US REITs outperformed the broad market significantly again in August, for the second consecutive month and for the third time over the last 4 months. However, it was only the 5th time of stronger dynamics vs the broad market (SPX index) over the last 19 months.
EXECUTIVE SUMMARY
US REITs outperformed the broad market significantly again in August, for the second consecutive month and for the third time over the last 4 months. However, it was only the 5th time of stronger dynamics vs the broad market (SPX index) over the last 19 months. On an absolute basis, REITs (BBREIT index) ended the month in the green, for the 4th time in a row or for the 8th time over the last 10 months. Thus, BBREIT index increased by 5.4% MoM in August vs +2.3% MoM of SPX index. Absolute August performance was +0.9 std from the mean monthly performance, and it was in the top 14% of absolute monthly performance in the index history. In turn, August relative performance was +3% MoM. It is +0.7 std from the mean monthly performance, and it is in the top 21% of relative performance vs SPX index since the BBREIT index inception. Moreover, the first half of September remained strong for US REITs. Nonetheless, the index increased only by 9.8% ytd vs +17.8% ytd of SPX index as of September 18, 2024. Moreover, performance of BBREIT index on a relative basis during the first 8 months of 2024 remained relatively weak from a historical point of view, -0.8 std from the mean. US REITs remained quite volatile in the first 8 months of the year, but volatility decreased significantly in July and August, even despite an impact of the 2Q24 earnings season. A difference of monthly price changes for the best and the worst performers among top 50 REITs from BBREIT index decreased to 22.6% in August vs 30.7% in June. All major CRE sectors increased in August.
As a result of still weak both absolute and relative performance year-over-year, valuations of US REITs remained depressed even despite a notable reverse movement in recent months. Relative valuations vs SPX index still kept going down on a yoy basis, staying near the lowest levels over more than 20 years. In turn, 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 BBREIT index was 2.69x as of September 18, 2024, +0.9 std from the mean since April 2002, and +0.23x since the end of July 2024. P/Sales of BBREIT index increased by 0.52x from the end of July to 7.0x as of September 18, 2024 vs the average since May 2002 of 5.6x. In turn, a discount to SPX on P/B index was 46% as of September 18, 2024 vs the average discount since 2002 of just 21%, -1.5 std. As for P/Sales, the current premium to SPX index was 139% vs the average premium of 220%, -1.2 std. On P/FFO basis, a median figure of REITs was 19.4x as of September 18, 2024 vs the historical average of 17.9x, or +0.4 std. In turn, median dividend yield of 50 largest BBREIT index members was 3.51% as of September 18, 2024 vs the historical average of 4.05%, or -0.5 std. On EV/EBITDA basis, a median figure of REITs was 21.6x as of August 19, 2024 vs the historical average of 19.85x, or +0.6 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 (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 11.9x/11.5x for FY24/25 as of September 18 vs industrial’s ratios of 22.2x/20.2x.
The US economy continues growing above expectations but recession risks have begun going up either. In any case, imbalances held intensifying on, especially in the labor market. In turn, the US GDP growth accelerated to 3.0% in 2Q24 (up from the first estimate of 2.8%) vs just +1.4% in 1Q24 and the initial consensus estimate of 2.0%. The revision was mainly driven by private consumption, which increased from the initial estimate of 2.3% to 2.9% vs just 1.8% in 1Q24. But despite the key driver of GDP growth – consumer spending growth – was quite strong in 2Q24 after a bleak growth in 1Q24, real disposable income growth was quite weak, having continued going down. So, despite both hard and soft data ytd imply that the economic growth still remains solid and even higher than initially expected in 3Q24, the most recent data points to growing imbalances in the US economy, implying inevitable deceleration of US GDP growth in the near term. Moreover, according to Fed’s chair at Jackson Hole, the Fed doesn’t seek or welcome further cooling in labor market conditions while the upside risks to inflation have diminished. So, interest rate expectations tumbled in recent months. Thus, expected FF rates for the end of 2025/26 years decreased by more than 130 bps since the end of May 2024. Moreover, it is already expected that the federal funds (FF) rate will decline below 3% already in 2H25. On the other hand, pressure on CRE fundamentals will remain quite high in the near future, especially in the office segment, given that one of the main drivers of the interest rates expectations decline is the weaker labor market. Thus, payrolls increased by 142K in August vs the consensus of 165K (and the revised down July figure of just +89K). So, it was the second consecutive payrolls miss. Moreover, underemployment rate increased by 10 bps MoM to 7.9% in August, the highest figure over the last 34 months while a ratio of job openings to unemployed workers has already turned below pre-pandemic levels, to just 1.07x in July, the lowest figure over more than 6 years.
CRE fundamentals remain better than feared and continue gradually plateauing with a more and more balanced underlying property market. Thus, CPPI increased on MoM basis in July, and growth of prices was broad-based amid key CRE segments – even office prices didn’t decline. Moreover, it was the third consecutive month of sequential growth, and the July rate of decline on a yoy basis was the lowest one over the last 20 months, even despite still elevated interest rates. Transaction volumes remained depressed but they also improved slightly on a yoy basis. And the start of the rate cutting cycle could become a catalyst for volumes growth acceleration. So, lending conditions have already begun to improve. At least, a share of banks which still tightening CRE lending standards continues going down. Nonetheless, given that correlation between average monthly 10yr treasury yield and BBREIT index is still -0.89 (since the beginning of 2022), the key driver of both quotes and fundamentals will be interest rates dynamics in the near term. But we expect that it will be a bumpy road ahead, at least anytime soon and at least for quotes, because we believe that confidence in the speed of rate cuts is excessive. Moreover, the key driver of substantial decline of interest rate expectations is a fast labor market cooling, which, in turn, may be quite negative for CRE fundamentals through possible decline of NOI/revenue growth projections. Nonetheless, gradual improvement of CRE fundamentals will continue under the current baseline economic scenario. So, growth of effective rent will remain positive in the near term while growth of vacancy rates will continue declining due to gradual improvement in demand and inevitable decline of supply. The only exception is the office segment, but even here risks look manageable, from our point of view. In any case, 2Q24 earnings confirmed again that recent 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, despite solid 2Q24 earnings, estimates of REITs revenue/FFO still remain negative on a yoy basis, and the decline even accelerated slightly in recent weeks. Thus, a median decline of 3Q24 FFO of our sample of REITs was 2.6% yoy as of mid-September while revenue projections decreased by 1.5% yoy. Given recent REITs outperformance, we are not sure any more that the start of the rate cut cycle will be a strong catalyst for the quotes. So, we still remain neutral on the sector, but gradually becoming more optimistic.
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