The Nareit All Equity REIT Index rose 5.36% in June and is now up 2.97% year-to-date with almost every property subsector—even the beleaguered office segment—posting strong gains for the month.
For the month, timber REITs (up 15.90%) and office REITs (up 10.38%) were the leading segments. Retail REITs as a whole were up 7.03%, with shopping center REITs (up 11.04%) and regional malls (up 11.70%) posting strong numbers.
June also marked the introduction of a new sector—gaming REITs—to the Nareit All Equity REIT Index. The two firms that make up that group were down 0.54% for the month. Previously, the REITs were counted as part of a bigger group of specialty REITs.
WMRE spoke with Edward F. Pierzak, Nareit senior vice president of research, to discuss the June REIT results.
This interview has been edited for style, length and clarity.
WMRE: Can you walk us through the June numbers?
Ed Pierzak: With June performance the numbers look good. Month-to-date the index was up nearly 5.4%, quarter to date it’s up 1.2% and year-to-date nearly 3%.
Some of the question comes down to sectors. We had broad strength across the board. But three to highlight would be office, data centers and gaming.
For offices, we’ve often had the conversation related to the challenges the sector has faced. And as we’ve said before, not all offices are experiencing the same challenges. The portion of the market [that] is doing quite well are newer buildings that are highly-amenitized. We are really seeing there is a recognition of that performance and that REITs often own those types of assets. That’s a big point to note. That said, office is only 4.5% of the total index weight. The strong performance overall related to other sectors as well.
Data centers are a great representation of the modern economy. The sector has had a tremendous amount of growth starting in 2019. Today, data centers are about 8.7% of the overall index. It’s almost double that of office. The investment case is really compelling. The continuing developments in AI are going to benefit data center demand, but also influence the design of data centers going forward. We can look back on what happened with the industrial sector and the rise of e-commerce as an analogy. As e-commerce started to bloom and blossom, it influenced warehouse and distribution demand and design.
Lastly, I wanted to touch on the gaming sector. The big news there is that as of the second quarter of this year, the gaming sector is an individual sector. It has two constituents. At this point it already accounts for over 3% of the weight of the index.
When we talk about the rules for adding a sector, the minimum combined sector weight in terms of investable market cap has to be 3% combined and it has to hold that level for two quarters. Gaming REITs surpassed that threshold in 2022 and everything will be made official as of second quarter quarterly review.
WMRE: That’s such an interesting observation about data centers making up a larger percentage of the index than offices. I don’t think most people would guess that when they think about the index.
Ed Pierzak: Oftentimes—particularly when we meet with clients and step through the current makeup of the REIT indices—what you find is that today the four traditional commercial real estate sectors—office, industrial, multifamily and retail—account for less than half of the index. A lot of the next gen real estate sectors have taken on the dominant role.
WMRE: On offices, there’s been some talk of owners divesting weaker assets to make their portfolios more concentrated on stronger properties. Has that also played a role?
Ed Pierzak: We certainly have heard that people have taken a critical look at their portfolios and are identifying assets that are long-term holds vs. potential sales.
WMRE: On another front, in June you published a piece analyzing whether private and public real estate values are converging. Can you talk about what you found?
Ed Pierzak: We have been talking about divergence between public and private for quite some time. Through time we expected the gap to close—and, in this case, we are using cap rates. The good news is when we look at implied REIT cap rate and the cap rates of private real estate transactions, the gap has closed meaningfully. The narrowing has come from implied REIT cap rates coming down a bit, but also the transaction cap rates on the private side have come up a bit. The gap stood at 42 basis points as of the first quarter.
However, when we look at the implied REIT cap rate and the private real estate appraisal cap rate, there’s still a significant gap there, at about 180 basis points. The challenge there is when we take a look at the weight of capital behind those new cap rates, that volume on the transaction side in the first quarter of 2023 was just $1.4 billion. But when you compare it to appraisal volume, that’s nearly $330 billion.
What that tells us is that there is still a fair distance to go in terms of the market coming into equilibrium. And, unfortunately, that likely means there will be more writedowns related to the private real estate sector. So, we are making progress, but the wheels of progress turn slowly.
WMRE: In our past conversations, I think you also mentioned that looking at past periods of divergence, there’s generally a time period—two years or so—during which the convergence plays out. So where are we today relative to that?
Ed Pierzak: Historically, it’s taken about nine quarters. You can’t always use that as a judge for the future. As we sit here today, we are about six quarters into the convergence. I don’t think it’s unreasonable that it may take another year for things to effectively converge.
WMRE: Do factors like the Fed’s interest rate targets come into play here?
Ed Pierzak: It’s interrelated. I would focus on the capital markets. If we look at debt, it’s gotten much more expensive. That puts its own pressures on valuations, particularly on anyone that needs to get a new mortgage. Not only have underwriting standards gotten more strict, but lending costs have gone up and there is likely to be a revaluation by the lender. There are likely some pressures you see from that. But it’s really the private real estate investment managers. They are receiving broker opinions of value. Many times, they are reluctant to accept those as we’ve seen transaction activity throttled. The quicker we can get to a more normal level of transaction activity, the quicker the market will clear.
WMRE: Looking back a bit further, in early June you had your annual REIT Week event in New York. Were there any major themes you can touch on?
Ed Pierzak: REIT Week was well attended with over 2,500 at the event. New York has come back to life on the restaurant scene. But it was also very smoky because of the forest fires. So it was an interesting environment that way.
In terms of the themes, it’s consistent with what we’ve been talking about. There was a fair amount of discussion on on the public/private divergence. REITs are in a great position.
When we talked with a lot of REIT management teams, we heard a discussion of their current state in terms of operations and balance sheets. With their balance sheets, we find that for REITs over 75% of their debt is unsecured. This provides them with an advantage. Even as we went to individual presentations for companies, we did see this theme. People were talking about using unsecured debt and others were trying to establish investment grade credit ratings to use unsecured debt. In the first quarter, there was a bit of an uptick with 15 issuances with a median value of $650 million and a median cost of 5.3% that is competitive with traditional mortgage or secured debt.
WMRE: Do investors see the potential value of REITs?
Ed Pierzak: We saw that in our conversations with investors at REIT Week, but also in our conversations with investors as part of our outreach process. Even those that have not been traditional investors in REITs recognize this divergence and opportunity. As you look across historically, this type of divergence hasn’t happened that often, but now is one of those times.
