US REITs outperformed the broad market significantly in July, for the second time over the last three months. However, it was just the 4th time of stronger dynamics vs the broad market over the last 18 months. On an absolute basis, the REITs ended the month in the green, for the third time in a row or for the 7th time over the last 9 months.
EXECUTIVE SUMMARY
US REITs outperformed the broad market significantly in July, for the second time over the last three months. However, it was just the 4th time of stronger dynamics vs the broad market over the last 18 months. On an absolute basis, the REITs ended the month in the green, for the third time in a row or for the 7th time over the last 9 months. Thus, BBREIT index increased by 7.0% MoM in July vs +1.1% MoM of SPX index. Absolute July performance was +1.2 std from the mean monthly performance, and it was in the top 8% of absolute monthly performance in the index history. In turn, July relative performance was +5.8% MoM. It is +1.3 std from the mean monthly performance, and it is in the top 9% of relative performance vs SPX index since the BBREIT index inception. Moreover, the first half of August was quite strong for US REITs as well. Nonetheless, the index increased just by 2.9% ytd vs +14.4% ytd of SPX index as of August 14. Moreover, the first 7 months of 2024 were the second worst start of a year for BBREIT index on a relative basis over the last 15 years, -0.9 std from the mean. On an absolute basis, it was also -0.3 std from the sample average over the last 30 years. US REITs remained quite volatile in the first 7 months of the year, but the volatility decreased significantly in July, despite the start of the 2Q24 earnings season, mainly driven by a notable decline of interest rates expectations. A difference of monthly price changes for the best and the worst performers among top 50 REITs from BBREIT index decreased to 19.9% in July from 30.7% in June. All major CRE sectors except for hotels increased in July.
As a result of weak both absolute and relative performance on a year-over-year basis, valuations continue going down even despite a notable reverse movement in recent months. Moreover, relative valuations vs SPX index still kept going down, staying near the lowest levels over more than 20 years. On the other hand, absolute valuations don’t look extremely cheap vs historical averages, given still elevated rates, even after a significant decline of the REITs in recent months. Thus, P/B of BBREIT index was 2.53x as of August 19, 2024, +0.5 std from a mean since April 2002, and +0.23x since the end of June 2024. P/Sales of BBREIT index increased by 0.54x from the end of June to 6.6x as of August 19, 2024 vs an average since May 2002 of 5.6x. In turn, a discount to SPX on P/B index was 50% as of August 19, 2024 vs an average discount since 2002 of just 21%, -1.8 std. As for P/Sales, the current premium to SPX index was 123% vs an average premium of 220%, -1.5 std. On P/FFO basis, a median figure of REITs was 18.1x as of August 19, 2024 vs a historical average of 17.9x, or +0.1 std. In turn, a median dividend yield of 50 largest BBREIT index members was 3.71% as of August 19, 2024 vs a historical average of 4.05%, or -0.3 std. On EV/EBITDA basis, a median figure of REITs was 19.78x as of August 19, 2024 vs a historical average of 19.86x, or -0.03 std. In turn, interest coverage ratio of US REITs was 4.8x as of the end of 2Q24 vs a historical average of 3.9x (the quarterly average since 2005), or +0.9 std. As for individual names, multipliers are still quite different, but dispersion across REITs has decreased significantly in the recent 2 years. Thus, median P/FFO estimates for offices were 11.2x/10.9x for FY24/25 as of August 19, 2024 vs industrial’s figures of 21.8x/19.9x.
The US economy continues growing at a solid pace but imbalances also hold intensifying on. Thus, the US GDP growth accelerated to 2.8% in 2Q24 vs just +1.4% in 1Q24 and the consensus estimate of 2.0%. On the other hand, the main driver of acceleration was a notable growth of private inventory investments while the key core driver of GDP, namely a growth of consumer spending, was roughly flat vs 1Q24. Moreover, a faster than expected GDP growth may be an additional argument for the Fed to hold the rate longer than expected, especially in case of weaker disinflation process. Nonetheless, it is still expected that the US GDP growth remains resilient in the near future albeit decelerating. At least, according to the current market expectations, US GDP will increase by 1.5%/1.5%/1.7% qoq in 3Q/4Q of 2024 and 1Q25, respectively. In turn, the probability of recession in the nearest 12 months has already been estimated at just 30% even after growing concerns about the labor market. Despite both hard and soft data ytd imply that the economic growth still remains solid and even higher than expected, at least so far, the most recent data points to growing imbalances in the US economy. So, even the Fed has already acknowledged that inflation is no more the only problem. Hence, rate expectations continued going down in recent months. Thus, expected FF rates for 2025/2026 years decreased by around 100 bps since the end of May. Moreover, it is already expected that FF rate will decline below 4% already in 1Q25. Nonetheless, a pressure on CRE fundamentals will remain quite high in the near future, especially in offices, given that one of the main drivers of the interest rates expectations decline is a weaker labor market. Thus, payrolls increased just by 114K in July vs the consensus of 175K. Despite it was just the third miss over the last 10 months, underemployment rate soared by 40 bps MoM to 7.8% in July, the highest figure over the last 33 months. Moreover, a ratio of job openings to unemployed workers has already returned to pre-pandemic levels, to just 1.2x in June, the lowest figure over more than three years.
CRE fundamentals still remain mixed but gradually improving with a more and more balanced underlying property market. At least, 2Q24 earnings confirmed again that last market fears were clearly exaggerated. Thus, more than 70% of our sample of REITs reported higher revenue with a median surprise of +0.6%, and around 60% of the sample exceeded net income estimates with a median surprise of solid +5%. Nonetheless, the key near term driver of REITs’ quotes still remains interest rates dynamics, from our point of view, given that more than $900 Bn of CRE debt outstanding will expire in 2024 (more than $100 Bn of them are in offices). Unsurprisingly, correlation between average monthly 10yr treasury yield and BBREIT index is still -0.9 (since the beginning of 2022). So, despite solid 2Q24 earnings, estimates of REITs revenue/FFO still remain negative on a yoy basis. Thus, a median decline of 3Q24 FFO of our sample of REITs was 2.4% yoy as of mid-August while revenue projections decreased by 1.0% yoy. In other words, 2Q24 earnings confirmed that REITs/CRE have been very successful in resisting very high interest rates so far, but it is still unclear how long this can last, especially considering renewed fears about the labor market cooling. So, banks continued tightening lending standards for CRE loans as well as expecting further tightening of standards in 2024. On the other hand, banks also expect higher demand in 2024, albeit accompanied by deterioration in credit quality. In turn, the property market continues to search for a balance of supply and demand. Thus, CPPI decline decelerated significantly in recent months, with prices being flat yoy in June, the first month of non-negative dynamics over the last 19 months. On the other hand, transaction volume still remains quite weak. Nonetheless, NOI growth on a yoy basis remains positive in all key CRE segments except for offices. Effective rent growth also remained positive so far. Moreover, the recent growth of vacancy rates was mainly driven by supply growth, especially in apartments, where multifamily units under construction still remained near an all-time high, while net absorption rates kept healthy among all key segments except for offices. In other words, the overall picture still remains mixed but there are more and more signs that the US CRE market isn’t far from the inflection point, at least under the current baseline economic scenario. The start of the rate cut cycle could be a strong catalyst for US REITs but how long its momentum will last will depend on whether rates decline will be driven by lower inflation or by labor market deterioration. So, we still remain neutral on the sector, but gradually becoming more optimistic.
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