Over the past several months, media coverage and research reports alike noted that a certain office REIT or the office REIT sector in general is trading at a large discount to net asset value (NAV). According to Green Street, the average discount to NAV as of the end of April 2023 was 48.7%.
Why are these REITs trading at such huge discounts? And does this imply that they should be considered good investments?
The primary reason for these large discounts is that analysts are using an average cap rate of approximately 7% to estimate the NAV, but the implied cap rate indicated by the stock price is closer to 10%. Estimating cap rates is easier when there are ample transactions in the marketplace. Absent data points in asset trades, there are only a few sources to rely on. Investors and appraisers typically incorporate and rely upon third-party surveys such as the PwC Investor Survey, one of the most relied-upon sources for capitalization rates.
Private market expectations and public market’s reactions are drifting further apart
As illustrated in the PwC Investor Survey graph above, the gap continues to widen in the office sector between investors’ expected cap rates (shown as the orange line) and public REITs’ implied cap rates (shown as the silver line). Capitalization rates included in the PwC Investor Survey for CBD National Office have remained relatively flat since 2021. However, the average implied cap rate for public REITs has shown a sharp increase during the same period.
One can argue that a 7% cap rate (used to estimate NAV) is relatively close to the historical average of the implied cap rate (silver line) and the stock market may be overreacting. Since public REIT share prices are influenced by the stock market volatility, we reviewed how the office REIT market has performed compared to the S&P 500.
Office REITs are not moving in sync with S&P 500
The graph above shows a pattern of office REITs (red line) moving in sync with the market in 2021. Beginning in March 2022, office REIT share prices start plummeting while the S&P 500 increased. As of April 2023, the office REIT index dropped by 41% from March 2021 compared to the S&P 500, which had a 5% increase during the same period. This would suggest that the recent declining trend for office REITs is not related to market volatility, but rather is the result of weak fundamentals.
Issues that are driving office REIT prices down
Will the gap close between private investors’ expectations and public market reality as either the private or the public market corrects itself or the two converge? Or are private investors fooling themselves by accepting cap rates that were achieved years ago? There are several indicators to consider:
- Higher cost of debt. As of April 2023, the 5-year Treasury yield increased by approximately 200 basis points compared to early 2022. A drastic drop in future interest rates is not anticipated based on the 5-year Treasury forward curve. It appears that the higher cost of debt is not factored in by the respondents of the PwC Survey as of the first quarter of 2023 (assuming required return on equity is similar to prior quarters; in reality, it is likely higher).
- Interest rate spreads began widening in the third quarter of 2022 for office properties specifically, compared to other property types, such as multifamily, retail and industrial (see graph below).
- Investors are skeptical of long-term office demand as hybrid work becomes more accepted by employees and employers alike. Actual office traffic is only about half of pre-pandemic levels, according to Kastle Systems, which tracks keycard entry into office buildings.
- Layoffs are increasing in certain sectors and companies are focusing on cutting costs.
- Further decline in value may result from lower effective rent in the future. In selected markets (such as Manhattan), office rents appear to have held up better than expected, but caution is required. In many cases, newly constructed properties can command a premium and, as a result, buoy the average rent in the market. Additionally, hefty concessions in free rent and tenant improvements are not always disclosed, which will lower the effective rent. In many cases, landlords are offering larger concession packages to maintain their face rents.
How to interpret the discrepancy between private vs. public market data?
Owners face challenges obtaining financing (or refinancing) due to the higher cost of debt, lower valuations and more conservative loan-to-value requirements, as lenders have become cautious about the office sector in general and require more cushion. Ultimately, lower net operating income, increasing interest rates, and tightening credit standards will be reflected in cap rates as transactions begin confirming public market sentiments. The public market has captured future expectations of lower projected yield and pricing, whereas the private market is slow to accept the higher cap rates and appears to be in denial. Third-party surveys are often relied on for valuation purposes; however, one must be cautious in their use when actual trades in the public market are confirming a value that is substantially different.
Yunsoo Kim serves as managing director with FTI Consulting. She specializes in real estate valuation and has conducted assignments for litigation support, restructuring, financial reporting and acquisition & divestiture. Kim has over 25 years of experience in real estate valuation and consulting. She can be contacted at [email protected].
The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates or its other professionals. FTI Consulting, Inc., including its subsidiaries and affiliates, is a consulting firm and is not a certified public accounting firm or a law firm.
