Total returns for the FTSE Nareit All Cap Index rose 2.2% in June, bringing the index down 2.1% year-to-date. It was the second consecutive month of gains for equity REITs, with the all-equity index now nearly recovered from a low of nearly 10% this spring.
Gains for the month were broad-based with almost every property segment posting positive returns. On the upside, specialty REITs (up 7.8%), self-storage (up 7.3%) and residential (up 5.8%) were the biggest movers. Most other property types posted gains with diversified REITs (down 7.6%), timber REITs (down 5.1%) and telecom REITs (down 1.5%) the exceptions. alone.
For the year, REIT performance has been dampened by continued inflation concerns and changing expectations for a rate cut by the Fed. But with growing optimism about the potential for at least one rate cut before the end of the year, REITs remain positioned for upside. This outlook is protected by REITs that maintain stable fundamentals and conservative balance sheets.
WealthManagement.com spoke with Edward F. Pierzak, Nareit's senior vice president of research, and John Worth, Nareit's executive vice president of investor research and outreach, about REITs in the first half of the year and the latest results.
This interview has been edited for style, length and clarity.
WealthManagement.com: What are your top takeaways from this month's returns?
Ed Pierzak: REITs rose 2.2%, which is good to see. When we do a comparison to the broader market, often our benchmark is the Russell 1000. That was 3.3%, so REITs were trading slightly below the broader market. When you look at all sectors, you will see positive results or close to 0% almost across the board. One area with some challenges is timber REITs. This is a continuation of a trend.
On the upside, we see strong performance in several areas. One of them is the specialty REIT, with an increase of 8.0%. Much of that has to do with the strong performance of Iron Mountain, which is a document and data storage firm. This business has been doing quite well. They have also started several new initiatives, including entering data centers. YTD, performance for Iron Mountain is up nearly 32%.
We also saw a rebound in self-storage and residential, which was really driven by apartment REITs (up 6.8%). When you look at these two, the drivers of demand for self-storage are linked to the residential sector. When apartments do well, self-storage tends to do well.
With apartments, there is a degree of softening with supply and demand, but rental gains have continued. One of the other elements we've identified through T-Tracker is that there is quite a wide spread in implied cap rates for apartment REITs versus private apartments. It's still around 190 basis points, which means to the extent you appreciate the 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 investor reaction to changing interest rate expectations and the state of inflation?
EP: If you go back to 2022, we find a clear trend. As we've seen Treasury yields rise, REIT performance has fallen and vice versa. Today we are getting more clarity, although expectations for a rate cut have changed. We had expected some rate cuts and now we are at a point where we expect one. But as there is more clarity on the way forward, people feel more confident.
WM: Looking at some of the sector's performance, I recall that self-preservation was a better performer in previous years before things slowed down earlier this year. Is this a return to form? What about housing?
EP: We started to see a slow demand, and while it dropped a little, it was accompanied by supply that didn't stop. So there was a little pause there. This is starting to come back.
With apartments in terms of occupancy and rental growth, apartments have done very well. Often, we compare net absorption with net shipments. We will do this on a four quarter basis. You can get their simple change. If you look at net absorption less net shipments, you can see if there is more demand than supply. We saw the peak of the demand measure in the second half of 2021. It declined and, moving into the second quarter of 2023, reached a low point. Since then, we've seen the demand side pick up a bit.
It is important to note that despite this, the utilization rate has remained north of 95%. It's a very solid number in total and allows you to continue to push rents, albeit not at the same rate. There is some tempering. When you get to the double digit rent increases that we were in, it's just not sustainable and the tenants wouldn't appreciate that either. 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. A new offering came in with slightly lower demand. Now, we are reaching a balance.
WM: Nareit is releasing his midterm outlook this week. What are some of the themes you have identified?
EP: Looking at the first half, we had economic uncertainty and higher interest rates. Within property markets, some fundamentals are diminishing and there is 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 moving forward with a good pace of economic growth. The outlook for 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. A 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”.
This is the situation today. We still see headwinds and REIT returns have been muted in the first half of the year, but we believe public REITs are well positioned on several different elements.
First, operational performance remains stable. REITs are experiencing year-over-year growth in funds from operations, net operating income (NOI) and same-store NOI. We have big numbers. Occupancy rates in the four traditional property sectors are high in an absolute sense and they have tended to outperform their private market counterparts. This suggests that REITs have a knack for asset selection and management.
Second, 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 around 34%. The average term to maturity is 6 1/2 years, and the cost of debt remains just over 4%. They are also focused on fixed rate debt, 90% of their portfolio and 80% of their debt is unsecured.
A third point is that public REITs have continued to outperform. Compared to ODCE funds, over the past six quarters, REITs have outperformed by nearly 33%. However, even with this outperformance, there is still a significant cap rate spread of 120 basis points between the valuation 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 the REIT's outperformance in the second half of 2024.
The last key point is that when we look at REIT occupancy rates and the pricing advantage that they have and you combine the two, it's 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, this spread peaked at 244 basis points. So it's effectively cut in half. It has been slow, seen in a historical context. If you go back to the Great Financial Crisis, the cap rate gap reached 326 basis points, but it closed completely in the following four quarters.
So you might ask, “What's going on this time?” Much of the slowdown is due to modest, measured and potentially manageable increases in private-side valuation cap rates. They are taking a slow approach to adjust mid single digit values every quarter. They wait to see if the market will come to them instead of them coming to the market.
WM: Can you also quantify how much of the tightening that has occurred resulted from the REIT upgrade versus the cap rate reduction?
EP: Going back to the third quarter of 2022, the implied REIT rate was at 6.07%, and the private valuation cap rate was 3.63%. Fast forward to today, the implied REIT rate through the first quarter was 5.8%, and the private equity rate was 4.6%. So on one hand you can see that the implied REIT rate has been somewhat stable in its pricing while the private cap rate has increased by over 100 basis points.