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  • Writer's pictureArbat Capital

Commercial Real Estate Report - June 2024

US REITs outperformed the broad market slightly in May, for the first time over the last 5 months. Moreover, it was just the third time of stronger dynamics vs the broad market over the last 16 months.



EXECUTIVE SUMMARY


US REITs outperformed the broad market slightly in May, for the first time over the last 5 months. Moreover, it was just the third time of stronger dynamics vs the broad market over the last 16 months. On an absolute basis, REITs ended the month in the green, for the third time over the last 4 months as well as just for the third time over the last 7 months. Thus, BBREIT index increased by 5.1% MoM in May vs +4.8% MoM of SPX index. Absolute May performance was +0.8 std from the mean monthly performance, and it was in the top 16% of absolute monthly performance in the index history. In turn, May relative performance was +0.3% MoM. It is +0.1 std from the mean monthly performance, and it is in the top 42% of relative performance vs SPX index since BBREIT index inception. Nonetheless, the first half of June wasn’t strong for US REITs. So, the index decreased by 4.4% ytd vs +13.9% ytd of SPX index as of June 14. Moreover, the first 5 months of 2024 were the worst start of a year for BBREIT index on a relative basis since 1998, -1.6 std from the mean. On an absolute basis, it was also -1.0 std from the sample average over the last 30 years. US REITs dynamics remained quite volatile during the first 5 months of the year, albeit decreasing notably in May after a substantial growth in April, mainly driven by the 1Q24 earnings season. Thus, a difference of monthly price changes for the best and the worst performers among top 50 REITs from BBREIT index decreased to 26.3% in May vs 39.8% in April. So, all major CRE sectors except for hotels increased in May.

As a result of weak both absolute and relative performance year-over-year, 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. But 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 2.30x as of June 14, 2024, roughly in-line with a mean since April 2002, but +0.14x since the end of April 2023. P/Sales of BBREIT index increased by 0.41x from the end of April to 6.03x as of June 14 vs an average since May 2002 of 5.6x. In turn, a discount to SPX on P/B index was 53% as of June 14, 2024 vs an average discount since 2002 of just 21%, -2.0 std. As for P/Sales, a current premium to SPX index is 110% vs an average premium of 221%, -1.7 std.  On P/FFO basis, a median figure of REITs was 16.1x as of June 14, 2024 vs a historical average of 17.9x, or -0.5 std. In turn, median dividend yield of 50 largest BBREIT index members was 4.12% as of June, 2024 vs a historical average of 4.05%, or +0.06 std. On EV/EBITDA basis, a median figure of REITs was 19.8x as of June 14, 2024 vs a historical average of 19.9x, or -0.03 std. In turn, interest coverage ratio of US REITs was 4.6x as of the end of 1Q24 vs a historical average of 3.9x (a quarterly average since 2005), or +0.7 std. As for individual names, multipliers are still quite different, but their dispersion across REITs has decreased significantly in the recent 2 years. Thus, median P/FFO estimates for offices were 9.6x/9.2x for FY24/25 as of June 14, 2024 vs industrial’s figures of 19.5x/17.4x.

The US economy continues growing at a solid pace but imbalances are intensifying recently. Thus, US GDP increased by 1.6% qoq at annualized in 1Q24 vs the consensus of 2.5%. But excluding an impact of inventory investment, government spending and net exports it increased by 2.8%. Moreover, the key driver of GDP growth – consumer spending growth – remained strong albeit slowing somewhat from the last year dynamics. So, it is still expected that the US GDP growth remains resilient in the near future albeit decelerating. At least, according to the current market expectations, US GDP will increase by 2.2%/1.6%/1.6% qoq in 2Q/3Q/4Q of 2024, respectively (vs December’s projections of just +0.3%/+0.9%/+1.5% qoq). Hence, the probability of recession in the nearest 12 months has already been estimated at just 30%. Nonetheless, FOMC economic projections revealed at the June meeting were slightly weaker vs March forecasts. Thus, GDP growth rates were unchanged with CAGR for the next three years remains above 2% yoy, but inflation and unemployment rates were revised slightly up. So, the Fed continues to worry primarily about inflation risks, which implies higher for longer interest rates. Thus, expected Federal Funds (FF) rates increased by 110/73/94 bps ytd for 2024/2025/2026 years, respectively. It is also expected that the FF rate will remain above 4.0% in two nearest years. So, despite a negative impact of quite high interest rates on the economy was quite limited so far, it will gradually increase, given very high refinancing volumes in the nearest years, at least in CRE. Moreover, despite quite strong headline payrolls in 1H24, the underlying picture remains mixed with more and more signs of gradual cooling of the labor market. Thus, the ratio of job openings to unemployed workers decreased to the lowest figure over almost three years in April while unemployment rate increased by 10 bps MoM to 4.0% in May vs the consensus of 3.9%, the highest figure over more than two years. So, the Fed still has some room for maneuver, but the window of opportunity continues narrowing.

CRE fundamentals still remain mixed but already gradually starting to improve. At least, 1Q24 earnings showed that market fears were clearly exaggerated. Thus, more than 85% of our sample of REITs reported higher revenue with a median surprise of +1.3%, and around 75% of the sample exceeded net income estimates with a median surprise of solid +15.8%. Nonetheless, the key near term driver of REITs’ quotes still remains interest rates dynamics, taking into account that more than $900 Bn of CRE debt outstanding will expire in 2024 (more than $100 Bn ofthem arein offices). Unsurprisingly, correlation between average monthly 10yr treasury yield and BBREIT index is -0.91 (since the beginning of 2022). So, despite strong 1Q24 earnings, estimates of REITs revenue/FFO continues going down, driven by growth of rate expectations. Thus, a median decline of 2Q24 FFO of our sample of REITs was 1% ytd as of mid-June while revenue projections decreased by 0.3% ytd. In other words, 1Q24 earnings confirmed that REITs/CRE have been very successful in resisting very high interest rates so far, but it is still unclear how long this can last, especially considering return of the higher for longer interest rates paradigm and gradual cooling of the labor market. So, banks continued tightening lending standards for CRE loans as well as expecting further tightening of standards in 2024. On the other hand, banks also expect higher demand in 2024, albeit accompanied by deterioration in credit quality. In turn, the U.S. property market continues to search for a balance of supply and demand. Thus, CPPI decline decelerated significantly in recent months, falling by just -2.2% yoy in April vs -10.9% in July 2023. On the other hand, transaction volume still remains quite weak. Nonetheless, NOI growth on a yoy basis remains positive in all key CRE segments except for offices. Effective rent growth also remained positive so far. Moreover, recent growth of vacancy rates was mainly driven by supply growth, especially in apartments, where multifamily units under construction still remained near an all-time high, while net absorption rates kept healthy among all key segments except for offices. In other words, the overall picture still remains mixed but there are more and more signs that the CRE market isn’t far from the inflection point, at least under the current baseline economic scenario. A start of the rate cut cycle could be a strong catalyst for US REITs, from our point of view, but how longits momentumwill lastwill dependon whether rates decline will be driven by lower inflation or labor market deterioration. Nonetheless, we remain neutral on the sector, but gradually becoming more optimistic.


AC - CRE Report - Jun-2024
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