REIT earnings offer limited vision on a cloudy market

Real estate investment trust earnings, which have given a typically reliable snapshot of valuations and funding costs for publicly traded real estate companies, have not yet added much clarity to a market still muddled with volatility.

Al Otero, portfolio manager at Shelton, Connecticut-based Armada ETF Advisors, analyzed the first round of released REIT earnings and said the market was still shadowed by uncertainties. “There’s still very little price discovery in the markets [and] a very wide spread between the bid and ask [between buyers and sellers],” he says. 

This lack of clarity has dragged real estate transactions across the markets, in part because of opacity around funding costs. 

“The lack of clarity on the macroeconomic front has meant a big pause in acquisition and development activity for the past few months because companies have not been able to get a handle on what their funding costs are,” says Tayo Okusanya, managing director of equity research at Credit Suisse. “I think once you have that ability, then the transactions will [be] clear and we will have a new backdrop to operate from.” 

Meanwhile, REITs have been navigating a valuation correction that could cause asset mispricing. 

“Public market investors move price, not value. They are betting on value, whereas private real estate buyers and sellers are setting real estate value,” says Gavriel Kahane, managing partner of Arkhouse, a New York-based real estate activist hedge fund.  He adds that such a differentiation “can create an extreme, inverse mispricing and, in some cases, tremendous undervaluation of the hard assets that these public companies hold.” 

 “We think demand for real estate in the private market is not reflected in public investor demand for real estate,” he adds.

Okusanya says funding costs driven by interest rate hikes are a catalyst for downward valuations: “In order for real estate investors to make the same type of returns when funding costs go up, the implication will be that real estate valuations will have to come down.” 

Valuation corrections contributed to the faltering performance of REITs in 2022. The Real Estate Select Sector SPDR ETF index declined 26.13 percent year to date as of December 2022, underperforming the benchmark S&P 500, which was down around 19 percent last year. 

Cap rates, a crucial financial metric that helps evaluate purchase and asking prices in the real estate market, have low visibility. 

“We don’t believe the cap rates are as low as the market is stating,” Otero says, noting the disconnect between the solid operating metrics in 2022 and REITs’ performance in the stock market. “Why were the results on the ground so good and so strong, [but] the stocks did so poorly? The answer is that the stock market was discounting moderation.” 

“Public market investors move price, not value. They are betting on value, whereas private real estate buyers and sellers are setting real estate value”

Gavriel Kahane
Arkhouse

Cap rates have a reverse correlation to property values. In the debt market, rising cap rates and decreasing valuations may cause additional pressure on lending and borrowing.  

Okusanya said the rising cap rates, driven by the Federal Reserve’s interest rates hikes, will have a negative impact on net asset values for both public and private REITs, and that real estate valuations would probably need to get through a period where they are adjusted downward to reflect higher financing costs.

“The question everyone has is: if valuations are going down, does that start to create issues with loan-to-values or potential margin calls? No one really knows that yet, but it is the kind of thing we are all concerned about,” he adds.  

Possible twist

Okusanya says that REITs’ performance can improve once the financial pressure comes to a halt, based on the historic cycle. “It feels like the market has been on a little bit more of a run since the Federal Reserve has indicated that it will become a bit more accommodative, and you’ve seen REITs outperform the broader market again on that thesis,” he says. 

If this theory does play out, the coming year could be one in which it is possible for REITs to recover from prior-year performance and return to form on the heels of recovering valuations. 

“The challenge will be what earnings growth will look like this year,” Okusanya says. “Part of this will be driven by interest rates, just because everyone’s interest expense and cost of capital have gone up.” 

In addition, downward valuations could also create new investment opportunities for managers looking to expand by acquiring REITs in full. 

Erin Williams, vice-president at Hodes Weill, says in the company’s 2023 market commentary that the firm expected M&A activities to accelerate through this year because of lower valuations.  

“Potentially lower valuation multiples represent an attractive buying opportunity for well-capitalized companies and stakes buyers with a long-term view on growth opportunities, especially for managers operating in desirable sectors and markets,” Williams writes. 

“From a seller’s perspective, the challenges are raising capital in a slower market environment, succession considerations, and potential liquidity needs to fund new initiatives.” 

However, for undervalued REITs, seeking to exit the public market could be an alternative to avoiding losses amid market corrections. 

Steve Hentschel, senior managing director and head of M&A at JLL, says that the market will see more REITs taken private in 2023. “I think there are more REITs viewing the public markets as being broken, [or] it being a less than optimal place to be. So, I do think there’s going to be more take-private activities,” says Hentschel. “A lot of public REITs have a relatively diverse profile of assets, so they naturally lend themselves, if they are going to exit the public market, to being sold in several transactions, as opposed to just one.”