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  • Writer's pictureArbat Capital

Commercial Real Estate Report - November 2023

US REITs underperformed the broad market again in October 2023, for the 9th consecutive month, driven by industrial and office segments while retail CRE increased slightly MoM. On an absolute basis, REITs ended the month in the red for the third consecutive time.


EXECUTIVE SUMMARY


US REITs underperformed the broad market again in October 2023, for the 9th consecutive month, driven by industrial and office segments while retail CRE increased slightly MoM. On an absolute basis, REITs ended the month in the red for the third consecutive time. Thus, BBREIT index decreased by 3.3% MoM in October vs -2.2% MoM of SPX index. Absolute October performance was -0.7 std from the mean monthly performance, and it was in the bottom 21% of absolute monthly performance in the index history. In turn, October relative performance was -1.1% MoM. It is -0.2 std from the mean monthly performance, and it is in the bottom 41% of relative performance vs SPX index since BBREIT index inception. In turn, the first half of November was quite strong due to lower rate expectations, but REITs index decreased by 6.2% ytd as of November 21, 2023. So, it continues underperforming the broad market, as it did in 6 out of 7 previous years. On a relative basis, it tumbled already by 20.6% ytd in 2023 – roughly the same degree of underperformance that was observed through the 2nd decade of November during the first pandemic year. Volatility of monthly price changes remains high for US REITs ytd, what is usual for underperforming sectors, but it decreased slightly MoM in September and October. Thus, it was 23.2% in October vs 28.7% in September. The worst performers were industrial and office segments, which decreased by 9.7% MoM and 9.5% MoM in October, respectively. In turn, retail increased by 0.9% MoM. On ytd basis, hotels subsector remained the best performer, having lost just 3.9%.

As a result of weak both absolute and relative performance, valuations went down until so far, and decline accelerated in September and October. So, relative valuations vs SPX index still remain 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 2.1x as of November 21, 2023, slightly below an average since April 2002 of 2.32x, and -0.1x since the end of September. P/Sales of BBREIT index was 5.7x, roughly in-line with an average since May 2002 of 5.6x. In turn, a discount to SPX on P/B index was 50% as of November 21, 2023 vs an average discount since 2002 of just 19%, -1.9 std. As for P/Sales, the current premium to SPX index is 131% vs an average premium of 226%, -1.6 std. On P/FFO basis, a median figure of REITs was 14.6x as of November 21, 2023 vs a historical average of 18x, or -1.0 std. In turn, median dividend yield of 50 largest BBREIT index members was 4.5% as of November 21, 2023 vs a historical average of 4.1%, or +0.3 std. On EV/EBITDA basis, a median figure of REITs was 20.5x as of November 21, 2023 vs a historical average of 19.9x, or +0.2 std, which is quite consistent with still relatively low financial risks of the segment. Thus, interest coverage ratio of US REITs was 5.5x as the end of 3Q23 vs a historical average of 3.9x (a quarterly average since 2005), or +1.8 std. 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 were 8.2x and 8.9x for FY23 and FY24, respectively, as of November 21, 2023 while industrial median multipliers were 20.6x and 19.6x, respectively.

The US economy continued growing well above expectations, but it would inevitably decelerate noticeably in the coming quarters after very strong GDP growth in 3Q23. Thus, despite skyrocketing rates growth, still elevated inflation, inverted yield curve since 3Q22, the regional banking crisis in 1H23 and significant of tightening lending standards, the US economy increased by 2.1% qoq and 4.9% qoq at annualized rate in 2Q23 and 3Q23, respectively. Nonetheless, both hard and soft data qtd imply that the GDP growth rate will decelerate significantly in 4Q23. So, despite recession probability is still relatively high, it is not so inevitable at the moment, and ‘soft landing’ is already a baseline scenario for a number of market participants. Moreover, according to the current Fed’s projections, the US economy will also manage to avoid recession in the nearest future. However, the risks are still tilted to the downside, from our point of view, and the US economy is far from being out of the woods at the moment. At least, majority of key macro data revealed so far in November were worse than expected. Also, the rates will be higher for longer, remaining the key threat for highly leveraged CRE industry. So far, the negative impact of very high rates was mitigated by incredible resilience of the labor market as well as limited volume of debt expirations. However, there were more and more signs of gradual softening of the labor market in recent months. Thus, headline payrolls missed estimates slightly in October, for the first time over the last three months. On the other hand, both CPI and PPI figures were noticeably better than expected in October, strengthening the market's confidence that the beginning of the easing cycle may be closer to us than the phrase ‘higher for longer’ suggests. However, even ‘soft landing’ scenario doesn’t imply any significant improvement of CRE fundamentals in the nearest future. But it doesn’t imply noticeable deterioration of fundamentals either.

REITs fundamentals remain resilient so far despite gradual deceleration of the economy and still quite high interest rates. Thus, NOI growth remains positive albeit decelerating even in the riskiest CRE segment – the office one. But we see a noticeable demand decline with significant slowdown of net absorption rates across all major segments. Banks also noted weaker CRE demand in 3Q23. So, they continued tightening lending standards in the segment. Moreover, banks expect to tighten standards in CRE further, what will be accompanied by deterioration of credit quality and decline of the collateral values. Thus, commercial property price index decreased by 8.0% yoy, but flat MoM, as of the end of October 2023, driven by industrial CRE, which was still positive on a yoy basis, while apartment prices already tumbled by 16.3% from its all-time high. However, total index is still +16.3% vs the end of 2019, remaining roughly flat during the last 6 months. Moreover, 29 out of 37 largest REITs from BBREIT index reported better than expected 3Q23 revenue figures. Also, more than 1/3 of REITs increased their FY guidance during the recent earnings season. However, strong figures relate mainly to the healthiest subsegments, such as industrial and hotels, while 3Q23 results of offices and residential weren’t strong. REITs estimates remain resilient ytd (except for EPS forecasts), and estimates even increased in recent months. Thus, median growth of revenue estimates of 20 largest members of BBREIT index was 1.7% ytd as of November 21, 2023 while median growth of EBITDA CY estimates was +0.8% ytd. So, fundamentals remain solid so far due to stronger than expected US economy dynamics, and even decline of CRE prices has already decelerated noticeably. Hence, we do not share the general 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 the still 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 - Nov-2023
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