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Global REITs present attractive opportunity, fundamentals remain strong amid sell-off

Rick Romano
Rick Romano11/17/2022 10:48 AM GMT+08  • 4 min read
Global REITs present attractive opportunity, fundamentals remain strong amid sell-off
. Fears about interest rates and the regulatory climate, for example, have created unprecedented discounts for industrial and apartment REITs in Canada / Photo: Bloomberg
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This year has brought a sizeable disconnect between the value of publicly listed REITs and private real estate. The disparity has been fuelled by a combination of factors: inflationary pressures, a hawkish response to high inflation by the Fed, heightened geopolitical tensions, including the Russian invasion of Ukraine, and fears of a recession. The conditions that brought considerable volatility in equity markets have had a negative impact on REITs’ valuations that, upon close inspection, does not seem warranted.

The current market conditions have created an extraordinary public real estate market arbitrage opportunity across many property sectors, particularly among those with strong fundamentals and strong demand from real estate buyers.

Overall, it appears that we have entered a period similar to the one that unfolded in the early days of the pandemic, when volatility in the public markets set the stage for REITs to deliver strong outperformance. The global REITs market, as defined by the FTSE EPRA Nareit Developed Index, has sold off by 31.8% yearto-date (as of Oct 11). Tight monetary policy by central banks across the globe has caused valuation compression among public REITs, while having a much smaller impact on the private real estate market.

Even though higher interest rates and the rising cost of debt can impact valuations, certain real estate classes still have the ability to materially outgrow inflation. That enables them to deliver income growth that can outpace the negative effects of rising debt costs. This year, asset classes that benefit from structural growth have been even more negatively impacted than asset classes that have had growth headwinds.

In the past, buying REITs at moments when they were selling at steep discounts to the value of their underlying assets enabled investors to realise considerable outperformance, relative to the private markets.

During the past 25 years, in periods when REITs were selling at discounts to their NAVs of 10% or more, they subsequently delivered three-year returns, relative to private real estate, that were in the range of 20% to more than 50%. Given that REITs this year are trading at an average discount of 32%, with discounts for some REITs even higher, we believe the same attractive opportunity exists today.

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Opportunities in three key sectors

The disruptions in the supply chain for building materials brought about by the pandemic persist. These disruptions have created a supply/demand imbalance that has been working in the favour of apartment owners, and especially for those with properties in urban locations. The demand for rental units has been increasing as employees, who have been working remotely, are returning to offices in metropolitan areas.

Private equity firms have significant dry powder, and apartments have always been a preferred asset class because of their favorable financing. The potential for M&A activity has also been enhanced by the large discounts to apartment REITS’ asset value that are prevalent today in the public real estate market. Self-storage REITs also present strong acquisition opportunities with the rollup of local operators, and rarely trade at significant discounts to their NAVs because these businesses require relatively low capital expenditures.

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Self-storage platforms are unique and highly valuable. That makes self-storage REITs attractive M&A candidates because it is difficult, if not impossible, for a private equity firm to replicate the platforms.

Given these attributes, the performance of self-storage REITs this year may seem surprising. They also have been caught up with the volatility in public markets, and self-storage REITs have been trading this year at a deep discount to their NAVs and well below their long-term historical averages.

Meanwhile, some of the world’s most-favourable supply/demand dynamics for real estate now exist for industrial and multifamily properties. REITs focused on those two market sectors are now prime M&A candidates for private equity firms, given the scarcity of large portfolios of these properties and the severe supply shortage of both asset classes. Fears about interest rates and the regulatory climate, for example, have created unprecedented discounts for industrial and apartment REITs in Canada.

In fearful markets, strong fundamentals are often overlooked. Listed REITs have been affected by the overall negative sentiment in public markets. But the prices REITs are trading at do not reflect strong fundamentals, particularly in several key asset classes. History, though, does demonstrate that listed REITs have rebounded strongly after their valuations have been unfairly discounted. We believe the current market could be a repeat of that scenario and that listed REITs present an attractive opportunity for investors.

Rick Romano is head of global real estate securities and senior portfolio manager at PGIM Real Estate

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