State of the REIT Sector
In our quarterly State of the REIT Sector, we analyze the recently-released NAREIT T-Tracker data to review REIT fundamentals over the past quarter. We review our commentary published at the outset of the pandemic in early March, REITs: This Time Is Different when we concluded: “It may be hard to believe now, but things will get better. We believe that the residential and commercial real estate sectors are prepared to weather the storm, but pockets of stress will undoubtedly emerge if the COVID-19 outbreak intensifies, but highly-levered retail and lodging REITs could be in a fight for survival.”
REIT Fundamental Metrics Slammed Amid Pandemic
While the coronavirus crisis isn’t yet over, the REIT sector appears likely to avoid the type of long-term, lingering pain that was felt by the sector during the Financial Crisis. The Vanguard Real Estate ETF (VNQ) plunged nearly 75% from its peak in 2007 to its trough in 2009 and didn’t recover to its previous pre-recession highs until nearly eight years later in 2015. While REITs have been slower to rebound than the S&P 500 ETF (SPY), the sector has recovered half of its losses over the last five months, a feat that took nearly two years during the Great Financial Crisis, suggesting that while some aspects of this crisis were more acute than the GFC, strong balance sheet management and ample access to capital prevented the type of shareholder dilution that plagued the REIT sector in the early post-recession period.
As anticipated, however, REITs reported significant declines in FFO (“Funds From Operations”), dividends, and NOI (“Net Operating Income”) growth in the second quarter as REITs struggled to collect rent from “non-essential” tenants. FFO per share dipped -31.3% from last year, which was the fourth-worst quarterly decline on record, topped only by 4Q08, 1Q09, and 3Q09 amid the depths of the Financial Crisis. Dividends per share, meanwhile, declined by -9.9% on a year-over-year basis as 62 of the 170 equity REITs eliminated or reduced their distribution from March through July while roughly 20 REITs raised payouts. Same-store NOI growth – reported by NAREIT on a trailing-twelve-month basis – recorded record declines of -7.5% in Q2, far exceeding the -2.1% maximum decline during the Financial Crisis.
The plunge in NOI growth in Q2 underscores the central theme that we’ve discussed extensively throughout the coronavirus pandemic: it all comes down to rent collection. Last week, we published our Real Estate Earnings Recap which reviewed earnings season on a granular level, detailing the rent collection metrics reported from over 100 individual equity REITs. Aggregated below, we see that collection has been a far less significant factor for the “essential” property sectors – technology, industrial, and housing – while retail REITs struggled mightily to collect rent during the “shutdown months.” Importantly, rent collection has sequentially improved across all sectors over the last four months, which bodes well for a rebound in these metrics in 2H20.
It’s been a story of “haves and have-nots” in the REIT sector over the past half-decade and that bifurcation will surely intensify further in 2020. Among the “haves” are these essential property sectors noted above, which continue to report mostly positive same-store NOI growth, led by technology REITs. Among the “have-nots” are the troubled retail and hotel REIT sectors, which reported massive quarterly declines in same-store NOI growth. Last quarter, we forecast that same-store NOI growth to “decline by roughly 3-5% in 2020, in line with the Financial Crisis.” Again, despite the brutal numbers reported in Q2, we maintain this forecast, as we expect a significant bounce-back in these fundamental metrics in Q3 and Q4 due to improved rent collection.
Occupancy rates recorded the largest year-over-year decline on record in Q2, dipping from record-highs last quarter around 94% to below 90%, towards the upper-end of our forecast last quarter that occupancy would “pull back at least 200-400 basis points over the next year.” Among the four property sectors that NAREIT breaks out, Industrial REITs were the lone sector to record a positive year-over-year increase in occupancy, increasing 60 basis points to 95.9%. We forecast that occupancy rates in this NAREIT data series will bottom out at here around 90%, supported on the upside by resilient occupancy in the residential and industrial sectors, before rebounding back above 92% by 2022. By comparison, occupancy levels dipped as low as 88% during the Financial Crisis and took three years to recover back above 90%
The historically large REIT development pipeline continues to represent a source of “shadow leverage” and we expect REITs to significantly scale back on in-house development over the next several quarters until the dust settles. Before 2005, only a handful of REITs had in-house development teams, but that changed significantly over the last decade, and many large REITs are now among the most active real estate developers in the country. The development pipeline ended 2Q20 at roughly $41 billion, pulling back from the $49.2 billion level as of the end of 2019. We forecast that we’ll see the size of the pipeline in this data set to dip below $30 billion by early 2021 after currently-under-development projects are completed and as REITs pause new projects.
External Growth Has Come To A Halt Amid Pandemic
For the year, the Vanguard Equity REIT ETF is lower by roughly 17.0% compared with the 5.5% gain on the S&P 500 ETF (SPY). Just 4 of the 18 REIT property sectors are in positive territory for the year while seven are lower by more than 30%. On the residential side, five of the eight U.S. housing industry sectors in the Hoya Capital Housing Index are in positive territory for the year. Astoundingly, the gap between the best-performing REIT sector – data centers – and worst-performing REIT sector – hotels – is a whopping 83% in 2020. At 0.64%, the 10-year Treasury yield has retreated by 128 basis points since the start of the year and is 261 basis points below recent peak levels of 3.25% in late 2018.
Before the pandemic, REITs were beginning to get back to doing what they do best: utilizing their access to equity capital markets – one of their primary competitive advantages over private market peers – to accretively grow via external acquisitions and internal development. At the end of Q2, equity REITs traded at an average Price/FFO multiple of 17.4x, a nice recovery from their 14.8x levels in March, and roughly in line with post-recession levels. Somewhat counterintuitively, elevated or depressed equity valuations for REITs (as measured by Net Asset Value discounts or low FFO valuations) tend to be self-reinforcing, as it serves as an “on/off” switch for external growth.
Interestingly, while Price/FFO valuations have recovered in recent months, REITs still trade at sizable discounts to their private market peers, reflecting the fact that private market real estate asset values have held relatively firm even as most equity REIT sectors have dipped at least 20% this year. Green Street Advisors’ Commercial Property Price Index declined by roughly 8% from last year. We estimate that hotel and retail assets have likely seen a 10-20% decline in private market values while office and healthcare assets are likely lower by 5-15%. Residential, industrial, and technology real estate prices, we estimate, are roughly flat during this time and transaction volumes have begun to pick up modestly over the two months after a sharp decline in Q2.
On a sector-by-sector level, we note that the average REIT trades at a 15% discount to Net Asset Value with significant disparity between property sectors with data center and cell tower REITs trading at roughly 30% premiums to NAV, while prisons, malls, and billboard REITs trade at 40-50% discounts to NAV. However, buying REITs that trade at valuation discounts and avoiding those that trade at a premium has been an underperforming strategy over most recent periods. In our report, “The REIT Paradox: Cheap REITs Stay Cheap”, we discussed our study that showed that higher-valued REITs in faster-growing property sectors have historically produced better total returns, on average, than their “cheaper” higher-yielding counterparts.
As noted above, REITs were back in “external growth mode” in early 2020, powered by a strong year of share price appreciation in 2019, but this momentum has quickly faded amid the pandemic. The $32.9 billion in net acquisitions last year was the largest annual net “buy” since 2016, but this past quarter saw the second-lowest quarter for net acquisitions since 2009. REITs acquired just $2.9 billion in assets in Q2 while selling $4.5 billion. However, we forecast that REITs will be net sellers in 2020 and project that a handful of REITs in troubled sectors are likely to be taken private – or get handed over to creditors as we’ve seen with CBL & Associates (CBL).
Speaking of M&A activity, the “merger mania” theme of early 2020 that saw a flurry of announcements and countless rumors seems like a distant memory. Two M&A deals that were announced in 2019 have closed this year with Prologis (PLD) closing on its acquisition of Liberty Property (LPT) in February and Digital Realty (NYSE:DLR.PK) closing on its acquisition of InterXion (INXN) in March. One deal remains pending – Simon Property’s (SPG) ill-timed deal to acquire Taubman Centers (NYSE:TCO.PK) which was announced in February which remains in limbo after Simon and Tauman have exchanged lawsuits. Meanwhile, Front Yard Residential’s (RESI) $2.3 billion acquisition from private equity firm Amherst Residential that was announced in February was terminated in May and there have been no new M&A announcements since the start of the pandemic in late February.
Access to capital – or lack thereof – was the accelerant that turned a bad situation into a dire one for REITs during the financial crisis. Many REITs were forced to raise capital at firesale valuations during the Great Financial Crisis to stay afloat, resulting in substantial dilution to equity shareholders and contributing to the roughly 70% plunge in the Equity REIT ETF during that time. REITs entered this period of volatility with a “war chest” relative to their position in 2008 as REITs raised more capital in 2019 than in any prior year since the recession. Despite the headwinds on the sector, access to capital hasn’t been a major issue this year either, aided by the unprecedented levels of monetary stimulus provided by the Federal Reserve. REITs have raised more capital in 1H20 than in any other first-half, 75% of which was unsecured debt.
The REIT IPO pipeline is likely to remain stagnant in 2020 given the turbulent environment and steep NAV discounts. Just two REITs, Postal Realty Trust (PSTL) and Alpine Income Property (PINE) went public last year, raising a combined $250 million in equity. This quiet year for IPOs comes after five REITs went public in 2018, the largest two being casino REIT VICI Properties (VICI) and cold storage operator Americold Realty (COLD). There have been some signs of life over the past month, however. Last week, net lease REIT NetSTREIT Corporation (NTST) began trading on the NYSE, raising $225 million at $18 per share. NTST’s portfolio consists of 163 single-tenant net-leased properties with top-10 tenants of 7-Eleven, Walmart (NYSE:WMT), CVS (CVS), and Lowe’s (LOW). Also last week, Broadstone Net Lease (BNL) filed to go public in an offering that could top $500 million.
REIT Balance Sheets Have Cushioned The Blow
Owing to the harsh lessons learned during the financial crisis, REITs have been far more conservative with their balance sheet management in the post-recession period than in the period before the GFC. This diligent balance sheet management cushioned the blow from the unique challenges presented by the coronavirus crisis – specifically that many REITs struggled with the most basic of all functions as a property owner – rent collection. Impaired rent collection resulted in a dip in EBITDA coverage to 3.4x, which still remains firmly above the lows around 1.5x during the Financial Crisis. Debt as a percent of the market value of assets retreated back down to 36% by the end of Q2 after briefly climbing above 40% during the sell-off in March and into April.
Not all REITs are created equal, however, and the broad-based sector average does mask some of the issues brewing in several of the troubled sectors. Five REIT sectors still operate with debt ratios in the “danger-zone” above 50% – hotels, malls, prisons, and billboards – while more than a dozen small-cap REITs in the retail and hotel sectors are currently operating in the potential “bankruptcy-zone” with leverage ratios above 80%. On the flip side, the “essential” property sectors including housing, industrial, and technology continue to operate with debt ratios below 30%. We break down the relative balance sheet strength on a sector-by-sector level below.
REIT balance sheets look far more like a typical operating company than the highly leveraged holding companies of yesteryear, which has served them well during the pandemic-related volatility. REITs have used lower interest rates this year to extend their maturities and lower their average long-term interest rate from 3.86% to 3.82% over the last quarter. Interest expense as a percent of NOI, however, ticked higher in Q2 to 25.1% of NOI, which is the highest since 2013, but still remains well below the average around 35% in the pre-recession period. As more REITs have obtained investment-grade bond ratings, they have been able to issue longer-term unsecured debt, pushing the average term to maturity to 83 months, the longest term on record.
Key Takeaways: This Time Has Been Different
While the coronavirus crisis isn’t yet over, the REIT sector appears likely to avoid the type of long-term lingering pain that was felt by the sector during the Financial Crisis. Most REITs had been “preparing for winter” for the last decade and while some aspects of this crisis were more acute than the GFC, including the wave of dividend cuts in Q2, strong balance sheet management and ample access to capital prevented the type of shareholder dilution that plagued the REIT sector for many years in the immediate post-recession period. Fueled by improved rent collection, we expect to see the back-half of 2020 see by a solid rebound in FFO, NOI growth, and dividend distributions.
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Disclosure: I am/we are long HOMZ, AMT, ARE, AVB, BXMT, DRE, DLR, EFG, EQIX, FB, FR, MAR, MGP, NLY, NHI, NNN, PLD, REG, ROIC, SBRA, SPG, SRC, STOR, STWD, PSA, EXR, AMH, CUBE, ELS, MAA, UDR, SUI, CPT, NVR, EQR, INVH, ESS, PEAK, LEN, DHI, HST, AIV, MDC, ACC, PHM, TPH, MTH, WELL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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