After suffering a rough 2022, with total returns on the FTSE All Equity REIT Index down nearly 25 percent, publicly-traded REITs are poised for a bounce back in 2023 and things got off to a strong start with total returns rising 10.07 percent in January.
Most property types posted double-digit gains for the month, led by lodging/resorts (up 17.13 percent), industrial (up 13.71 percent) and data centers (up 13.21 percent). Even the much-maligned office sector saw total returns up 11.35 percent in January.
WMRE spoke with Edward F. Pierzak, Nareit senior vice president of research, and John Worth, Nareit, executive vice president for research and investor outreach, to discuss the results from the first month of 2023.
This interview has been edited for style, length and clarity.
WMRE: Let’s start with the overall view. It looks like it was a very strong month for REITs. Can you break down the results a bit?
Ed Pierzak: The all-equity index up over 10 percent is the best monthly performance since 2019. If you look across the property types, hotels were the best performer, followed by industrial and data centers. For hotels, the news was positive. People are traveling. And perhaps there’s more of a glimmer of optimism in 2023 on industrial and data centers. The modern economy sectors are showing strength.
One of the interesting elements is if you take a look at the office sector. Its performance for the month was greater than the aggregate index. That’s notable for a few reasons. If you look back to 2022, office was the poorest performer. That may not be surprising. There’s a natural experiment taking place where roles of hybrid work and work-from-home are being fleshed out and that’s going to determine the future of offices. The results reinforce the sentiment that offices are still important.
You also had Ken Griffin, the head of Citadel, which brought in a historic return of $16 billion in 2022. When asked what elements drove that, he credited that to employees returning full time to the office.
In addition, if you look at the most recent Kastle data for office occupancy levels, the 10-city average has broken 50 percent. There’s a been a forward progression. There is probably still quite a ways to go. Labor Day seemed to be a bit of a litmus test on a push back to office. If you dial back to then, the occupancy was just under 44 percent. Two weeks after that we saw a bump to 48 percent and forward progression since then to 50 percent.
WMRE: Do you attribute any of the results as a response to macro conditions or expectations about where monetary policy is going?
Ed Pierzak: In terms of the broader economic outlook, Bloomberg’s most recent monthly survey of economists put [the chance of a recession] at about 70 percent over the next 12 months. So clearly there remains some uncertainty. Meanwhile, the Fed just bumped up rates by 25 basis points. There’s recognition that inflation has eased. It’s still elevated overall, but the process of decline has started.
But this underscores what we have found in our research that REITs have performed quite well in recessionary periods. When we look at operations, things are still in great shape. It’s a little early into earnings season, but at this point we are seeing that strength in operational performance is likely durable.
WMRE: Can you address the gap between public and private real estate markets?
Ed Pierzak: There’s a divergence in REIT valuations versus REIT performance. And there’s also a divergence in cap rates and total returns between the public and private markets. Data shows that as of the end the third quarter, the spread between the NAREIT index implied cap rate and NCREIF transaction cap rate was about 120 basis points.
If all else is equal, if private markets adjust to public markets, we would see a decline of 20 percent or more on the private side. We would expect over 2023 that this gap will close.
When we look at rolling four-quarter total returns for the FTSE Nareit All-Equity index and NCREIF-ODCE, as of the third quarter of 2022, the delta was over 38 percent. That is showing REITs were really underperforming private markets. In fact, it was the most significant underperformance in the history of those indexes. In the fourth quarter, the delta had dropped to 32 percent. That was due both to a positive performance in the public sector and a negative performance in the private sector. The ODCE posted a decline of 5 percent, the greatest since the great financial crisis.
As we take a look at that, the adjustment process has started and we anticipate that this will unfold through 2023.
WMRE: Can you talk a bit about any recent conversations you’ve had with portfolio managers? I’ve seen a lot of bullishness in the market for REITs in 2023.
John Worth: Ed and I recently did a tour of some big institutional investors. We got to hear a bunch of different perspectives on this public/private valuation gap question as well as different approaches they are taking in addressing that valuation gap.
The first one was looking at REITs as a tactical play. The investor is viewing the valuation dislocation as an opportunity and trying to move cash and assets into REITs, because they view the divergence with private real estate as a short-term phenomenon. They want to create some alpha by positioning themselves there.
Other investors are using REITs more strategically, really executing on the idea of a “completion portfolio.” They’ve changed the shape of their real estate allocations and using REITs as part of real estate portfolio to get access to different property types.
And a third approach is using REITs as the real estate sleeve of their portfolios. It’s not necessarily tilted toward completion. It’s just about building up their real estate allocation.
Across the board, the notion was that with where valuations are, it provides an entry point for REITs. So it was really a positive set of conversations.
WMRE: I recently saw Nareit also publish its capital markets update summarizing 2022 activity and it seemed like offerings dropped down a bit in the latter half of the year.
John Worth: The latter half of last year was quiet. REITs only raised $2.5 billion from secondary equity and debt offerings, although they also raised $5.8 billion through at-the-market programs. Taken altogether, the last time REITs raised less capital in a quarter was 2009.… The data takes you back in time. We’ve seen very slow capital market issuance. But it’s important to draw the contrast between these two time periods.
In 2009, we were in a financial market crisis. Today, because of balance sheet strength, REITs are well-positioned to navigate a period of higher interest rates. The slow equity issuance and slow debt issuance is because they are not being forced to issue. We will continue to see more debt issuance as refinancings come up. But because REITs have a weighted 7.5 years to maturity on their debt, it will be slow and steady process rather than them rushing into market irrespective of what rates and spreads look lie.
The lack of activity is a sign of the strength of the balance sheets and their flexibility as opposed to a risk characteristic. We think it’s an interesting phenomenon. We will see more issuance in 2023. But it is reflective of all the preparation REITs did to make their balance sheets more resilient.
