Coming off of one of the strongest years on record, the REIT market is relatively well placed despite the recent volatility. JLL’s Strategic Transactions Monitor details themes driving the REIT market, including a constructive outlook in light of sharply rising rates, an increase in take-private activity and dissipating COVID-19 driven trends.
REITs, along with broader markets, are down 20% year to date, driven by growing inflation, Federal Reserve rate hikes and broader geopolitical risks. Though market participants have focused on near-term underperformance, REITs have outperformed on a longer-term basis. Since January 2021, REITs have outperformed the S&P 500 by over 14%, driven by 43% total shareholders returns achieved by REITs during the year. Self-storage and industrial sectors led the outperformance, up 59% and 45%, respectively, in 2021.
“There is an ever-larger correlation of REIT trading performance with broader equity markets, currently 92% compared to the S&P 500 on a rolling three-month basis, which is exacerbated by the proliferation of quant driven trading activity and the advent of passive equity investors, like index funds, in the REIT space,” said Steve Hentschel, Head of the M&A and Corporate Advisory Group within JLL Capital Markets. “The correlation has been even more pronounced during periods of extreme volatility such as the Global Financial Crisis and COVID-19, and we are also seeing it today. The big picture trend is that REIT trading prices continue to be further and further disassociated from real estate values.”
REITs are trading at an average discount to net asset value (NAV) of over 15%. A sustained dislocation in public and private values could be a precursor of opportunities for fundamentals driven private market participants, leading to take-private M&A. In addition, discounts to NAV have resulted in an unfavorable equity cost of capital, evidenced by follow-on equity issuance of only $8 billion year to date, a much slower trajectory than 2021 when over $27 billion of follow-on equity capital was raised during the year.
Growing “stickiness” of the core inflation index, currently at over 8.5%, has led the Fed to raise rates considerably this year, driving rates up 150 basis points, on average, across both the longer and shorter parts of the curve. This, in turn has led to the aforementioned underperformance of REITs, which, in turn, has caused the implied trading cap rate of REITs to rise by over 60 basis points.
“Though current cap rate yields are the tightest they have been compared to fixed income yields, it is important to factor in the tremendous growth prospects for REITs, which are projected to generate 20% average same store NOI growth over the next three years,” Hentschel added. “The fundamentals still support positive longer-term outlook for REITs despite the volatility in the capital markets today.”
The rise of take-privates
The proliferation of non-traded REITs is triggering a paradigm shift in REIT equities and M&A markets. REIT take-private equity volume has totaled $86 billion since 2018, more than 17 times larger than IPO equity volume. With no IPOs issued year-to-date 2022, there were five take-privates representing over $21 billion in equity volume already. This is the continuation of a trend that started a few years ago.
“The tremendous amount of capital raised in the non-traded REIT space has driven the need to execute larger transactions,” said Sheheryar Hafeez, Managing Director of the M&A and Corporate Advisory Group within JLL Capital Markets. “M&A transactions are an efficient way to deploy that capital, and we may see the trend continue if the prolific fundraising stays on track, new players to non-traded REITs start to raise significant capital and the prolonged dislocation in public and private market persists.
“In many ways, non-traded REITs have supplanted the public REIT market as a form of growth capital as investors seeking returns from real estate that are uncorrelated with public equity markets reallocate capital to the non-traded REIT space,” he continued
Inflation leading to rotations into safer REITs
As inflation accelerated to an 8.5% annual rate in May, public REITs that offer higher inflation hedges have outperformed the market and other REITs. REITs with longer weighted average lease terms (WALT) had previously outperformed those with shorter WALT since December 2019, but the relationship flipped mid-2021, resulting in shorter WALT REITs booming recently.
“With the market seemingly anticipating a slowdown in economic activity, a rotation toward what is deemed ‘safe’ is now in play,” Hafeez added. “The two largest REITs in major sectors analyzed outperformed their peers by 5.5% since December 2021, as compared to the same two REITs, which outperformed their sectors by only 2.0% between December 2020 and 2021.”
COVID-19 impact on REIT performance may be dissipating
A silver lining on recent performance data has been the thawing of the impact of COVID-19 on REIT performance. COVID-19 beneficiaries like sub-sectors tied to the e-commerce boom had outperformed during the pandemic compared to retail REITs, which had struggled during the shutdown of physical stores. Similarly, gateway focused REITs had underperformed compared to non-gateway focused REITs in 2020. Those trends are reversing today.
“Though COVID-19 will remain a fact of life we will all have to live with for the foreseeable future, we are seeing the COVID-19 ‘laggards’ start to make a strong bounce back, which is encouraging to see and is reflective of the broader U.S. psyche, which wants to move forward,” Hentschel said.
Debt markets driven asset re-pricing in private real estate markets mitigated by significant dry powder
Repricing of assets in the private capital markets was initially driven by rising rates; however, debt markets continue to be liquid, albeit volatile. Broader risk assessment of new acquisitions is currently underway, and investors are stress-testing their models based on an inflationary environment, future rate increases and the potential for economic slowdown, but, with the significant dry powder on the sidelines (closed-end funds alone have over $240 billion of dry powder today), the risk of significant repricing may be mitigated.
Neighborhood centers benefiting from shifting behaviors
Neighborhood retail centers, which account for 953 million square feet of U.S. inventory, are experiencing significant tailwinds. Neighborhood centers are generally defined as those with 10,000 to 100,000 square feet of leasable space and, in general, do not contain a large, big-box tenants. Hence, they pool a consumer base from close-by distances for shopping and service needs. Nearly 90% of all consumption now occurs within a 15-minute drive from a consumer’s residence, and this shift in consumer habits toward shopping closer to home has driven overall performance of these assets.
Additionally, shorter average leasing terms versus the traditional big-box retailers, along with little new development, has allowed owners to be more proactive when it comes to rental growth, making these assets top targets for investors.
JLL Capital Markets is a full-service global provider of capital solutions for real estate investors and occupiers. The firm’s in-depth local market and global investor knowledge delivers the best-in-class solutions for clients — whether investment sales and advisory, debt advisory, equity advisory or a recapitalization. The firm has more than 3,000 Capital Markets specialists worldwide with offices in nearly 50 countries.