What Can CRE Stakeholders Learn From The Rising Popularity Of REITs?

What Can CRE Stakeholders Learn From The Rising Popularity Of REITs?

Lowery Property Advisors

09/27/2021

In the early weeks of the pandemic, large segments of the economy shut down. We’ve discussed how this shock to the financial system affected commercial real estate in previous installments of LPA Insights, but we’ve not yet covered those financial instruments most closely associated with commercial properties: real estate investment trusts or REITs.

As COVID-related uncertainty slowed development plans or halted them altogether in 2020, REIT managers pulled back on capital expenditures. Their retreat throttled already tight cash flows. Eventually, managers regained a measure of confidence, thanks largely to the spectacular performance of REITs specializing in data centers and the infrastructure, physical as well as digital, that support online commerce.

Only now, with the phased expiration of stay-at-home mandates, have hospitality and retail REITs begun to rebound. The combination of effective, widely available vaccines and pent-up demand are driving consumers out of their homes to shop, dine, and travel. Office occupancy rates are up as well. More and more businesses are opening doors to dynamic workplaces, and more and more employees are choosing to walk through those doors.

Although a surge in Delta variant outbreaks has somewhat dampened this rally, analysts with the National Association of Real Estate Investment Trusts (Nareit) have cited strong underlying fundamentals in forecasting a robust recovery continuing through the end of 2021 and into 2022. In fact, Nareit reports that, by May 2021, aggregate REIT funds from operations (FFO) have returned to pre-pandemic levels.

Like the downturn, this recovery has been unevenly spread across all property types. But the fact remains that REITs are very popular with investors large and small right now. The proof is in this statistic (recently cited by CNBC): “The S&P U.S. REIT Index is one of the best performing parts of the stock market this year, up 27.9 percent through July 27.”

Deriving actionable business intelligence from figures such as these requires an understanding of the optimism and anxieties motivating financial decisions being made with regard to real properties. In this article, we’ll investigate the three main drivers of REIT performance and why they’re significant — even for CRE stakeholders whose portfolios don’t contain any REITs.

1) Inflation

Since April 2021, annual inflation has well exceeded the Federal Reserve’s target of 2 percent. The causes are complex and perhaps unprecedented. The government has injected nearly $4 trillion into the economy via several stimulus packages. Demand for goods has surged as consumers have resumed pre-pandemic activities, but supply chains remained snarled, creating scarcities that have driven up prices. Thus far, the Fed’s bankers have downplayed the threat of overheating. But, should that occur, they will deploy one of their most trusted offensive measures against inflation. They will raise interest rates, potentially causing stock prices to fall.

Unlike most securities, however, multifamily, retail, and office CRE are traditionally resistant to this upward pressure. Landlords have several mechanisms at their disposal to ensure that rents keep pace with rising prices, including CPI-dependent escalator clauses. The long terms of leases prevalent in retail, office, and healthcare provide an extra degree of protection.

Inflation worries also give REIT managers incentives to find unique, risk-adjusted solutions for increasing the income their tangible assets generate. Those properties stand to attract more investment and pay more generous dividends, attracting even more investment in turn. Far from creating a speculative CRE price bubble, moderate inflation can create a set of economic conditions in which appraisal values and cap rates move forward in lockstep.

Indeed, historical data shows that, even during what Brad Thomas of Forbes has termed “the eight worst years in U.S. inflationary history” (1974-1981), REITs “delivered inflation-adjusted total returns of 7.0 percent.” By contrast, the S&P 500 achieved 0.8 percent in inflation-adjusted returns over the same period.

As Nareit points out, however, that period predates the “modern REIT era.” Yet more recent data apparently validates the assertion that (in Nareit’s words), “REITs provide natural protection against inflation.” Comparing 20 years of weighted average REIT dividend growth per share to the annual inflation rate reveals that only on three occasions has the latter surpassed the former: in 2002, 2009, and 2020. In other words, it takes a world-changing event — 9/11, the Great Recession, and the pandemic — for REIT dividend growth to lag behind inflation.

2) Value

Industrial CRE is as hot now as it’s ever been. That’s been good news for those who’ve built an investment strategy around warehouses, cold storage, manufacturing complexes, transportation hubs, and data centers. But it has driven investors eager to diversify their REIT holdings (or diversify into REITs altogether) to seek value in those property types that experienced the most distress in 2020. So, where have investors been buying low, and what property types are they pinning their hopes to?

Healthcare has been a major beneficiary of the rising popularity of REITs. Again, the long-term leases signed by many individual medical practitioners have helped shelter REITs focused on these property types. Simultaneously, the increased use of telemedicine and suspension of elective surgeries prompted by the pandemic caused more cautious investors to hold back. Recognizing both the stability of these properties in general and patients’ ever-increasing preference for non-hospital care settings, value-seekers have flocked to REITs that have heavied up on medical offices, outpatient clinics, and ambulatory surgery centers.

Investors have also found value in shopping centers, especially those whose landlords have been most proactive about adjusting to consumers’ overwhelming — and still-growing — desire to order online and schedule curbside pick-up or delivery. Through Q2 2021, retail REITs are up 40 percent. Some malls have even been able to fill vacant anchor stores with e-commerce tenants who utilize the space as last-mile delivery hubs.

Residential REITs in the form of both multifamily and manufactured home communities have also enjoyed strong growth. However, the strength of these markets varies widely according to geography.

In March and April of last year, people and organizations migrated from densely populated, traditionally high-priced urban centers to suburbs, exurbs, and smaller cities. Yet preliminary 2020 Census data shows that this population shift, which has greatly benefited states like Texas and Arizona, is a trend that began picking up steam before the pandemic. This demographic shift helps explain the very tight Sunbelt housing market that’s turning potential homeowners into renters and leasers. Many REITs are acquiring or developing new multifamily properties across the region in response.

Case in point: as Kiplinger reports, the 17,000 Sunbelt apartment units managed by Bluerock Residential Growth REIT (BRG) have seen their aggregate occupancy rate rise to nearly 96 percent since this time last year. Average lease rates at Bluerock’s properties have increased by 3.5 percent in that same time. Bluerock plans to extensively renovate 4,300 apartments in its portfolio, adding value that more and more investors are hoping will lead to returns of between 20 and 25 percent.

Meanwhile, cities like New York and San Francisco are now seeing an influx of returning and new residents. Business Insider, citing a recent study conducted by UBS, notes that “temporary mover data signal the shift from cities to suburbs and exurbs has almost entirely ended.” The reason? Big employers. “The return to trend is most likely fueled by companies’ return-to-office efforts.”

3) “The most valuable buildings are the ones still standing.”

Economic recovery typically spurs new construction. However, present circumstances are quite different. Spring 2021 saw lumber prices skyrocket more than 300 percent. That inflation is starting to flatten, but building starts are lagging, and banks continue to exercise caution with financing. These forces are, in turn, placing a premium on existing structures. And that’s great news for equity REITs.

One notable exception might be office space in large urban centers. According to The New York Times, office building vacancy rates in Manhattan, Chicago, and Los Angeles exceed the current national average. Landlords in this sector are still sorting out the long-term effects of remote work and may need to rethink and repurpose their square footage. However, as businesses juggle the need for face time in the workplace with employee quality of life, compromise solutions such as co-working spaces and satellite offices will likely help buoy the office sector. Per The Wall Street Journal, WeWork had one of its “strongest desk sales months” ever — $215 million — and Industrious experienced its “strongest sales week in its nine-year history” in July.

Consequently, look for more REITs to pursue strategic diversification in the hopes of getting out in front of coming trends in adaptive reuse. As John Kevill, Avison Young’s President of U.S. Capital Markets, recently told Connected CRE Magazine: “Investors are taking a look at the pie chart everybody throws together of asset allocation and adding new slices to the pie. Now you’re seeing a slice for senior living, medical office, self-storage, last-mile industrial, data center.”

Finally, landlords and REIT managers alike must also factor federal legislation into the calculation. Congress is currently wrangling over infrastructure spending, and the passage of the bi-partisan bill could change the construction landscape. The Build Back Better Plan primarily focuses on non-building construction — roads, bridges, and electric vehicle infrastructure — but also includes funding for airports, seaports, and energy grids. A boom in those areas could create all-new shortages of raw materials. What the infrastructure bill augurs for vacant land not subject to eminent domain or right-of-way condemnation remains to be seen.

The state of the REIT market demonstrates that Lowery Property Advisors President Mark Lowery’s advice remains as relevant now as when he shared it in 2020. To ensure the accuracy of any CRE valuation, it pays to view the market from multiple perspectives and analyze as many data points as possible.

LPA’s principle-driven CRE valuation experts are committed to providing their clients with credible, actionable business intelligence. Contact us today to learn how we use every tool at our disposal to ensure the accuracy, robustness, and timeliness of our appraisals.

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