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  • Writer's pictureArbat Capital

Commercial Real Estate Report - February 2024

US REITs underperformed the broad market in January, after two consecutive months of outperformance. Nonetheless, it was the 10th month of weaker dynamics over the last year. On an absolute basis, REITs ended the month in the red for the 4th time over the last 6 months.


US REITs underperformed the broad market in January, after two consecutive months of outperformance. Nonetheless, it was the 10th month of weaker dynamics over the last year. On an absolute basis, REITs ended the month in the red for the 4th time over the last 6 months. Thus, BBREIT index decreased by 5.5% MoM in January vs +1.6% MoM of SPX index. Absolute January performance was -1.1 std from the mean monthly performance, and it was in the bottom 11% of absolute monthly performance in the index history. So, January relative performance was -6.9% MoM. It is -1.5 std from the mean monthly performance, and it is in the bottom 6% of relative performance vs SPX index since BBREIT index inception. Moreover, the first half of February wasn’t strong for US REITs either. So, the index decreased by 5.0% ytd as of February 16, 2024. Also, despite strong rally in 4Q23, BBREIT index underperformed the broad market in 2023, as it did in 6 out of 7 previous years. On a relative basis, it tumbled by 15.9% ytd in 2023 vs median FY underperformance of just -0.4% since 1995 year. US REITs dynamics remained quite volatile in January, driven by the 4Q23 earnings season, and the range of variability even increased to the highest level over more than 3 years. Thus, a difference of monthly price changes between the best and the worst performers among top 50 REITs from BBREIT index was 41.2% in January vs 26.7% in December. And even the best performing subsectors ended the month in the red.

As a result of weak both absolute and relative performance yoy, valuations went down until not so far, but there was a notable reverse movement in 4Q23. Nonetheless, relative valuations vs SPX index still remain low but increased markedly from local minima. On the other hand, absolute valuations don’t look cheap vs historical averages, especially taking into account still elevated rates even after their notable decline in 4Q23. Thus, P/B of BBREIT index was 2.3x as of February 16, 2024, roughly in line with an average since April 2002 of 2.32x, but -0.1x since the end of December. P/Sales of BBREIT index decreased by 0.3x from the end of December to 6.0x as of February 16, 2024 vs an average since May 2002 of 5.6x. In turn, a discount to SPX on P/B index was 48% as of February 16, 2024 vs an average discount since 2002 of just 20%, -2.0 std. As for P/Sales, the current premium to SPX index is 121% vs an average premium of 225%, -1.6 std. On P/FFO basis, a median figure of REITs was 15.5x as of February 16, 2024 vs a historical average of 17.9x, or -0.7 std. In turn, median dividend yield of 50 largest BBREIT index members was 4.2% as of February 16, 2024 vs a historical average of 4.05%, or +0.1 std. On EV/EBITDA basis, a median figure of REITs was 20.4x as of February 16, 2024 vs a historical average of 19.9x, or +0.2 std. Interest coverage ratio of US REITs remained strong, staying at 4.9x as of the end of 4Q23 vs a historical average of 3.9x (quarterly average 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 1.5 years. Thus, median P/FFO estimates for offices were 9.6x/9.2x for FY2023/2024 as of February 16, 2024 vs industrial’s figures of 22x/19.9x.

The US economic outlook continues improving but the recent inflation data missed expectations. Moreover, US macro indicators released ytd were mixed again. On the one hand, much stronger payrolls were released in January as well as higher ISM indexes. On the other hand, retail sales missed expectations notably while CPI/PPI prints exceeded expectations. Moreover, CPI was roughly flat on a yoy basis for 4 consecutive months. Nonetheless, it does not negate the fact that the probability of recession continues decreasing. Thus, it is already expected that a recession in the next 12 months will occur with a probability less than 50%. And GDP growth forecasts continue going up. Now it is expected that US GDP growth will be +1.0% qoq in 1Q24 and +0.5% qoq in 2Q24 (vs September 2023 forecasts of +0.1%/+0.6% qoq, respectively). In other words, the ‘soft landing’ remains the baseline scenario but the risks still tilted to the downside, from our point of view, even taking into account that the US economy has so far successfully coped with all the challenges realized in the recent years. Nonetheless, the much stronger than expected labor market as well as the faster-growing economy also mean that the Fed has an additional argument not to rush to cut rates very fast, especially taking into account the recent deceleration of inflation decline. Thus, future implied rates increased notably ytd, and majority of them still remained higher on a yoy basis. So, the first rate cut is expected in 2Q24 with total rate cut of less than 100 bps till the end of 2024. Hence, the fed funds rate will remain above 4% in the nearest 4-5 quarters, at least under current expectations. And it obviously does not add optimism to the 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 office and apartment segments. Nonetheless, recent macro data carries much more positive than negative for CRE market, in our opinion.

4Q23 earnings of US REITs were better than expected but the market reaction was restrained. CRE fundamentals still remained under pressure as a result of elevated interest rates, weaker services activity, expected softening of the US economic growth and lower investment activity. Hence, banks continued tightening lending standards for the segment. According to the Fed’s January SLOOS, banks tightened standards on all categories of CRE loans again in 4Q23. Moreover, it is expected that standards will continue to be tightening in 2024. Nonetheless, despite banks noted weaker demand for CRE loans in 4Q23, they would also expect higher demand in 2024, albeit accompanied by deterioration in credit quality. Given the fact that banks hold around 60% of total CRE debt, we perceive such news as the first signs of gradual stabilization in the segment, especially against the background of decline of the rate expectations in 4Q23. It doesn’t mean that the ‘blue sky’ scenario is ahead, especially taking into account that rates are still elevated and more than $900 Bn of CRE debt outstanding will expire in 2024. No wonder, the reaction to NYCB’s 4Q23 earnings was so nervous. Nonetheless, the situation looks definitely better so far than could have been expected a few quarters ago as the commercial property price index decreased just by 5.9% yoy in December, but remaining roughly flat during 9 months. Also, according to MBA, CRE loan originations increased by 13% qoq in 4Q23 but -25% yoy. So, transaction volumes were still more than 40% lower on a yoy basis, but there was some stabilization across majority of segments in recent months. Moreover, 4Q23 earnings were better than expected. Thus, more than 75% of 20 largest REITS from BBREIT index (which have already revealed 4Q23 results for the current date) reported higher FFO per share and around 70% of them exceeded revenue consensus. In turn, market perception of 4Q23 earnings was negative – less than half of the companies ended the day of report in the green. REITs estimates dynamic wasn’t strong ytd (but it wasn’t weak either). So, the overall picture still remains mixed but there are more and more signs that CRE market isn’t far from the inflection point, at least from our point of view. On the other hand, risks are still relatively high. So, we remain neutral on the sector, and recommend to be selective, avoiding high-risk segments.

AC - CRE Report - Feb-2024
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