Guest view: The untold story about REITs

It is no secret that the US commercial real estate market is facing economic headwinds from high interest rates and stricter underwriting standards. Every day, news headlines issue fresh warnings about the risks of commercial real estate. But there’s always more to the story, especially when it comes to real estate investment trusts (REITs). With their strong balance sheets, historical outperformance versus private real estate after valuation divergences, and exposure to modern economic sectors, REITs offer institutional investors some of the best tactical and strategic opportunities in today’s market. 

US public equity REITs have not been immune to capital and mortgage market turmoil, but data from NAREIT’s T-Tracker® series show that they have limited their exposure by maintaining modest leverage ratios and focusing on unsecured, fixed-rate and longer-term debt. In the second quarter of 2023, the following was true:

• Average leverage ratios (debt-to-market assets) were at 34.6%;
• Weighted-average term to maturity of REIT debt was nearly seven years;
• Weighted-average interest rate on total debt was 4%;
• Percentage of total debt at a fixed rate was 91.4%;
• Percentage of total debt that was unsecured was 78.8%.

REITs also displayed operational strength during Q2. More than half  reported year-over-year increases in funds from operations while same-store net-operating income rose 5%, underscoring that REITs are keeping pace with inflation. 

With their sound fundamentals, REITs are well positioned to navigate ongoing economic headwinds and can provide tactical opportunities, especially given the current divergence between private and public real estate market valuations. 

Cap-rate divergence: harbingers of REIT outperformance

For more than a year, US public and private real estate market valuations have diverged. That’s partly because public real estate valuations are more responsive to economic changes and are usually ‘forward looking’, while private real market valuations rely on historical appraisals and are typically ‘backward looking’. This gap is attempting to close as illustrated through cap-rate differences. 

Figure 1 compares public real estate cap rates using NAREIT T-Tracker data (REIT implied) to private appraisal real estate cap rates using National Council of Real Estate Investment Fiduciaries (NCREIF) Open End Diversified Core Equity (ODCE) funds. The REIT implied cap rate stayed close to 6% over the past four quarters after rising dramatically in the first half of 2022. 

Notably, the appraisal cap rate represents the bulk of private capital and has been incredibly slow to adjust to current market conditions. While the private appraisal cap rate increased from 3.63% to 4.23% between Q3 2022 and Q2 2023, the total adjustment since Q4 2021 has been just 40bps compared with a total REIT adjustment of 158bps. In fact, in Q2 2023, the difference between the REIT implied and appraisal cap rates was 185bps. If all else stays equal, private real estate valuations would have to decline by nearly 30% to close that gap, which would likely take several quarters. 

Investors should pay attention to this valuation divergence. With public real estate cap rates significantly greater than their private-market counterparts, REITs provide a tactical opportunity – particularly considering analysis of historical public and private real estate market divergences.

In comparison to the private market, public equity REIT total returns have often bounced backed – or surged – in the four quarters after extreme periods of REIT total-return underperformance. REITs outperformed private real estate in nine of 11 instances, or 81.8% of the time, from Q4 1978 to Q2 2023. The average REIT outperformance total return spread was 31.3%. REIT recoveries also tended to be stronger after more extreme divergences.

The historical total return outperformance of REITs during times of private and public real estate valuation divergences – combined with solid operational performance –offer investors powerful tactical opportunities. REITs, however, also offer strategic opportunities. 

Access to the modern economy

Institutional investors often use REITs because the strategic role they play in optimising and complementing real estate allocations. For example, research shows that REITs consistently outperform private real estate by about 2% per year in defined benefit plans. That may be one of the reasons why approximately 64% of the top 25 largest defined benefit and sovereign wealth plans in North America and the world use REITs. 

Institutional investors also use REITs to get strategic exposure to different regions worldwide. Using the FTSE EPRA Nareit Index series as a benchmark, which includes 508 constituents with a combined market cap of nearly $2trn across 40 countries, investors are leveraging REITs to diversify their geographic footprint.

Another popular reason institutional investors are using REITs is to gain efficient exposure to sectors that house the modern economy. REITs offer easy access to preeminent operators of modern-economy sectors, including cell towers, health care, data centres and self-storage. Institutional investors are increasingly understanding this and using REITs to ‘complete’ their portfolios. Case studies include:

•A US healthcare system using an active REIT strategy to radically reconfigure its real estate allocation to better align with today’s real estate universe.
•The National Pension System of Korea allocating $1bn to an active strategy benchmarked against a custom completion-oriented index.
•The City of Austin Employees’ Retirement System (COAERS) using a passive completion REIT index to improve property sector diversification.

The chart shows COAERS’s REIT completion portfolio, which significantly increased its exposure to new and emerging sectors. COAERS reduced its exposure to office, industrial, apartments, and shopping centres from nearly 100% to around 60% and added health care, data centres, self storage, lodging and others to gain strategic exposure to modern sectors. 

Perhaps at no other time in history have REITs provided the powerful tactical and strategic opportunities that they do today. Amid gloomy headlines about commercial real estate, institutional investors should remember there is more to the story when it comes to REITs.  

Edward Pierzak is senior vice-president of research and John Worth is executive president of research and investor outreach at the National Association of Real Estate Investment Trusts (NAREIT)