Total returns for the FTSE Nareit All Equity Index were up 2.2% in June, putting the index down 2.1% year-to-date. It was the second consecutive month of growth for equity REITs, with the all-equity index now nearly recovered from a low point of being down nearly 10% this spring.
The gains for the month were broad-based with nearly every property segment posting positive returns. On the high side, specialty REITs (up 7.8%), self-storage (up 7.3%) and residential (up 5.8%) were the biggest movers. Most other property types eked out gains with diversified REITs (down 7.6%), timberland REITs (down 5.1%) and telecom REITs (down 1.5%) being the lone exceptions.
For the year, REIT performance has been tempered by ongoing inflation concerns and shifting expectations on rate cuts from the Fed. But with rising optimism for the potential of at least one rate cut before the end of the year, REITs stand positioned for a rally. That outlook is bulwarked by REITs retaining solid fundamentals and conservative balance sheets.
WealthManagement.com spoke with Edward F. Pierzak, Nareit senior vice president of research, and John Worth, Nareit executive vice president for research and investor outreach, about REITs in the first half of the year and the most recent results.
This interview has been edited for style, length and clarity.
WealthManagement.com: What are your main takeaways from this month’s returns?
Ed Pierzak: REITs were up 2.2%, which is nice to see. When we make a comparison to the broader market, oftentimes our comparison is the Russell 1000. That was up 3.3%, so REITs traded a little lower than the broader market. When you look across the sectors, you will see positive or near 0% results almost across the board. One area with some challenges is timberland REITs. That’s a continuation of a trend.
On the upside, we see strong performance in a few areas. One of them is specialty REITs, up 8.0%. A lot of that has to do with the strong performance of Iron Mountain, which is a document and data storage firm. That business has been doing quite well. They have also started some new initiatives, including going into data centers. YTD, performance for Iron Mountain is up nearly 32%.
We also saw a bounce back in self-storage and residential, which was really driven by apartment REITs (up 6.8%). When you look at those two, self-storage demand drivers are interlinked with the residential sector. When apartments do well, self-storage tends to do well.
With apartments, there’s a degree of softening with supply and demand, but rent gains have continued. One of the other elements we have identified through T-Tracker is that there is quite a large spread in implied cap rates for apartment REITs vs. private apartments. It’s still about 190 basis points, which means to the extent that you appreciate good value, REITs in the apartment sector offer an opportunity for further gains in the sector.
WM: In terms of overall REIT performance for 2024, how much of that has been a reflection of investors reacting to shifting expectations on interest rates and the state of inflation?
EP: If you go back to 2022, we find an obvious trend. As we’ve seen Treasury yields increase, REIT performance has declined and vice versa. Today, we are getting more clarity, albeit expectations for rate reductions have changed. We had expected a few rate cuts, and now we are at a point where we are expecting one. But as there is more clarity on the path forward, people are feeling more confident.
WM: Looking at some of the sector’s performance, I recall self-storage being an outperformer in past years before things slowed down earlier this year. Is this a return to form? And what about residential?
EP: We started to see some sluggish demand, and as that fell off a bit it was coupled with supply not stopping. So, there was a little bit of a pause there. That’s starting to bounce back.
With apartments in terms of occupancy and rent growth, apartments have done very well. Oftentimes, we compare net absorption with net deliveries. We will do this on a rolling four-quarter basis. You can take the simple difference of those. If you look at net absorption less net deliveries you can see if there’s more demand than supply. We saw the demand measure peak in the latter half of 2021. It tumbled, and going through the second quarter of 2023, it hit a low point. Since that time, we’ve seen the demand side pick up a little bit.
It’s important to note that despite this, occupancy rates have remained north of 95%. It’s a very solid number in aggregate and it allows you to continue to push rents, although not at the same pace. There’s a bit of tempering. When you hit double-digit rent growth, which we were at, it’s just not sustainable, nor would tenants appreciate that. So, it’s fallen off some, but there’s still strength there.
John Worth: I would add that there are some similarities between self-storage and apartments. They both performed extremely well in 2021 and 2022. Some new supply came in with slightly lower demand. Now, we are reaching an equilibrium.
WM: Nareit is publishing its midyear outlook this week. What are some of the themes you have identified?
EP: Looking back on the first half, we had economic uncertainty and higher interest rates. Within property markets, some fundamentals are waning, and there’s still a divergence between public real estate and private real estate valuations.
The overall economy still has some inflation, but the job situation looks good. We are clipping along at a decent pace of economic growth. The outlook on whether we will have a recession has also changed dramatically from a year ago.
According to the Bloomberg consensus forecast, only 30% of economists say there will be a recession in the next 12 months. One year ago, it was 60%. People are a bit more optimistic and see the economy as a “glass half full” rather than a “glass half empty.”
That’s the situation today. We still see headwinds, and REIT returns have been muted in the first half of the year, but we do believe that public REITs are well-positioned across several different elements.
Firstly, operational performance remains solid. REITs are experiencing year-over-year growth with funds from operations, net operating income (NOI) and same-store NOI. We have great numbers. Occupancy rates across the four traditional property sectors are high in an absolute sense, and they have tended to outperform their private market counterparts. That suggests that REITs have a prowess in asset selection and management.
Secondly, REITs have continued to maintain disciplined balance sheets. They enjoy greater operational flexibility and face less stress than their private counterparts, who carry heavier debt loads and higher costs. For REITs, the loan-to-value ratio is right at about 34%. The average term to maturity is 6 1/2 years, and the cost of debt remains a little over 4%. They are also focused on fixed-rate debt, at 90% of their portfolios, and 80% of their debt is unsecured.
A third point is public REITs have continued to outperform. If we compare with ODCE funds, over the last six quarters, REITs have outperformed by nearly 33%. Yet even with this outperformance, there’s still a sizable cap rate spread of 120 basis points between the appraisal cap rate for private real estate and the implied REIT cap rate. This wide gap is a suggestion that there is more fuel in the tank for REIT outperformance in the second half of 2024.
The last main point is that when we look at REIT occupancy rates and the pricing advantage they have and you combine the two, it is an opportunity for real estate investors. REITs offer more for less.
WM: On the third point, how much has the spread between private real estate and REITs tightened in this cycle?
EP: In the third quarter of 2022, that spread peaked at 244 basis points. So, it effectively has been cut in half. It’s been slow, viewed in a historical context. If you go back to the Great Financial Crisis, the cap rate gap reached 326 basis points, but it fully closed in the following four quarters.
So, you might ask, “What is going on this time?” A lot of the sluggishness is due to the modest, measured, and potentially managed increase in the appraisal cap rates on the private side. They are taking a slow approach to adjusting values in the mid-single digits every quarter. They are waiting to see if the market will come to them rather than them coming to the market.
WM: Can you also quantify how much of the tightening that has occurred resulted from REIT improvement compared with the appraisal cap rate coming down?
EP: Going back to the third quarter of 2022, the REIT implied cap rate was at 6.07%, and the private appraisal cap rate was 3.63%. Fast forward to today, the REIT implied cap rate through Q1 was 5.8%, and the private cap rate was 4.6%. So, on the one hand you can see the REIT implied cap rate has been somewhat consistent in its pricing while the private cap rate has increased by over 100 basis points.