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  • Writer's pictureArbat Capital

Commercial Real Estate Report - March 2024

US REITs underperformed the broad market again in February, for the second consecutive month. Moreover, it was the 11th time of weaker dynamics over the last 13 months. On an absolute basis, REITs ended the month in the green but just for the third time over the last 7 months.


US REITs underperformed the broad market again in February, for the second consecutive month. Moreover, it was the 11th time of weaker dynamics over the last 13 months. On an absolute basis, REITs ended the month in the green but just for the third time over the last 7 months. Thus, BBREIT index increased by 1.7% MoM in February vs +5.2% MoM of SPX index. Absolute February performance was +0.2 std from the mean monthly performance, and it was in the top 40% of absolute monthly performance in the index history. In turn, February relative performance was -3.3% MoM. It is -0.7 std from the mean monthly performance, and it is in the bottom 23% of relative performance vs SPX index since the BBREIT index inception. Moreover, the first half of March remained weak for US REITs either. So, the index decreased by 4.9% ytd as of March 18, 2024. Even 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 the first two months of the year, driven by the 4Q23 earnings season, and a range of variability even increased to the highest level over more than 3 years. Thus, a difference of monthly price changes of the best and the worst performers among top 50 REITs from BBREIT index was 50.3% in February vs 41.2% in January. So, CRE sectors dynamics were also differently directed in February.

As a result of weak both absolute and relative performance on an annual basis, 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 2.29x as of March 18, 2024, -0.1 std from the mean since April 2002 of 2.32x, and -0.1x since the end of January. P/Sales of BBREIT index decreased by 0.1x from the end of February to 6.0x as of March 18 vs an average since May 2002 of 5.6x. In turn, a discount to SPX on P/B index was 51% as of March 18, 2024 vs an average discount since 2002 of just 20%, -1.9 std. As for P/Sales, the current premium to SPX index is 118% vs an average premium of 225%, -1.5 std. On P/FFO basis, a median figure of REITs was 15.6x as of March 18, 2024 vs the 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 March 18, 2024 vs the historical average of 4.06%, or +0.1 std. On EV/EBITDA basis, a median figure of REITs was 19.8x as of March 18, 2024 vs the historical average of 19.9x, or just -0.02 std. Interest coverage ratio of US REITs remained strong at 4.9x as of the end of 4Q23 vs the historical average of 3.9x (the 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 2 years. Thus, median P/FFO estimates for offices were 9.6x/9.2x for FY2023/24 as of March 18, 2024 vs industrial’s figures of 21.4x/18.8x.

The US economic outlook continues improving but inflation data missed expectations again in February. Moreover, US macro indicators released ytd were mixed. On the one hand, much stronger payrolls were released in February, but January payrolls were revised down notably, and there were more and more signs of gradual cooling of the labor market. On the other hand, retail sales weren’t strong once again, consumer sentiment missed expectations for the second consecutive month while inflation was higher than expected in both January and February, albeit still continued moving in the right direction. 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 of around 40%. 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). So, 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 successfully coped with all the challenges realized in the recent years so far. Nonetheless, a stronger than expected labor market as well as a 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 slowdown in inflation deceleration. Thus, future implied rates increased notably ytd, and the majority of them still remained higher on a yoy basis. So, the first rate cut is expected only in June with total rate cut of less than 70 bps till the end of 2024. Hence, the fed funds rate will remain above 4% in the nearest 4-6 quarters, at least under current expectations, which 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.

4Q23 earnings of US REITs were better than expected but estimates remained roughly unchanged ytd. CRE fundamentals kept being under pressure as a result of still 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 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 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 4.7% yoy in January, and it was even roughly flat during the last 10 months. NOI growth still remained positive on a yoy basis in all key segments except for offices. According to MBA, CRE loan originations increased by 13% qoq in 4Q23, but -25% yoy. So, transaction volumes were still more than 20% 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 reported higher than expected revenues and around 60% of them exceeded net income estimates. In turn, market perception of 4Q23 earnings was negative – just half of the companies ended the day of report in the green. Hence, REITs estimates dynamics 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 - Mar-2024
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