of 3.9x (qoq since 2005), or +1.1 std. As for individual names, multipliers are still quite different, but dispersion across REITs has decreased significantly in the recent 2 years. Thus, median P/FFO estimates for offices were 9.3x/8.9x for FY23/24 as of April 11, 2024 vs industrial’s figures of 20.5x/17.9x.
The US economy continues growing well above expectations and recent macro data implies that it will remain much stronger in 1H24 than it has been expected until so far. Thus, according to the recent market expectations, US GDP is estimated to increase by 3.0% qoq at annualized rate in 1Q24. It is below than the GDP growth rate in 2H23 when it was 4.9% qoq and 3.3% qoq in 3Q23 and 4Q23, respectively. But it is also much higher than December’s projection of just +0.6% qoq. Moreover, US macro indicators revealed ytd still remained strong, implying that the US economy would continue going up at solid pace in the remaining quarters of 2024, albeit slower than in 2H23. Hence, the probability of recession in the next 12 months has already been estimated at just 35%. But the flip side of a higher than expected GDP growth coin is the more hawkish Fed, mainly driven by higher than expected inflation data in early 2024. The latter, among other things, is another indicator that the economy continues growing faster than expected. So, the Fed’s balance of risks is still shifted towards inflation, all the more so CPI missed expectations again in March. Hence, the first rate cut is currently expected only at the June meeting with total cut of less than 70 bps till the end of the year. The good news is that very high interest rates haven’t had a significant negative impact on the US economy yet, but the key word here is ‘yet’. Thus, the fed funds rate will remain above 4% in the next 2-2.5 years, at least under current expectations, which obviously does not add optimism to CRE market participants, given very high refinancing volumes in the nearest years in conditions when initial LTVs deteriorated substantially in the recent quarters because of property prices decline, especially in the office and apartment segments. Nonetheless, the overall macro situation continues improving for real estate markets, albeit risks still tilted to the downside, especially in case of fast labor market deteriorating. However, the latter remained quite strong so far with much higher than expected payrolls again in March, but there were more and more signs of gradual cooling of the labor market recently.
The 1Q24 earnings season of US REITs will not be decisive for the near-term dynamic of quotes. Sure, it should shed more light on how well-founded the market's fears about the segment are. At least, after publication of NYCB’s 4Q23 results, CRE concerns increased considerably, even despite the 4Q23 earnings season of US REITs was better than expected. Thus, more than 75% of 20 largest REITS from BBREIT index reported higher than expected revenues and around 60% of them exceeded net income estimates. But we don’t think that 1Q24 REITs’ earnings will be the main driver for stocks in the near term either, given skyrocketing growth of rates in the last two years and the fact that more than $900 Bn of CRE debt outstanding will expire in 2024 (more than $100 Bn of them are in offices). Given the nature of CRE debt such as balloon payments/interest only loans etc., so high level of refinancing in 2024 could be a real problem for a number of REITs, some of which may even go bankrupt. Unsurprisingly, correlation between average monthly 10yr treasury yield and BBREIT index at the end of the month was -0.91 (since the beginning of 2022). Nonetheless, we also don’t believe that it could lead to a full-scale CRE crisis, especially taking into account the first signs of gradual stabilization in the segment, mainly driven by better than expected economic growth. So, despite banks continued tightening lending standards for CRE loans as well as expecting further tightening of standards in 2024, they would also expect higher demand in 2024, albeit accompanied by deterioration in credit quality. Moreover, the property market continues to try to find a balance. At least, CPPI decreased just by 4% yoy in February, remaining roughly flat during the last 10 months, while transaction volumes decline decelerated notably in recent months. In turn, according to MBA, CRE loan originations increased by 13% qoq in 4Q23 but -25% yoy. Moreover, underlying fundamentals still remained solid so far across majority of CRE segments but gradually deteriorating. Thus, rent and same-store NOI continue going up in the majority of them, but they could turn negative in a number of them in the nearest quarters, especially in case of weaker economic growth accompanied by higher unemployment. So, the overall picture doesn’t look cloudless, but there are more and more signs that the CRE market isn’t far from the inflection point. So, we remain neutral on the sector, and recommend to be selective, avoiding high-risk segments.