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  • Writer's pictureArbat Capital

Commercial Real Estate Report - December 2023

US REITs outperformed the broad market in November 2023, for the first time over the last 10 months, driven by regional malls and the office segment while apartment’s growth was relatively weak. On an absolute basis, REITs ended the month in the green for the first time over the last 4 months.


US REITs outperformed the broad market in November 2023, for the first time over the last 10 months, driven by regional malls and the office segment while apartment’s growth was relatively weak. On an absolute basis, REITs ended the month in the green for the first time over the last 4 months. Thus, BBREIT index soared by 11.6% MoM in November vs +8.9% MoM of SPX index. Absolute November performance was +2.0 std from the mean monthly performance, and it was in the top 2% of absolute monthly performance in the index history. In turn, November relative performance was +2.4% MoM. It is +0.6 std from the mean monthly performance, and it is in the top 26% of relative performance vs SPX index since BBREIT index inception. Moreover, the first half of December remained quite strong due to lower rate expectations, but REITs index increased just by 4.2% ytd as of December 19, 2023. So, it continues underperforming the broad market, as it did in 6 out of 7 previous years. On a relative basis, it tumbled by 16.1% ytd in 2023 vs median FY underperformance of just -0.4% since 1995 year. US REITs dynamics remained volatile in November, still driven by 3Q23 earnings season. Moreover, max/min difference of performance in November was the highest one over the last three months. Even apartments – the worst performer of November – managed to end the month in the green, having added 4.1% MoM. In turn, regional malls soared by 13.7% MoM. On ytd basis, regional malls were also the best performer, having added 7.2% ytd as of the end of November.

As a result of weak both absolute and relative performance ytd, valuations went down until not so far, but there was some reverse movement in two recent months. Nonetheless, relative valuations vs SPX index still remain low but increased notably from local minima of the year. Moreover, absolute valuations don’t look cheap vs historical averages, especially after the rally in November and December. Thus, P/B of BBREIT index was 2.2x as of December 19, 2023, just slightly below an average since April 2002 of 2.32x, and +0.2x since the end of October. P/Sales of BBREIT index increased by 3x from the end of October to 8.2x as of December 19 vs an average since May 2002 of 5.6x. In turn, a discount to SPX on P/B index was 48% as of December 19, 2023 vs an average discount since 2002 of just 19%, -2.0 std. As for P/Sales, the current premium to SPX index is 215% vs an average premium of 225%, -0.2 std. On P/FFO basis, a median figure of REITs was 16.2x as of December 19, 2023 vs a historical average of 17.9x, or -0.5 std. In turn, median dividend yield of 50 largest BBREIT index members was 4.0% as of December 19, 2023 vs a historical average of 4.1%, or -0.1 std. On EV/EBITDA basis, a median figure of REITs was 20.5x as of December 19, 2023 vs a historical average of 19.9x, or +0.2 std, which is quite consistent with still relatively low financial risks of the segment. Thus, interest coverage ratio of US REITs was 5.5x as of the end of 3Q23 vs a historical average of 3.9x (a quarterly average since 2005), or +1.8 std. As for individual names, multipliers are still quite different, but dispersion across REITs has decreased significantly in the recent 1.5 years. Thus, median P/FFO estimates for offices were 10.5x/ 10.1x for FY23/24 as of December 19, 2023 vs industrial’s figures of 23.9x/22.6x.

The US economy continued growing well above expectations, but it would inevitably decelerate noticeably in the coming quarters after very strong GDP growth in 3Q23. Thus, US macro indicators revealed in November and early December weren’t strong but GDP growth forecasts continued going up. So, despite notable deceleration of economic activity after quite strong 3Q23, US GDP growth will remain positive in the nearest quarters. According to the Fed’s December projections, US GDP will increase by 1.4% yoy in 2024, by 1.8% yoy in 2025 and by 1.9% yoy in 2026. In other words, the ‘soft landing’ remains the baseline scenario, even despite a number of indicators still pointing to a recession. On the other hand, the Fed continues to adhere to the data-dependent paradigm, emphasizing at each meeting that risks are tilted to the downside and that inflation still remains unacceptably high, even despite both economic activity and inflation were notably better than expectations in recent months. So far, a negative impact of very high rates was mitigated by incredible resilience of the labor market as well as a limited volume of debt expirations. But there were more and more signs of gradual softening of the labor market in recent months while consumer spending growth, which strength was the key reason of the resilience of the US economy ytd, continued going down in 2H23. However, the dovish Fed’s meeting in December accompanied by lower CPI/PPI data finally convinced us that rates will not be so high for longer as it was expected just 1-2 quarters ago. At least, rate expectations for the following years moved significantly down in 4Q23, implying gradual easing of pressure on the fundamentals of US CRE, what is quite important for the segment, given relatively high refinancing volumes in the nearest years. So, macro environment has improved notably for CRE recently. But better doesn’t mean good, and it is still challenging, in our opinion, especially in case of unemployment growth.

REITs fundamentals remain resilient so far despite gradual deceleration of the economy and still high interest rates. Thus, NOI growth remains positive albeit decelerating even in the riskiest CRE segment – the office one. But we also see noticeable demand decline with a significant slowdown of net absorption rates across all major segments. Banks noted weaker CRE demand in 3Q23 either. So, they continued tightening lending standards in the segment. Moreover, banks expect to tighten standards in CRE further, what will be accompanied by deterioration of credit quality and decline of collateral values. Thus, CPPI decreased by 8% yoy but it remained roughly flat during the last 6 months. Even apartments, which prices decreased by 13.7% yoy, doesn’t look too risky, given the decline was mainly driven by excessive supply while demand still remained resilient, especially taking into account significant rates growth and realized risks so far. Moreover, 29 out of 37 largest REITs from BBREIT index reported better than expected 3Q23 revenue figures. Also, more than 1/3 of REITs increased their FY guidance during the recent earnings season. However, strong figures relate mainly to the healthiest subsegments, such as industrial and hotels, while 3Q23 results of offices and residential weren’t strong. REITs estimates remained resilient ytd (except for EPS forecasts), and estimates even increased in recent months. Thus, median growth of revenue estimates of 20 largest members of BBREIT index was 1.8% ytd as of December 19, 2023 while median growth of EBITDA CY estimates was +1.1% ytd. Nonetheless, underlying CRE fundamentals will continue deteriorating in the coming quarters even in case of ‘soft landing’. On the other hand, we believe that most CRE subsegments are near achieving balance between buyers and sellers, especially after meaningful decline of the rate expectations, which implies limited decline of property prices in the near future. Of course, risks are still tilted to the downside, but the worst-case scenario has been avoided, from our point of view. Nonetheless, we think that recent rally was excessive and it overestimated the positive impact of lower rate expectations on CRE fundamentals, especially taking into account current REIT’s valuations. So, we are again neutral on the sector, and recommend to be selective, avoiding high-risk segments.

AC - CRE Report - Dec-2023
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