US REITs outperformed the broad market again in December 2023, for the second consecutive time after 9 months of weaker dynamics in a row. The growth was broad-based but key outperformers were regional malls and offices. On an absolute basis, REITs ended the month in the green for the second consecutive time either, after ending three months in the red.
EXECUTIVE SUMMARY
US REITs outperformed the broad market again in December 2023, for the second consecutive time after 9 months of weaker dynamics in a row. The growth was broad-based but key outperformers were regional malls and offices. On an absolute basis, REITs ended the month in the green for the second consecutive time either, after ending three months in the red. Thus, BBREIT index soared by 7.9% MoM in December vs +4.4% MoM of SPX index. Absolute December performance was +1.3 std from the mean monthly performance, and it was in the top 7% of absolute monthly performance in the index history. In turn, December relative performance was +3.3% MoM. It is +0.8 std from the mean monthly performance, and it is in the top 19% of relative performance vs SPX index since the BBREIT index inception. However, the first half of January wasn’t strong for US REITs, and the index decreased by 4.2% ytd as of January 23, 2024. Nonetheless, despite strong rally in 4Q23, BBREIT index underperformed the broad market in 2023 as it did in 6 out of 7 previous years. On a relative basis, it tumbled by 15.9% ytd in 2023 vs median FY underperformance of just -0.4% since 1995 year. US REITs dynamics remained volatile in December. Thus, a difference of monthly price changes between the best and the worst performers among top 50 REITs from BBREIT index was 26.7% in December vs 30.2% in November. Even the worst performing sectors of 2023 managed to end each of the last two months of the year in the green. Nonetheless, offices ended the year in the red – the only one among key CRE segments, -2.9% yoy in 2023.
As a result of weak both absolute and relative performance ytd, valuations went down until not so far, but there was a notable reverse movement in the recent months. Nonetheless, relative valuations vs SPX index still remain low but they increased markedly from local minima. On the other hand, absolute valuations don’t look cheap vs historical averages, especially after the rally in November and December. Thus, P/B of BBREIT index was 2.4x as of December 29, 2023, already a bit higher than an average since April 2002 of 2.32x, and +0.2x since the end of November. P/Sales of BBREIT index increased by 0.5x from the end of November to 6.3x as of December 29 vs an average since May 2002 of 5.6x. In turn, a discount to SPX on P/B index was 47% as of December 29, 2023 vs an average discount since 2002 of just 20%, -1.7 std. As for P/Sales, the current premium to SPX index is 144% vs an average premium of 225%, -1.2 std. On P/FFO basis, a median figure of REITs was 16.4x as of December 29, 2023 vs a historical average of 17.9x, or -0.8 std. In turn, median dividend yield of 50 largest BBREIT index members was 3.9% as of December 29, 2023 vs a historical average of 4.1%, or -0.1 std. On an EV/EBITDA basis, a median figure of REITs was 19.4x as of December 29, 2023 vs a historical average of 19.9x, or -0.2 std, which is quite consistent with still relatively low financial risks of the segment. Thus, interest coverage ratio of US REITs was 5.5x as of the end of 3Q23 vs a historical average of 3.9x. As for individual names, multipliers are still quite different, but dispersion across REITs has decreased significantly in the recent 1.5 years. Thus, median P/FFO estimates for offices were 10.3x/10x for FY23/24 as of January 19, 2023 vs industrial’s figures of 23.4x/21.3x.
The US economy continued growing well above expectations, and GDP growth estimates kept going up either. However, US macro indicators released in December and January were mixed again. Nonetheless, it does not negate the fact that the probability of recession continues decreasing. Thus, according to the Fed’s December projections, US GDP will increase by 1.4% yoy in 2024, by 1.8% yoy in 2025 and by 1.9% yoy in 2026. In other words, the ‘soft landing’ remains the baseline scenario, even although uncertainty is still high, and the fact that even better than expected indicators haven’t been strong. Thus, the most recently released nonfarm payrolls and ADP employment were better than expected but, according to household survey, total employment tumbled by 683K in December, and it was the worst decline since the first wave of the pandemic. Moreover, duration of unemployment continued going up, albeit still remaining low. Dynamics of ISM indicators, both manufacturing and services, remained weak in December, despite to substantial decline of rate expectations. So, even better than expected December's industrial production was mainly driven by negative revisions of IPs data in previous months rather than strength of the economy. In turn, retail sales and consumer spending still remained strong while consumer sentiment published by Michigan University skyrocketed in two recent months. Thus, for almost every optimistic argument about the future dynamics of the economy, you can find a pessimistic one. Nonetheless, the dovish Fed’s meeting in December accompanied by lower CPI/PPI data finally convinced us that rates will not be so high for longer as it was expected just 1-2 quarters ago. At least, rate expectations for the nearest years moved significantly down in 4Q23, implying gradual easing of pressure on the US CRE fundamentals, what is quite important for the segment, given relatively high refinancing volumes in the coming years.
REITs fundamentals remain resilient so far despite gradual deceleration of the economy and still high interest rates. Thus, NOI growth remains positive albeit decelerating, even in the riskiest CRE segment – the office one. But we also see noticeable demand decline with a significant slowdown of net absorption rates across all major segments. Banks noted weaker CRE demand in 3Q23 either. So, they continued tightening lending standards in the segment. Moreover, banks expect to tighten standards in CRE further, what will be accompanied by deterioration of credit quality and decline of the collateral values. Thus, CPPI decreased by 8% yoy in November but it remained roughly flat during the last 8 months. Even apartments, which prices decreased by 12.1% yoy, doesn’t look too risky, given the decline was mainly driven by excessive supply while demand still remained resilient. Nonetheless, the US property market is still trying to find a balance, given roughly flat price dynamics but depressed volumes. Moreover, NOI growth could turn negative in a number of segments in the nearest future, especially in case of notable unemployment growth, even despite more than 1/3 of REITs increased their FY23 guidance. Moreover, strong 3Q23 figures related mainly to the healthiest subsegments, such as industrial and hotels, while 3Q23 results of offices and residential weren’t strong. So, REITs estimates remained roughly flat. Thus, median growth of revenue estimates of 20 largest members of BBREIT index was 2.1% yoy as of December 29, 2023 while median growth of EBITDA CY estimates was +1.0% yoy. Given tighter lending standards, still high interest rates and further deceleration of the economic activity, we expect that fundamentals will continue deteriorating in the near future, but the worst-case scenario has been already avoided, from our point of view. Nonetheless, we still believe that risks are still tilted to the downside, even taking into account higher probability of ‘soft landing’ and substantial decline of rate expectations. So, we think that recent rally was excessive, and it overestimated the positive impact of lower rate expectations on CRE fundamentals, especially taking into account current REIT’s valuations. So, we remain neutral on the sector, and recommend to be selective, avoiding high-risk subsegments.
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