REIT Market Trends 2024: Fed Impact, Real Estate Recovery, and Growth

Deeper Dive: REIT Fundamentals

As noted, the pockets of distress are almost entirely debt-driven - and further isolated to the office sector - as nearly every property sector reported "same-store" property-level income above pre-pandemic levels. REIT company-level metrics have tracked this rebound in property-level performance relatively closely throughout the pandemic - with the exception of the highly-levered REITs that expect sharp FFO declines this year even as property-level cash flows continue to increase. REIT FFO ("Funds From Operations") has fully recovered the sharp declines from early in the pandemic and in the second quarter, FFO was 20% above its 4Q19 pre-pandemic level on an absolute basis, and roughly 11% above pre-pandemic levels on a per-share basis. On a year-over-year basis, FFO/share was up 0.1% in Q2. Same-store Net Operating Income ("NOI"), meanwhile, was roughly 3.0% higher on a year-over-year basis in the second quarter, and 14% above the pre-pandemic level.

Powered by more than 120 REIT dividend hikes in both 2021 and 2022 - and another 80 dividend hikes in 2023 - dividends per share have finally fully recovered from the wave of pandemic-era dividend cuts in 2020. In 2024, we've tracked 60 dividend increases, while 15 REITs have reduced their dividends. With FFO growth significantly outpacing dividend growth since the start of the pandemic, REIT dividend payout ratios remained at around 70% in Q2 on a trailing twelve-month basis - well below the 20-year average of around 80%. With a relatively low dividend payout ratio, the average REIT has built up a buffer to protect current payout levels if macroeconomic conditions take an unfavorable turn. As always, the sector average does mask some elevated payout ratios across several sectors: Mortgage REITs currently pay out about 95-100% of EPS, on average, while Cannabis REIT payout ratios are also elevated. Other higher-risk sectors have built up a decent buffer, as office REITs pay just 70% of FFO while hotel REITs pay less than 40%.

After recording the largest year-over-year decline on record in 2020 - which dragged the sector-wide occupancy rate to 89.8% - REIT occupancy rates have rebounded since mid-2020 back to 93.6% - toward the upper-end of its 20-year average of 90-94%. By comparison, occupancy levels dipped as low as 88% during the Financial Crisis and took three years to recover back above 90%. Retail REITs have been the noted upside standout on the occupancy-front, as store openings have significantly outpaced store closings over the past three years - a sharp departure from the "retail apocalypse" trends of the 2010s. Residential REITs have continued to report near-record-high occupancy rates in recent quarters - despite record levels of multifamily supply growth. Industrial REITs reported a moderation in occupancy rates to around 96% in Q2 from their record highs of nearly 98% in late 2022. Office REIT occupancy, meanwhile, has seen substantial declines since the start of 2020 and remained 500 basis points below pre-pandemic levels at 86.0% in the second quarter.

Deeper Dive: REIT Valuations & Growth

The extended sell-off from late-2021 through mid-2023 - combined with the nearly 20% increase in FFO during this time - pulled REIT valuations to the lowest level since the end of the Great Financial Crisis, but REITs aren't quite as "cheap" now as they were at the end of June. For REITs, being "too cheap" can be a problem. Over most long-term investment horizons, "cheap" REITs tend to stay cheap via underperformance, and "expensive" REITs tend to stay expensive via outperformance. Valuations are a reflection of these REITs' cost of capital: highly valued REITs have access to cheap capital, while cheaper REITs must pay more to access capital. While modern equity REITs are more "dynamic" than a conventional bank, these "spreads" between cost of capital and return on capital are still critical. Further, equity valuations can and do play an important role in the ability of REITs to grow accretively: when REITs trade at persistent discounts to their private market-implied Net Asset Value ("NAV"), the "flow" of real estate tends to be from public markets and to private markets. Alternatively, when REITs trade with NAV premiums, the flow is positive- REITs are able to accretive acquire private market assets.

Lifted by the recent rally since early July, the average REIT now trades at an estimated 5% premium to its Net Asset Value - as implied by current private market valuations - the first time REITs have traded at NAV premiums since late 2021. Equity REITs currently trade at an average forward Price/FFO multiple of around 17.8x using a market-cap weighted average, which is roughly only slightly below the post-GFC average of 18.0x. The market-cap-weighted average, however, is somewhat distorted by the massive weight of richly-valued technology REITs, and on an equal-weight basis, REITs trade at a 14.5x median P/FFO multiple, which is near the lowest levels since the early 2000s. Equity REITs pay a dividend yield of 3.9% on a market-cap-weighted basis, but this dividend yield climbs to over 5.7% on an equal-weight basis, and roughly 8.5% when including mortgage REITs.

Deeper Dive: REIT Balance Sheets

The ability to avoid "forced" capital raising events has been the cornerstone of REIT balance sheet management since the GFC - a time in which many REITs were forced to raise equity through secondary offerings at "firesale" valuations just to keep the lights on, resulting in substantial shareholder dilution which ultimately led to a "lost decade" for REITs. While REITs entered this tightening period on very solid footing with deeper access to capital, the same can't necessarily be said about many private market players that rely on short-term borrowing or continuous equity inflows to keep the wheels spinning. Much the opposite of their role during the Great Financial Crisis, many well-capitalized REITs are equipped to "play offense" and take advantage of compelling acquisition opportunities if we do indeed see further distress in private markets from higher rates and tighter credit conditions.

Even as benchmark interest rates doubled from a year earlier and even with market values of REITs lower by 20-30% during that time, REITs balance sheets remain healthy by historical standards, merely giving back the incremental pandemic-era improvement. Debt as a percent of Enterprise Value still accounts for less than 35% of the REITs' capital stack, down from an average of roughly 45% in the pre-recession period - and substantially below the 60-80% Loan-to-Value ratios that are typical in the private commercial real estate space. Interest coverage ratios (calculated by dividing EBITDA over interest expense) have seen a shaper erosion over the past several quarters from its all-time highs set last year, however, but still stand at 4.1x, which roughly matches the coverage ratio at the end of 2019 and compares very favorably to the 2.75x average in the three years before the GFC period.

That said - not all REITs are created equal, and the broad-based sector average does mask some of the intensifying issues in several of the more at-risk sectors and among REITs that have been more aggressive in their balance sheet management. A handful of small and mid-cap REITs - some of which would be considered as having a rather strong balance sheet relative to similar private equity portfolios - have incurred significant charges to "fix" their floating rate debt exposure, while others have continued to roll the dice by maintaining a sizable chunk of variable rate debt. The BofA BBB US Corporate Index Effective Yield - a proxy for the incremental cost of real estate debt capital - has surged from as low as 2.20% in late 2021 to as high as 6.67% at the October 2023 peak and now sits at 5.12%. On a percentage basis, this represents a nearly 200% increase in interest costs on variable rate debt. The cost of equity - which we compute based on average FFO yields - is now 7.3% for the average REIT, up from a low of 4.4% in late 2021 but down from a peak of nearly 9% at the "bottom" of the REIT selloff in late 2023.

So naturally, REITs "hunkered down" in recent quarters as stock price valuations remained low by historical standards and in relation to private market-implied valuations but have started to rebound in recent months. S&P reported this month that REIT capital-raising activity surged in July as interest rates pulled back. On an annual basis, the amount of capital raised in July shot up 57% from a year earlier, which pulled the full-year total to roughly even with 2023 after a sluggish start. Through the first seven months of 2024, REITs have raised $48B in capital through equity and debt offerings. The majority of the capital raised over the last two years has been through debt offerings, which have accounted for roughly 65% of the total capital raised this year - above the historical average of around 50%. The largest common equity offering of 2024 has been the Lineage Logistics (LINE) $4.4 IPO, followed by the American Healthcare' (AHR) $773M IPO. Industrial REIT Prologis (PLD) has been the most active with $3.88B in capital raising, followed by cell tower REIT American Tower (AMT) with $2.38B raised. By property sector, industrial REITs have accounted for the largest share of total capital raised year to date, followed by data center and healthcare REITs.

REIT External Growth: Animal Spirits Awaken?

Distress for some is an opportunity for others, and we've begun to see - on a limited scale - public REITs with balance sheet firepower start to take advantage of capitulation from highly-levered players - a trend that will gather steam if debt markets remain tight. REIT external growth comes in two forms - buying and building. Acquisitions have historically been a key component of FFO/share growth, accounting for more than half of the REIT sector's FFO growth over the past three decades, with the balance coming from "organic" same-store growth and through ground-up development and redevelopment. With a historically large "bid-ask" spread for private real estate assets, REITs have slowed their acquisitions over the past several quarters, with gross purchases of only $1.2B in the second quarter - the second-lowest since Q4 of 2018 - following a total haul of just $700M in the first quarter, but we believe that opportunities should emerge if debt markets remain tight.

At the property-sector level, net lease, industrial, and strip center REITs have been the most active acquirers of private market assets in recent quarters - accounting for more than half of total net purchases across the REIT industry. Most other REIT sectors have been more reluctant to "hit the bid" on slow-to-adjust private market valuations. Data Centers and Office REITs have been the most significant "net sellers" over the past year. Many of the largest REIT acquisitions have emanated from Blackstone's (BX) nontraded fund, BREIT, which has faced a wave of investor redemption requests, prompting the need to raise capital to meet withdrawals. Since December 2022, BREIT has sold over $10B in assets to public REITs, including its most recent $1B sale of an 11-building apartment portfolio to Equity Residential (EQR) earlier this month, and a $1B sale of an industrial portfolio to Rexford (REXR) in march. These deals follow a $5.5B sale of two Las Vegas casinos to VICI Properties (VICI) in 2023, an $800M sale of a Texas resort to Ryman Hospitality (RHP), a $2.2B sale of Simply Self-Storage to Public Storage (PSA), and a $950M partial sale of The Bellagio casino to Realty Income (O). Of note, these deals have closed within four weeks, on average, a remarkably swift transaction timeline that few other entities besides public REITs could pull off.

While Blackstone's BREIT has been a net seller, the private equity giant's other funds have continued to scoop up public REITs this year, acquiring another pair of residential REITs - Tricon Residential and Apartment Income - earlier this year for a combined $14B. From 2020 through 2024, Blackstone and its affiliates acquired nine public REITs with a combined enterprise value of over $100B, paying an average premium of 35% relative to these REITs' prior closing price. Outside of these Blackstone-involved deals, M&A activity within the REIT sector has been almost non-existent in 2024, which followed a modest uptick in 2023 via a wave of public REIT-to-REIT mergers. Last year's merger wave was headlined by net lease REIT Realty Income's acquisition of Spirit Realty, healthcare REIT Healthpeak's (DOC) acquisition of medical office REIT Physicians Realty, and Extra Space's (EXR) acquisition of Life Storage. We also saw two smaller-scale consolidations in the strip center space: Regency Centers (REG) acquired small-cap Urstadt Biddle, while Kimco Realty (KIM) acquired mid-cap RPT Realty.

REITs have become some of the most active builders in the country over the past decade and - despite the slowdown in recent quarters - REITs still have nearly $45B of active development in the pipeline. Favorably, much of this pipeline is in the final stages of construction, as new groundbreakings have been few-and-far-between over the past few quarters given the unfavorable rate environment. The swelling of the development pipeline to the record-highs seen in 2023 was fueled by three property sectors - data center, industrial, and self-storage - which have expanded their pipelines by 145%, 33%, and 28%, respectively, since the end of 2019 - and some of this inflated pipeline is the result of higher construction costs and lingering supply chain delays that prolong the development timeline. Retail REITs, on the other hand, have engaged in minimal development activity over the past several years - which has fueled the recent occupancy increases - while the pipeline in office has also pulled back materially over the last several quarters, as expected.

Takeaways: A REIT Revival Has Begun

Two years of persistent rate-driven pressure on the residential and commercial real estate market appears to finally be abating as the worst of pandemic-era inflationary pressures subside. This 'light at the end of the tunnel' comes as commercial property values were approaching the critical 20% drawdown level - a level that can result in cascading distress that extends beyond the weakest players. But we're not out of the woods, yet: Expectations of "Higher for Longer" are merely shifting to "High for Long" in which benchmark rates will likely remain materially above pre-pandemic levels into 2025. The 'unwind' will continue for the "Zero-Rate Heroes," however, a list that includes many private equity real estate funds and non-traded REITs who's business models were contingent on cheap and plentiful debt, which counteracted the drag from higher fees, inefficient structure, and often poor governance. Macroeconomic conditions are aligning in an ideal manner for low-levered entities with access to "nimble" equity capital - conditions that maximize the true competitive advantage of the public REIT model, which these entities have been unable to exploit in the "lower forever" environment.

About the Author

David Auerbach boasts over two decades of experience in the securities industry, specializing as an institutional trader with a focus on Real Estate Investment Trusts (REITs), Equity and Preferred stocks, MLPs, ETFs, and Closed End Funds.

Based in Dallas, TX throughout his entire career, David currently serves as the Chief Investment Officer for Hoya Capital, managing the Hoya Housing 100 ETF (Ticker: HOMZ) and The High Yield Dividend ETF (Ticker: RIET). Previously, David held the position of Managing Director at Armada ETF Advisors, the sub-advisor for the Residential REIT ETF (Ticker: HAUS) and The Private Real Estate Strategy via Liquid REITs ETF (Ticker: PRVT).

Additionally, he acts as a consultant with IRRealized, LLC, focusing on corporate access in the REIT industry. David's industry journey includes roles at World Equity Group, Esposito Securities, and Green Street Advisors where he got his start in the REIT industry.

At Esposito Securities, he played a crucial role in building the REIT/Real Estate platform and worked extensively with institutional investors, Equity REITs, and ETF issuers.

Throughout his career, David has been quoted by reputable publications such as Bloomberg, WSJ, Financial Times, REIT.com, and GlobeSt.com. He has also made notable appearances as a featured guest on networks like Yahoo Finance, TD Ameritrade, and Bloomberg.

David holds a BBA in Finance from the University of Texas at Austin (May 1999) and an MBA in Finance from Southern Methodist University (May 2005). He maintains FINRA Series 7, 24, 55, and 63 registrations.

In his leisure time, David is an avid traveler, often found crisscrossing the country in pursuit of attending as many Phish concerts as possible.

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.