US REITs underperformed the broad market again in August 2023, for the 7th consecutive month, driven by regional malls and hotels while industrial REITs increased slightly MoM. On an absolute basis, REITs ended the month in the red for the first time over the last three months.
EXECUTIVE SUMMARY
US REITs underperformed the broad market again in August 2023, for the 7th consecutive month, driven by regional malls and hotels while industrial REITs increased slightly MoM. On an absolute basis, REITs ended the month in the red for the first time over the last three months. Thus, BBREIT index decreased by 3.4% MoM in August vs -1.8% MoM of SPX index. Absolute August performance was -0.7 std from the mean monthly performance, and it was in the bottom 19% of absolute monthly performance in the index history. In turn, August relative performance was -1.7% MoM. It is -0.3 std from the mean monthly performance, and it is in the bottom 34% of relative performance vs SPX index since BBREIT index inception. Despite all challenges, REITs index decreased just by 2.8% ytd on an absolute basis. Nonetheless, it continues underperforming the broad market, as it did in 6 out of 7 previous years. It underperformed by 17.8% ytd in 2023, the worst relative performance of the first 8 months of the year in the index history. US REITs dynamics were quite volatile in August 2023 as a result of the earnings season start and still not completely clear prospects of the sector. Thus, the worst performers were regional malls and hotels, which decreased by 8.9% MoM and 9.0% MoM in August, respectively. In turn, industrials increased by 0.1% MoM. On ytd basis, the industrial subsector remained the best performer, having added 10.0%. In turn, the office segment was the worst performer by a wide margin, -9.7% ytd as of the end of August.
As a result of weak both absolute and relative performance, valuations went down until so far, but there was some stabilization in the recent months. Nonetheless, 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 2.2x as of September 19, 2023, slightly below its average since April 2002 of 2.32x, and -0.1x since the end of July. P/Sales of BBREIT index was 5.7x vs its average since May 2002 of 5.6x, or +0.1 std. In turn, a discount to SPX on P/B index was 48% as of September 19, 2023 vs an average discount since 2002 of just 19%, -1.8 std. As for P/Sales, the current premium to SPX index is 134% vs an average premium of 226%, -1.4 std. On P/FFO basis, a median figure of REITs was 16.9x as of September 19, 2023 vs a historical average of 18x, or -0.3 std. In turn, a median dividend yield of 50 largest BBREIT index members was 4.5% as of September 19, 2023 vs a historical average of 4.1%, or +0.4 std. On EV/EBITDA basis, a median figure of REITs was 22.4x as of September 19, 2023 vs a historical average of 19.9x, or +0.8 std, which is quite consistent with still relatively low financial risks of the segment. Thus, interest coverage ratio of US REITs was 5.1x at 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 median P/FFO estimates for our REITs sample were 9.5x and 10.1x for FY23 and FY24, respectively, as of September 19, 2023, while industrial median multipliers were 22.4x and 21.2x, respectively.
The US economy continued growing above expectations, and it even accelerated in 2Q23 and 3Q23. Despite skyrocketing rates growth, still elevated inflation, inverted yield curve since 3Q22, the regional banking crisis and tightening lending standards, it increased by 2.0% qoq and 2.1% qoq at annualized rate in 1Q23 and 2Q23, respectively, vs the consensus of 0.8% qoq and 0.6% qoq, as of the end of 2022. The recent macro data only confirm that the economy remains noticeably stronger than it could have been, taking into account all the risks realized over the past 12 months. Moreover, both hard and soft data qtd imply that the GDP growth rate will increase in 3Q23. So, 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. Headline payrolls beat estimates slightly in August 2023 after two consecutive months of negative surprises. Nonetheless, despite the overall employment situation still remains quite strong, there are more and more signs of gradual softening of the labor market in recent months. Thus, payrolls increased by 187K in August vs the consensus of 170K (and the revised down July figure of 157K). Given the still strong labor market and better than expected GDP growth, consumer market indicators were also better than expected in recent months. But it is too early to call these figures strong, especially taking into account lagged effect of very tight monetary conditions. Thus, retail sales increased by 0.6% MoM in August 2023 vs the consensus of +0.1% MoM, but the July figure was revised down from 1.0% MoM to 0.7% MoM. On a yoy basis, it was +1.6% yoy in August. In any case, the probability of recession in the next 12 months is still estimated at 60%. However, GDP growth forecasts continue going up. On the other hand, the risks are still tilted to the downside, from our point of view, and the US economy is far from being out of the woods. So, the current economic scenarios do not imply a significant improvement of CRE fundamentals in the nearest quarters. On the other hand, it doesn’t imply noticeable deterioration of fundamentals either.
REITs earnings remain resilient despite gradual deceleration of the economy, elevated inflation and still quite high as well as growing interest rates. Thus,31 out of 37 largest REITs from BBREIT index reported better than expected 2Q23 revenue figures. Nonetheless, we see noticeable deceleration of the demand with significant slowdown of net absorption rates. Banks also noted weaker CRE demand in 2Q23. 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 the collateral values, despite it has already decreased noticeably. Thus, commercial property price index decreased by 9.6% yoy, but +0.3% MoM as of the end of July 2023, the second consecutive month of growth after 10 months of decline. Moreover, it is still +17.4% vs the end of 2019. Also, CRE loans issued by commercial banks even increased since early March 2023 despite noticeable growth of risks, adding 7.3% yoy, or +2.4% ytd, as of September 6, 2023. REITs estimates remain roughly stable ytd (except for EPS forecasts), but estimates resumed to decline after 2Q23 earnings season. Thus, median growth of revenue estimates of 20 largest members of BBREIT index was 1.3% ytd as of September 19, 2023 while median growth of EBITDA CY estimates was +0.7% ytd. So, underlying fundamentals also remained strong so far across all major CRE segments but gradually deteriorating. Thus, rent and same-store NOI continue going up at solid pace in majority of segments, but growth rates has already decelerated noticeably. 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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