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  • Writer's pictureArbat Capital

Commercial Real Estate Report - June 2023

US REITs underperformed the broad market again in May 2023, for the 4th consecutive month, driven by office and retail segments. On an absolute basis, REITs ended the month in the red for the third time over the last 4 months.


EXECUTIVE SUMMARY


US REITs underperformed the broad market again in May 2023, for the 4th consecutive month, driven by office and retail segments. On an absolute basis, REITs ended the month in the red for the third time over the last 4 months. Thus, BBREIT index decreased by 4.3% MoM in May vs +0.2% MoM of SPX index. Absolute May performance was -0.9 std from the mean monthly performance, and it was in the bottom 14% of absolute monthly performance in the index history. So, May relative performance was -4.5% MoM. It is -0.9 std from the mean monthly performance, and it is also in the bottom 14% of relative performance vs SPX index since BBREIT index inception. Despite possible consequences of the recent banking crisis for the CRE market, REITs index still remains roughly flat ytd. Nonetheless, it continues underperforming the broad market ytd (the worst relative performance of the first 5 months of the year since 2009), as it did during 6 out of 7 previous years. US REITs dynamics were volatile in May 2023 as a result of the earnings season and growing investor concerns about the sector's prospects. Unsurprisingly, the worst performers were shopping centers and offices, which decreased by 6.7% MoM and 6.4% MoM, respectively. In turn, hotels increased by 0.8% MoM in May.

As a result of weak both absolute and relative performance, valuations continue going down but not very fast due to still strong fundamentals trajectory. Nonetheless, relative valuations vs SPX index still remains quite low, not very far from GFC’s troughs. On the other hand, absolute valuations don’t look extremely cheap vs historical averages. Thus, P/B of BBREIT index was 2.2x as of the end of May 2023 vs an average since April 2002 of 2.32x, -0.3 std. P/Sales of BBREIT index was 5.7x vs an average since May 2002 of 5.6x, or +0.1 std. In turn, a discount to SPX on P/B index was 45% as of the end of May 2023 vs an average discount since 2002 of just 19%, -1.7 std. As for P/Sales, a current premium to SPX index is 147% vs an average premium of 226%, -1.2 std. On P/FFO basis, a median figure of REITs was 16.8x as of the end of May vs a historical average of 18x, or -0.4 std. In turn, median dividend yield of 50 largest BBREIT index members was 4.2% as of the end of May vs a historical average of 4.1%x, or +0.1 std. On EV/EBITDA basis, a median figure of REITs was 19.4x as of the end of May vs a historical average of 19.9x, or -0.2 std, which is not entirely consistent with all the still low financial risks of the segment. As for individual names, multipliers are still quite different, but dispersion across REITs has decreased significantly in the recent 1.5 years. Thus, office median P/FFO estimates for our REITs sample are 8.4x and 8.2x for FY23 and FY24, respectively, as the end of May 2023 while industrial median multipliers are 22.7x and 21.4x, respectively.

The US economy continues to demonstrate high resistance to all internal and external shocks. So, it still continues to grow noticeably faster than it was expected few quarters ago. The labor market remained very tight, and it beat estimates again in May 2023, adding 339K new jobs. Stronger dynamics of the US economy implies that underlying fundamentals of the CRE market will not deteriorate as fast as CRE prices have fallen recently. Moreover, a recession no longer looks a so inevitable event, even if it is still the main scenario for 2H23. Nonetheless, banks continued tightening lending standards for all types of CRE loans in 1Q23, and expected further tightening for the rest of 2023. However, CRE lending by commercial banks still remained roughly stable despite tightening and deposit outflows caused by the recent regional banking crisis. Thus, CRE loans increased by 10.2% yoy, or +1.8% ytd, as of May 31, 2023. Moreover, rent and same-store NOI growth continue at solid pace in all major segments, even in the office subsegment, which is perceived as the riskiest one at the moment. Despite this, prices and volumes of CRE properties continued going down in recent months. Thus, commercial property price index decreased by 1.1% MoM, or -9.4% yoy, as of the end of April 2023, -11% from its all-time high shown in July 2022. However, the fastest drop in prices on a yoy basis is now observed not in offices, but in apartments. In turn, total CRE sales volume tumbled even more, -72% yoy in April. Nonetheless, REITs estimates remain roughly stable ytd, albeit with relatively high dispersion among both trusts and subsegments. Thus, median growth of revenue estimates of 20 largest members of BBREIT index was 0.9% ytd as of the end of May 2023, while median growth of EBITDA CY estimates was positive again on ytd basis at the end of May, but just +0.4%.

REITs earnings remain resilient despite gradual deceleration of the economy, elevated inflation and still quite high as well as growing interest rates. REITs noticeable underperformance in 2022 was caused by skyrocketing rates growth, but the rates themselves are not as destructive for REITs fundamentals as for CRE property prices. So, estimates still remain resilient even despite an expected recession. The recent dynamics of fundamentals also set us up for a positive mood. Nonetheless, price reaction on the recent banking crisis also implies that it is too early for investors to be bullish on the sector, especially for offices. Nonetheless, we also do not share widespread high anxiety regarding both the entire segment and the offices in particular, especially taking into account very tight lending standards in the CRE lending after the GFC, strong property prices growth during the recent cycle as well as still the quite resilient economy. We fully assume that under certain conditions, REITs could continue to fall, but we remain cautiously optimistic on the sector at the moment given current relative valuations. Also, we recommend being selective and avoiding high-risk segments, at least in the nearest future.


AC - CRE Report - Jun-2023
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