This year has brought a sizable disconnect between the value of publicly listed REITs and private real estate. The disparity has been fueled by a combination of factors: inflationary pressures, a hawkish response to high inflation by the Federal Reserve, heightened geopolitical tensions, including the Russian invasion of Ukraine, and fears of a recession. The conditions that brought considerable volatility in equity markets have had a negative impact on REITs’ valuations that, upon close inspection, does not seem warranted.
In our view, the current market conditions have created an extraordinary public real estate market arbitrage opportunity across many property sectors, particularly among those with strong fundamentals and strong demand from real estate buyers. The apartments, self-storage and Canadian multifamily and industrial sectors of the REIT market may now offer the most-promising opportunities.
Overall, it appears that we have entered a period similar to the one that unfolded in the early days of the pandemic, before vaccines were developed, when volatility in the public markets set the stage for REITs to deliver strong outperformance.
A REITs Sell-off
Year-to-date (through August 23), the global REITs market, as defined by the FTSE EPRA Nareit Developed Index, has sold off by 18.3% (Exhibit 1). Tight monetary policy by central banks across the globe has caused valuation compression among public REITs, while having a much smaller impact on the private real estate market.
Even though higher interest rates and the rising cost of debt can impact valuations, certain real estate classes still have the ability to materially outgrow inflation. That enables them to deliver income growth that can outpace the negative effects of rising debt costs. This year, asset classes that benefit from structural growth have been even more negatively impacted than asset classes that have had growth headwinds. That negative impact has occurred even in sectors where balance sheets have been strong, and the supply/demand dynamics have been favorable and seem likely to remain so.
A Disconnect Between This Year’s Performance by REITs and Private Real Estate
For the past 25 years, listed REITs and private real estate funds have delivered the same annualized total return: 8.9%. Both asset classes also provide access to institutional-quality commercial real estate. But their similarities have not prevented REITs from getting caught up in the volatility of this year’s equity markets. Listed REITs have significantly underperformed private real estate funds year-to-date (Exhibit 2).
Buying REITs Opportunistically Has Delivered Outperformance
In the past, buying REITs at moments when they were selling at steep discounts to the value of their underlying assets enabled investors to realize considerable outperformance, relative to the private markets. During the past 25 years, in periods when REITs were selling at discounts to their NAVs of 10% or more, they subsequently delivered three-year returns, relative to private real estate, that were in the range of 20% to more than 50%. (Exhibit 3). Given that REITs this year are trading at an average discount of 18%, with discounts for some REITs reaching as high as 40%, we believe the same buying opportunity exists today.
Promising Opportunities in Three Key Sectors
We think the most-appealing buying opportunities currently exist in three key sectors of the REIT market. In each of these, fundamentals are strong, but there is still a significant valuation dislocation because REITs are trading at deep discounts to their NAVs.
The disruptions in the supply chain for building materials that the pandemic brought persist. Those disruptions have created a supply/demand imbalance that has been working in the favor of the owners of apartment assets, and especially for those with properties in urban locations. The demand for rental units has been increasing as young employees, who have been working remotely, are returning to offices in metropolitan areas. Additionally, more and more college students have resumed on-campus learning and are looking for nearby apartments.
Private equity firms have significant dry powder, and apartments have always been a preferred asset class because of their favorable financing. The potential for M&A activity has also been enhanced by the large discounts to asset value that are prevalent today in the public real estate market (Exhibit 4).
Self-storage REITs rarely trade at significant discounts to their NAVs, because these businesses require relatively low capital expenditures. They also present strong acquisition opportunities with the roll-up of local operators. Self-storage platforms are unique and highly valuable. That makes self-storage REITs attractive M&A candidates because it is difficult, if not impossible, for a private equity firm to replicate the platforms. Given these attributes, the performance of self-storage REITs this year may seem surprising. They also have been caught up with the volatility in public markets, and self-storage REITs have been trading this year at a deep discount to their NAVs and well below their long-term, historical averages (Exhibit 5).
Canadian Industrial and Multifamily
Some of the world’s most-favorable supply/demand dynamics for real estate now exist for Canadian industrial and multifamily properties. REITs focused on those two market sectors are now prime M&A candidates for private equity firms, given the scarcity of large portfolios of these properties in Canada and the severe supply shortage of both asset classes.
Fears about interest rates and the regulatory climate, however, have created unprecedented discounts for industrial and apartment REITs in Canada, as shown in Exhibit 6. Better-than-expected regulatory developments and a return to immigration, with the resulting increased demand for rental units, could be strong catalysts for a rebound in share prices in these market segments.
History Suggests a Potential Rebound
In fearful markets, strong fundamentals are often overlooked. Listed REITs have been affected by the overall negative sentiment in public markets. But the prices REITs are trading at do not reflect strong fundamentals, particularly in several key asset classes. History, though, does demonstrate that listed REITs have rebounded strongly after their valuations have been unfairly discounted. We believe the current market could be a repeat of that scenario and that listed REITs present a significant buying opportunity for investors.