US REITs slightly outperformed the broad market in September, for the third consecutive month. However, it was only the 6th time of stronger dynamics vs the broad market (SPX index) over the last 20 months.
EXECUTIVE SUMMARY
US REITs slightly outperformed the broad market in September, for the third consecutive month. However, it was only the 6th time of stronger dynamics vs the broad market (SPX index) over the last 20 months. On an absolute basis, US REITs (BBREIT index) ended the month in the green, for the 5th time in a row and for the 9th time over the last 11 months. Thus, the index increased by 2.5% MoM in September vs +2.0% MoM of the SPX index. The absolute September performance was +0.4 std from the mean monthly performance, and it was in the top 34% of absolute monthly performance in the index history. In turn, the relative performance in September was +0.5% MoM. It is +0.2 std from the mean monthly performance, and it is in the top 39% of relative performance vs the SPX index since the BBREIT index inception. Nonetheless, the first decade of October wasn’t strong for US REITs. The index increased only by 6.0% ytd vs +20.6% ytd of the SPX index as of October 8, 2024. Moreover, on a relative basis, the BBREIT index’s performance during the first 9 months of 2024 remained relatively weak from a historical point of view, -0.6 std from the mean. US REITs remained quite volatile in the first 3 quarters of the year, and the volatility increased significantly in September after a decline in July and August. The latter was mainly driven by a notable decline of interest rate expectations. The difference of monthly price changes between the best and the worst performers among top 50 REITs from the BBREIT index increased to 34.3% in September comparing to 22.6% in August. In turn, dynamics of major CRE sectors were mixed in September.
As a result of still weak both absolute and relative performance year-over-year, REITs valuations remained depressed even despite a notable reverse movement during recent months. The relative valuations vs the SPX index still kept going down on a yoy basis, staying near the lowest levels over more than 20 years. In turn, the absolute valuations don’t look extremely cheap vs historical averages, given still elevated rates, even after a significant decline in recent months. Thus, P/B of the BBREIT index was 2.6x as of October 8, 2024, +0.6 std from the mean since April 2002, and +0.3x since the end of June 2024. P/Sales of the BBREIT index increased by 0.7x from the end of June to 6.75x as of October 8, 2024 vs the average since May 2002 of 5.6x. In turn, a discount to the SPX index on P/B was 49% as of October 8, 2024 vs the average discount since 2002 of just 21%, -1.7 std. As for P/Sales, the current premium to the SPX index was 126% vs the average premium of 220%, -1.4 std. On P/FFO basis, a median figure of REITs was 18.2x as of October 8, 2024 vs the historical average of 17.9x, or +0.1 std. In turn, median dividend yield of 50 largest BBREIT index members was 3.74% as of October 8, 2024 vs the historical average of 4.05%, or -0.3 std. On EV/EBITDA basis, a median figure of REITs was 20.4x as of October 8, 2024 vs the historical average of 19.9x, or +0.2 std. In turn, interest coverage ratio of US REITs was 4.8x as of the end of 2Q24 vs the historical average of 3.9x (a quarterly average since 2005), or +0.9 std. As for individual names, multipliers are still quite different, but the dispersion across US REITs has decreased significantly in the recent 2 years. Thus, median P/FFO estimates for offices were 12.0x/11.7x for FY24/25 as of October 8, 2024 vs industrial’s ratios of 21.0x/19.1x.
The September US employment report eased somewhat fears of fast cooling of the labor market and moved interest rate expectations higher. Actually, September labor market indicators were stronger than expected across the board with better payrolls, stronger ADP data and higher JOLTs. Thus, payrolls increased by 254K in September vs the consensus of 150K while the unemployment rate decreased by 10 bps MoM to 4.1%, being 10 bps below consensus. JOLTs vacancies increased by 329K to 8.04 mln in August, beating the consensus by 347K, but the ratio of job openings to unemployed workers still remained weak. It so happened that the sequence of events was as follows – Powell’s statement at Jackson Hole that the Fed didn’t seek or welcomed further cooling in labor market conditions; jumbo rate cut at the September meeting; and then quite strong September job report. However, it is nothing more than a coincidence, from our point of view. At least, despite all fears about some weakness of the labor market, the US economy continued growing above expectations. Yes, imbalances held intensifying recently on, but the 2Q24 growth rate of 3% can in no way be called weak, especially taking into account that it was driven not by one-timers but by a still solid private consumption growth. Nonetheless, despite both hard and soft data ytd imply that US economic growth in 3Q24 still remains solid and even higher than initially expected, the most recent data points to growing risks to the US economy, implying inevitable deceleration of GDP growth in the near term. On the other hand, the recession isn’t even close to being on the agenda. Thus, it is expected that a recession in the next 12 months will occur with a probability of just 30%, the lowest figure over the last 2 years. The bad news is that interest rates expectations increased again notably after the publication of the September job report. So, it is expected again that the federal funds (FF) rate will be well above 3% at the end of 2025, implying ongoing pressure on CRE fundamentals.
Although CRE fundamentals remain better than feared, the recent rally was almost completely driven by rates dynamics. The upcoming 3Q24 earnings season should confirm again that market’s fears about the CRE segment were exaggerated. It will be kicked off by PLD’s report on October 16, 2024. Then the majority of BBREIT index members will reveal their earnings till the end of the month. Recall that both 1Q24 and 2Q24 earnings were notably stronger than expected as balance sheets of majority REIT’s, even those which have a relatively high share of offices in their portfolios, remained healthy. Nonetheless, the recent REIT’s rally was mainly macro-driven. Thus, the correlation between average monthly 10yr treasury yield and BBREIT index is -0.9 (since the beginning of 2022). Despite the start of the easing cycle, future debt refinancing still remains key risk in the near term. On the other hand, the risk was manageable until so far due to strong economic growth, but it is unclear how long this can last, especially if the economic situation begins to deteriorate. At least, current rate-cut scenarios imply gradual deterioration of the labor market, which is negative for REIT’s earnings. In turn, we don’t expect any significant deterioration of REIT’s operating results under the ‘soft landing’ scenario, which still remains the baseline one. Moreover, the underlying property market continued moving towards equilibrium recently, even despite still elevated rates, which were the key driver of prices decline during the previous 20 months. At least, CPPI increased by 0.2% on a yoy basis in August, delivering the first month of growth over more than 1.5 years. However, transaction volumes still remain depressed across the board. But lower interest rates will inevitably increase investors’ interest in the property market, especially in case of no significant deterioration in the labor market. Nonetheless, banks, the key source of CRE funding, continued tightening lending standards in 2Q24 and expected further tightening of standards in the rest of the year, albeit forecasting higher demand. In turn, underlying fundamentals continue gradually deteriorating across the majority of CRE segments, albeit remaining quite far from crisis levels. Moreover, the second derivatives of key fundamentals improved recently, pointing to soon achievement of this cycle’s lows. Of course, the latter will be possible only in the absence of recession. Also, given recent significant outperformance of the sector, high volatility of interest rates as well as current absolute valuations of the segment, we are afraid that too many rate cuts have been already priced in REIT’s quotes. So, we still remain neutral on the sector, but gradually becoming more optimistic.
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