US REITs underperformed the broad market again in September 2023, for the 8th consecutive month, driven by apartments and offices while hotels were roughly flat MoM. On an absolute basis, REITs ended the month in the red for the second consecutive time. Thus, BBREIT index decreased by 7.6% MoM in September vs -4.9% MoM of SPX index.
EXECUTIVE SUMMARY
US REITs underperformed the broad market again in September 2023, for the 8th consecutive month, driven by apartments and offices while hotels were roughly flat MoM. On an absolute basis, REITs ended the month in the red for the second consecutive time. Thus, BBREIT index decreased by 7.6% MoM in September vs -4.9% MoM of SPX index. Absolute September performance was -1.5 std from the mean monthly performance, and it was in the bottom 6% of absolute monthly performance in the index history. In turn, September relative performance was -2.9% MoM. It is -0.6 std from the mean monthly performance, and it is in the bottom 26% of relative performance vs SPX index since BBREIT index inception. The first half of October wasn’t strong either, and REITs index decreased by 13.3% ytd as of October 19, 2023. So, it continues underperforming the broad market, as it did in 6 out of 7 previous years. On a relative basis, it tumbled already by 22.2% ytd in 2023, the worst year over a quarter of a century. Volatility of monthly price changes remains high for US REITs ytd, what is usual for underperforming sectors, but it decreased slightly MoM in September. Thus, it was 28.7% in September vs 34.1% in August, which, in turn, was the highest figure over the last 16 months. The worst performers were apartments and offices, which decreased by 9.7% MoM and 11.2% MoM in September, respectively. In turn, hotels decreased by 0.4% MoM. On ytd basis, the industrial subsector remained the best performer, having lost just 0.1%. In turn, the office segment was the worst performer by a wide margin, -19.8% ytd as of the end of September.
As a result of weak both absolute and relative performance, valuations went down until so far, and the decline accelerated in September and October. So, relative valuations vs SPX index still remain low, not very far from GFC’s troughs. On the other hand, absolute valuations don’t look extremely cheap vs historical averages. Thus, P/B of BBREIT index was 2.0x as of October 19, 2023, slightly below than an average since April 2002 of 2.32x, going down by 0.2x since the end of August. P/Sales of BBREIT index was 5.2x vs an average since May 2002 of 5.6x, or +0.1 std. In turn, a discount to SPX on P/B index was 51% as of October 19, 2023 vs an average discount since 2002 of just 20%, -2.0 std. As for P/Sales, the current premium to SPX index is 121% vs an average premium of 221%, -1.6 std. On P/FFO basis, a median figure of REITs was 15.3x as of October 19, 2023 vs a historical average of 18x, or -0.8 std. In turn, median dividend yield of 50 largest BBREIT index members was 5.1% as of October 19, 2023 vs a historical average of 4.1%, or +0.9 std. On EV/EBITDA basis, a median figure of REITs was 18.6x as of October 19, 2023 vs a historical average of 19.9x, or -0.4 std, which is quite consistent with still relatively low financial risks of the segment. Thus, interest coverage ratio of US REITs was 5.1x as of the end of 2Q23 vs a historical average of 3.9x (a quarterly average since 2005), or +1.3 std. As for individual names, multipliers are still quite different, but dispersion across REITs has decreased significantly in the recent 1.5 years. Thus, office’s median P/FFO estimates for our REITs sample were 7.6x and 8.2x for FY23 and FY24, respectively, as of October 19, 2023 while industrial’s median multipliers were 19.4x and 18.2x, respectively.
The US economy continued growing above expectations, and hard data indicated that economic activity even accelerated in 3Q23, but soft data suggested that the start of 4Q23 wasn’t strong. Nonetheless, the Fed increased FY23 GDP growth forecast significantly at the September meeting. Thus, it is implied that GDP will increase by 2.1% yoy in 2023 (vs just +1.0% yoy implied growth a quarter ago). It is expected that GDP growth will decelerate to 1.5% yoy in 2024, and the soft landing is the Fed’s baseline scenario at the moment, even despite a number of indicators still pointing to a recession, while higher rates will remain for longer. In turn, the September FOMC minutes indicated that downside risks were still relatively high even despite a more optimistic outlook. In any case, given the still very tight labor market, robust consumer spending as well as picking up housing activity and waning inflation pressure, a recession does not look so inevitable at the moment. At least, current market expectations imply that the US economy will be able to avoid it. On the other hand, there were more and more signs of gradual softening of the labor market in recent months even despite quite high September payrolls, manufacturing activity remained relatively weak while inflation was still noticeably higher the Fed’s target. So, it is too early to say that the US economy has already been out of the woods, at least because the inverted yield curve has never been wrong before while the lag effects of the very tight monetary policy on the economic activity may not be fully taken into account in current forecasts, from our point of view. Nonetheless, even taking into account gradual growth of GDP growth forecasts, even a ‘soft landing’ scenario doesn’t imply any significant improvement of CRE fundamentals in forthcoming quarters. On the other hand, it doesn’t imply noticeable deterioration of fundamentals either, only if in the office segment, which still continues to suffer from structural problems that arose during the pandemic.
REITs fundamentals remain resilient despite gradual deceleration of the economy, elevated inflation and still quite high as well as growing interest rates. Thus, NOI growth remains positive albeit decelerating even in the riskiest CRE segment, such as the office one. Nonetheless, we see noticeable deceleration of the demand with a significant slowdown of net absorption rates. Banks also noted weaker CRE demand. So, they continued tightening lending standards in the segment. Moreover, banks expect to tighten standards in the segment over 2H23. According to banks, it will be accompanied by deterioration of credit quality and decline of collateral values, despite it has already decreased noticeably. Thus, commercial property price index decreased by 9.9% yoy, but it was roughly flat MoM, as of the end of August 2023, driven by apartments. Moreover, it is still +16.3% vs the end of 2019, remaining roughly flat during the last 5 months. CRE loans issued by commercial banks even increased since early March 2023 despite noticeable growth of risks, adding 6.5% yoy, or +2.5% ytd, as of October 4, 2023. REITs estimates remain roughly stable ytd (except for EPS forecasts), and estimates even increased in recent months despite mixed 2Q23 earnings season. Thus, median growth of revenue estimates of 20 largest members of BBREIT index was 1.3% ytd as of October 19, 2023, while median growth of EBITDA CY estimates was +0.9% ytd. So, fundamentals remain solid so far due to stronger than expected US economy dynamics, but a number of segments are far from the trough of the cycle, especially taking into account resumed growth of rates in recent months. Nonetheless, we do not share the general high anxiety regarding both the entire segment and the offices in particular, especially taking into account very tight lending standards in the CRE lending after the GFC, strong property price growth during the recent cycle as well as the still quite resilient economy. We fully assume that under certain conditions, REITs could continue to fall, but we remain cautiously optimistic on the sector at the moment given current relative valuations. Also, we recommend being selective and avoiding high-risk segments, at least in the nearest future.
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