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  • Writer's pictureArbat Capital

Commercial Real Estate Report - May 2024

US REITs underperformed the broad market again in April, for the 4th consecutive month. Moreover, it was the 13th time of weaker dynamics vs the broad market over the last 15 months. On an absolute basis, REITs ended the month in the red, for the first time over the last three months and just for the second time over the last 6 months.



EXECUTIVE SUMMARY


US REITs underperformed the broad market again in April, for the 4th consecutive month. Moreover, it was the 13th time of weaker dynamics vs the broad market over the last 15 months. On an absolute basis, REITs ended the month in the red, for the first time over the last three months and just for the second time over the last 6 months. Thus, BBREIT index decreased by 7.9% MoM in April vs -4.2% MoM of SPX index. Absolute April performance was -1.5 std from the mean monthly performance, and it was in the bottom 5% of absolute monthly performance in the index history. In turn, April relative performance was -3.9% MoM. It is -0.8 std from the mean monthly performance, and it is in the bottom 18% of relative performance vs SPX index since BBREIT index inception. Despite the first half of May was relatively strong for US REITs, the index decreased by 4.6% ytd vs +11.1% ytd of SPX as of May 15. Moreover, the first 4 months of 2024 were the worst start of a year for BBREIT index on a relative basis since 1998, -1.8 std from the mean. On an absolute basis, it was the worst start of a year over the last 4 years. US REITs dynamics remained quite volatile during the first months of this year, increasing notably in April after a significant decline in March, 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 increased to 39.8% in April vs just 18.8% in March. Nonetheless, all CRE sectors except for apartments decreased in April.

As a result of weak both absolute and relative performance yoy, valuations continue going down even despite a notable reverse movement in 4Q23. Moreover, relative valuations vs SPX index still kept going down, trading near the lowest levels over more than 20 years. On the other hand, 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 2.31x as of May 15, 2024, roughly in-line with the mean since April 2002, but +0.2x since the end of April. P/Sales of BBREIT index increased by 0.45x from the end of April to 6.1x as of May 15 vs the average since May 2002 of 5.6x. In turn, a discount to SPX on P/B index was 52% as of May 15, 2024 vs the average discount since 2002 of just 21%, -2.0 std. As for P/Sales, the current premium to SPX index is 114% vs the average premium of 225%, -1.7 std. On P/FFO basis, the median figure of REITs was 16.2x as of May 15, 2024 vs the historical average of 17.9x, or -0.5 std. In turn, median dividend yield of 50 largest BBREIT index members was 3.96% as of May 15, 2024 vs the historical average of 4.05%, or just -0.1 std. On EV/EBITDA basis, the median figure of REITs was 19.8x as of May 15, 2024 vs the historical average of 19.9x, or -0.03 std. Interest coverage ratio of US REITs was 4.6x as the end of 1Q24 vs the historical average of 3.9x (quarterly average since 2005), or +0.7 std. As for individual names, multipliers are still quite different, but dispersion across REITs has decreased notably in the recent 2 years. Thus, median P/FFO estimates for offices were 9.8x/9.4x for FY24/25 as of May 15, 2024 vs industrial’s figures of 19.8x/17.6x.

The US economy continues growing well above expectations even despite 1Q24 GDP missed expectations markedly. Thus, US GDP increased by 1.6% qoq at annualized in 1Q24 vs the consensus of 2.5%. But the headline miss was mainly driven by inventories and trade while the key driver of GDP growth – consumer spending growth – remained quite strong. Moreover, even despite the miss, the actual growth rate was much higher than December’s projection of just +0.6% qoq. Also, US macro indicators revealed ytd still remained strong, implying that the US economy would continue going up at a solid pace in the remaining quarters of 2024 albeit slower than in 2H23. At least, according to the current market expectations, US GDP will increase by 1.7%/1.3%/1.5% 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 next 12 months has already been estimated at just 30%. But the flip side of a higher than expected GDP growth coin is the more hawkish Fed, mainly driven by higher than expected inflation data in early 2024. The latter, among other things, is another indicator that the economy continues growing faster than expected. So, the Fed’s balance of risks is still shifted towards inflation, and the first rate cut is currently expected only at the September meeting with total cut of around 40 bps till the end of the year. So, the fed funds rate will remain above 4% in the nearest 2-2.5 years, at least under current expectations, which obviously does not add optimism to the CRE market participants, given very high refinancing volumes in the coming years in conditions when initial LTVs deteriorated substantially, especially in the office and apartment segments. Nonetheless, the overall macro situation continues improving for real estate markets albeit risks still tilted to the downside, especially in case of fast labor market deteriorating. The latter remained strong so far, even taking into account lower than expected payrolls in April, but with more and more signs of gradual cooling.

1Q24 earnings of US REITs were notably better than expected but debt refinancing risks still remained very high. 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%. Unsurprisingly, market perception of 1Q24 earnings was positive – despite more than 60% of the sample ended the day of report in the red, BBREIT index increased by 7.1% since the start of the earnings season. Quarterly results showed that the fears about the CRE segment were clearly exaggerated. But we still believe that REIT’s earnings will not be the key driver for the stocks in the near term. At least, prices of equity REITs continue to react sharply to the dynamics of interest rates expectations, which is not surprising at all, taking into account that more than $900 Bn of CRE debt outstanding will expire in 2024 (more than $100 Bn of them are in the office segment). Given the nature of CRE debt such as balloon payments/interest only loans etc., such a high level of refinancing in 2024 could be a real issue for a number of REITs. Unsurprisingly, correlation between average monthly 10yr treasury yield and BBREIT index is -0.92 (since the beginning of 2022). In other words, 1Q24 earnings confirmed that so far REITs/CRE segments have been very successful in resisting very high interest rates, but it is still unclear how long this can last, especially when the economic situation begins to deteriorate. At least, EPS/Revenue estimates haven’t improved significantly, remaining roughly flat ytd.  Nonetheless, we still believe that CRE could be able to avoid a full-scale debt crisis, at least as the first signs of gradual stabilization in the segment have already appeared, driven by stronger growth of the US economy. So, despite banks continued tightening lending standards for CRE loans as well as expecting further tightening of standards in 2024, they would also expect higher demand in 2024, albeit accompanied by deterioration in credit quality. At least, property market is in better balance now than it was few quarters ago with CPPI decreased just by 3% yoy in March vs -10.7% yoy in June 2023. On the other hand, underlying fundamentals continue deteriorating across majority of CRE segments so far, albeit remaining quite far from crisis levels and with gradually improving second derivatives. So, 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. So, we remain neutral on the sector, but gradually becoming more optimistic.


AC - CRE Report - May-2024
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