The gap in private real estate appraised cap rates and implied public REIT cap rates is not new. It first emerged in late 2021 and has persisted for nearly five years. Such market dislocations occur periodically, but never has one lasted this long.
The divergence has been driven primarily by private real estate appraisers keeping rates steady, even to the point of seeming illogical. The appraised cap rates from the second quarter were right around the risk-free rate for 10-year Treasuries, but a recent runup has left 10-year Treasuries around 5.3%, the highest level in about two decades, which means private real estate is priced below the risk-free rate, creating a negative risk premium.
Private funds have not yet announced third-quarter adjustments, and it remains to be seen how they will proceed. For REITs, meanwhile, there’s been a selloff since a July peak, and that will be reflected in the next implied REIT cap rate calculation.
For investors looking at real estate allocations, the gap remains a potential opportunity to capitalize on.
Wealth Management spoke with Ed Pierzak, senior vice president of research at Nareit and John Worth, executive vice president for research and investor outreach, about the market dynamics and the implications for investing in REITs.
This interview has been edited for clarity and length.
Wealth Management: Let’s start with the divergence between private real estate appraised cap rates and implied REIT cap rates. That’s something we’ve talked about a lot, but it remains, despite some macro factors that would seem to necessitate an adjustment in the appraisal rate.
Ed Pierzak: The divergence persists. Historically, it has corrected itself very quickly. This time, we’re it started all the way back at the end of 2021, and that gap is still about 127 basis points as of the second quarter. There are a lot of reasons that you would say, “This doesn’t make sense.” A lot of it stems from appraisal cap rates. They haven’t moved for the last few years. During that time, we’ve had a rise in the 10-year Treasury. As we look at that relationship, the appraisal rate is hugging the 10-year rate. That is untenable.
One of the interesting points that we saw and highlighted was an open-ended fund’s answer to the questions they have received. The fund provides a degree of liquidity. But when we have a market dislocation, a redemption queue can build. How do you resolve that? If everything were marked-to-market, you could sell assets and pay people.
This fund got creative. They said, “If you are in the queue, we’ll have a tender offer, and we’ll buy you out at a discount to NAV.” The level was around 95% of NAV. They didn’t indicate how much they would buy out. Then, for investors not in the queue, they offered a discount on management fees for the remainder of this year and into the next couple of years. Senior management also said they would put more money into the fund.
These are all pushes for alignment, but they are expensive in and of themselves. Yet it appears more palatable to management teams to take these measures than to mark to market and sell assets.
WM: It still seems jarring on the face, given the recent uptick in the 10-year Treasury to levels we haven’t seen in many years. Where those rates are now, they are above the appraised cap rates from the last quarter, which doesn’t make sense. It reads as a negative risk premium.
EP: They were almost at parity when you took a look at the end of the second quarter. If you look at the delta today on the 10-year vs. the end of the quarter, the delta is close to 90 basis points. It’s a huge jump. We’ll have to see what happens in terms of marking.
With the 10-year approaching 5.3%, that has implications for financing and values, and I’m also wondering if that ultimately is going to be the impetus for appraisers and managers to say, “Look, we’ve toed the line for a number of years, and we do have to make further adjustments.” The question is whether, in the next quarterly readings in the coming weeks, we see that upward adjustment. I don’t see how you can’t. But the question is whether it will be a modest, measured increase or something more sizable.
WM: You also did some recent analysis, breaking down the cap rate divergence by the major property types. It was interesting to see the divergences varied a bit.
EP: Sometimes, we will get the question of when you look at the REIT implied cap rate, whether it’s identical for all property types. There are some differences. The gaps persist across all four traditional property types, but it’s larger in some instances than others.
Two notable ones are industrial and apartments. The appraised industrial cap rate has been below the 10-year Treasury rate for years, and apartments have been very close.
When we talk to a lot of investors who see these divergences, particularly for apartments where the gap with REIT cap rates is sizable (172 basis points), we’ve had investors say they have a need and want to invest in residential, but with this valuation difference, they are going down the REIT route.
Interestingly enough, a year or two ago, that gap was really massive. It was about 300 basis points. Investors recognized there was some good value to be had in looking at REITs. You have best-in-class operators and know what you’re buying. You know the assets and locations and how they are operating.
WM: And, again, that chart is even more striking when you factor in that the 10-year Treasury has moved quite a bit from the end of the second quarter.
EP: One way to think about it is if you have to get a loan, the base rate on many starts with Treasuries. The spreads are more compressed than in the past, but no one is giving you a loan for free.
Something else to keep in mind is that the REIT implied cap rate is a market cap rate. Movements in Treasuries, the economy and financial markets are all translated into stock prices in real time. We already see the adjustments taking place.
Furthermore, if we look historically, REITs have performed well in low-, mid- and high-interest-rate environments. The current interest rate environment is higher than the recent past, but not the highest we’ve ever seen.
REIT operations are moving very well and are tied to elements of the economy that are still strong. Balance sheets are also in good shape. REITs tend to focus on unsecured debt, which is the best-priced debt you can get.
Another point is that when we see interest rates go up, there’s often a degree of uneasiness that comes with that, and it gets echoed in the press. But interestingly enough, if you look at financial market indicators that measure uncertainty, there is the VIX for equities and the MOVE index for bonds. Looking at those metrics today, they are in the normal range. We hear a lot of talk about uneasiness, but the financial markets are viewing uncertainty at normal levels.
WM: In terms of rates, another point you’ve made in the past is that given the state of REIT balance sheets, they have flexibility in when they can dip into markets. Since there isn’t, for example, a big wave of imminent maturities, they are not being forced to refinance at higher rates.
John Worth: The other aspect in terms of potential advantages, is as the 10-year has risen over the last couple of months, REIT returns have flattened. Since REIT total returns peaked in late July, the 10-year is up about 55 basis points, and REITs are down about 9.5%. They have repriced in the face of the rise in Treasuries. Historically, you see that near-term repricing and then REITs tend to perform well over the following year.
Their balance sheets are also a source of strength and can be even stronger when we think about them as potential purchasers. With debt becoming expensive, REITs may have advantages relative to other players in the commercial real estate space.