Research in Action: Publicly traded REITs shine amid bank lending concerns

Carolyn Bigda: From Janus Henderson Investors, this is Research in Action. A podcast series that gives investors a behind-the-scenes look at the research and analysis used to shape our understanding of markets and inform investment decisions.

Last year, listed property equities, or what might be better known as REITs, suffered losses as rising interest rates threatened to weigh on property values and make the dividends that REITs pay look less attractive. But this is a new year and many REITs have seen their valuations adjusted lower. Portfolio Manager Greg Kuhl, a member of the Global Property Equities Team, says investors may want to give REITs another look.

Greg Kuhl: Public REITs are expected to grow earnings in the low single digits this year. I think you contrast that with the S&P 500, where earnings keep getting revised down and are expected to fall in 2023.

Bigda: I’m Carolyn Bigda.

Matt Peron: And I’m Matt Peron, Director of Research.

Bigda: That’s today on Research in Action.

Greg, welcome to the podcast.

Kuhl: Thank you for having me, I appreciate it.

Bigda: So, Greg, let’s maybe start the conversation by talking about some of the more recent news: the events that have happened with the bank stress that we’ve seen in the U.S. and the impact that that’s had on the outlook for commercial real estate. There’s a lot of concern that because these banks do a lot of the lending for commercial real estate, that the sector as a result will come under stress. How does that impact public REITs?

Kuhl: It’s a really important question. Certainly, one that we have been hearing a lot. And I think, you know, there’s a couple of points I would make. One is, you’re right, there is certainly increased discussion, increased concern about lending specifically by the banks to commercial real estate. We think there’s kind of three main areas of concern that we’ve heard about, and those are, number one, cost of capital for real estate. Secondly, availability of capital. And then the third issue, which is a little tangential, is exposure to office buildings.

So, going through those in a little bit more detail, I, first, think it’s important to take a step back, and when we talk about commercial real estate, it is a very large asset class. Our publicly traded REITs are a very small portion of a much larger asset class. So, we think about 90% of commercial real estate is owned by private vehicles. Those could be non-traded REITs, private equity funds, etc. Only about 10% of commercial real estate is held by public REITs. So, when we read headlines about commercial real estate and we hear about commercial real estate issues, especially recently, those are almost always in reference to privately owned real estate.

So, there’s a couple of really important differences between private real estate, the 90%, versus public real estate, the 10%, which is where we invest. The first one that’s really important to highlight is that the capital structures each of these types of owners use are very different. And so, by capital structure, I mean, you know, basically, what does the balance sheet look like? How have these real estate-owning entities funded the buildings that they own? So, comparing public versus private on that. Right off the bat, the biggest difference, publicly traded REITs use, on average, 70% equity in their capital structure. Private real estate, on average, uses only 36% equity. So, right there, you know public rates have twice as much equity in their capital structure, or to say it differently, public REITs use half as much debt as private real estate. So, right there, you are vastly less dependent on the debt markets in the public vehicles. That’s very important. We think, you know, across an entire cycle that lowers the risk profile, but especially when you have issues in the debt markets, you would prefer to have less dependence on the debt markets, which is what the public companies do.

The next point is going to be, well, what kind of debt do they access? And this will get back to your kind of question around bank lending. So, when we talked about public companies, about 75% of their debt capital comes through the corporate bond market. That’s a really, really important differentiator. This is in an area that public REITs have access to capital through; private real estate does not. If we think about the credit quality of these public companies, 89% of U.S. REITs by market cap are investment-grade rated borrowers.

Contrast that with, you know, the 90% of commercial real estate, the private real estate market who cannot access the corporate bond market. So, if you think about their debt book, they’re almost entirely dependent on the bank loan market. That’s their biggest source of debt. I think, understandably, bank loans are in question. A lot of regional banks are pretty big into commercial real estate lending to privates. That seems to be on hold right now for reasons that make sense to us, at least.

The other big source of debt for private real estate is the CMBS [commercial mortgage-backed securities] market. And you know, we speak with our colleagues at Janus Henderson who are experts in that space, and we speak with them quite regularly. And what they tell us is that from a new issue perspective, there’s nothing happening in the CMBS market. So that market for now is turned off.

Bigda: And CMBS is the commercial mortgage-backed security market. Is that correct?

Kuhl: Exactly. So, I think access to debt capital is vastly better for public than private today, and they have much less debt in the capital structure, which to us means there’s much less risk.

The last point I mentioned at the beginning, exposure to office buildings. That is, I think understandably, an area where a lot of people are concerned about loans on office buildings because of the collateral, right. Office is a challenged property type. Maybe fundamentals are going to mean that some of those loans could default and probably the values of those buildings aren’t what we thought they were when the loans got originated. Office exposure is virtually a non-factor in the public REIT market. It’s less than 6% of U.S. REIT market cap. If we look at the private real estate market, it’s very different. We think between 20% and 25% of all private real estate ownership is in office. So, again, when you see these headlines about office loans defaulting – you know, capital not being available to commercial real estate – that’s really a private real estate comment, not a public real estate comment.

Putting that all together, what does this mean going forward? We think, again, public REITs are not the place where we’re going to see distress within commercial real estate. In fact, this limited availability of capital and the higher cost of capital that I just talked about in kind of the overall system could present an opportunity for the listed REITs to use those strong balance sheets and strong access to capital for growth.

Bigda: You mentioned office, and that’s something that I think we want to touch on later, to get into a little more detail on, but one thing, maybe I could just ask a very basic question, which is, what does commercial real estate actually mean? Because, you know, if 90% of it is privately owned – and so that means that only 10% is owned by public REITs – what is it that public REITs then are investing in? And how is that different from commercial real estate?

Kuhl: Yeah, so that’s another great question. Commercial real estate is probably too broad of a terminology, right. So, most people associate only a few property types with commercial real estate. We would call those the core property types. So that’s, you know, residential, retail, industrial, and office. Those core property types do make up the majority of privately owned real estate, but those core property types make up a minority of publicly traded REITs. So, there is a big difference there in terms of the composition of those markets and the property types that exist in each of them. Like I said, office in the public markets is only 6% of market cap. In the public markets, we have lots of other sectors or property types within real estate like cell towers and data centers, self-storage. We have single-tenant net lease assets; like we have one publicly traded REIT that owns casinos and leases them back to gaming operators. We have life science, we have cold storage, manufactured housing, assisted living. There’s a long list of property types that exist in the public markets that are much less important in that private market space.

Bigda: You’ve written a lot about this topic in the last couple of weeks, and you one of the points that’s been made is that valuations on public REITs actually look pretty attractive right now and that was because in 2022, the sector didn’t fare so well. Could you talk a little bit about what happened and why we saw the valuations get reset lower?

Kuhl: Yeah, another really important point when we’re comparing, again, the 90% that’s private versus the 10% that’s public. I think, you know, you look back at 2022, publicly traded REITs were down, roughly speaking, 25% on the year. And you contrast that with – you could use different measures of private real estate performance – but typically, private real estate reported returns of, let’s say, +7% to +12% or +13% for the year. So massive, massive dispersion in terms of the reported returns.

You know, there’s a couple of things going on there. The thing that’s not going on is, there’s not a difference in fundamentals, right. So, we look at, rent and occupancy – which combine for cash-flow growth at these underlying properties – the fundamentals in the public market were actually better than the private market. So, that’s not the explanation for the difference in returns. The explanation, in our view, is really just timing. So, public real estate gets priced 250 times a year every single day the stock market is open. Private real estate gets priced maybe four times a year, or maybe 12 times a year if it’s a monthly vehicle. So, far less frequent pricing. And then also, private real estate managers have significant discretion in reporting the values of their portfolios. For publicly traded REITs, the stock price is the stock price. It’s determined by the market, it’s not determined by the REIT. And that’s why, you know, when we saw the rate hikes, as you mentioned, that happened throughout 2022, those rate hikes are a negative for any financial asset because of the fact that it was it was really real rates that we saw move higher, which means higher cost to capital is going to be built in to share prices, higher return expectations. That means that values have to go down, which is what we saw in the public market.

We haven’t yet seen that in the private market. But we think we will. You know, one point that might be interesting to mention here is just looking at publicly traded REITs, historically, one of the times from an inflation perspective that public REITs have performed the best versus other types of equities is when inflation has been high but falling – [that] has been historically a really good environment for publicly traded REITs. We think that’s where we are today. We’ve seen inflation start to fall and that may continue. And then you kind of layer that in with the valuation that we have, which is a big discount certainly to private real estate. But also importantly, the valuations today, in our view, make sense relative to the cost of borrowing that we talked about. We think public REITs have pretty effectively priced in those rate hikes. So, to us, that’s an attractive entry point.

Bigda: And why do publicly traded REITs, why do they tend to perform well in an environment where inflation is high but perhaps easing off?

Kuhl: I think there’s probably a couple of different things happening there. But one of them is likely that in those situations, historically, you’ve also seen rate cuts, right? I think a lot of those situations probably have to do with a slowing economy. And what happens into a slowing economy is rates get reduced, which tends to be really favorable for capital-intensive assets like REITs.

Peron: I can certainly concur as a generalist that, looking across sectors, I’d certainly bank more on REITs’ cash flows, the durability of that, coming into the lagged effect of the rate hikes on the rest of the economy and feel more confident in REITs. Since you mentioned broken REITs subsectors, we’ve got to ask, is office in that category?

Kuhl: Yes, I think it is. I’ll just give you some examples there with office. One thing to point out is, just in our recent conversations with office landlords, the anecdotes that we hear are for the tenants who are renewing, it’s very common to see them downsize their space by 15%, 20%, 30%. Those are normal situations now. If you have a whole bunch of tenants doing that, obviously, you’re putting a whole lot of supply back into the market, effectively. If you’ve got a lot of vacancy in these buildings, that means that it is a tenant’s market, not a landlord’s market. You can’t raise rents and you can’t keep the building full; your cash flows are going to decline. I think everyone sees that. This has been one of the worst-performing property types in the public markets for the last couple of years for this reason. But you won’t see it play out in the fundamentals right away because of the fact that office leases are typically 10 years in length; a lot of the higher quality office buildings are leased to high-credit, good-quality tenants. They’re not going to default on their leases, but they may have a lease that matures three years from now and they already know either we’re not going to renew this or we’re going to downsize it by half, or something like that. There is just a ton of headwinds out there for office landlords.

The other point I’d make is that before the pandemic, pretty much the only industry that was growing office footprints was tech. What do we see today? It’s all sorts of headlines about tech layoffs. I don’t think you see many companies laying people off and taking more office space at the same time, right? That’s a tailwind that’s turned into a headwind. And then everyone else continues to shrink their office space. Until we turn the corner and see a growth environment with business formation – and it’s probably going to be led by tech again, I would imagine d – I think office is going to be tough.

Bigda: At the same time, there were some property categories that did particularly well during the pandemic. Industrial REITs, data centers, which benefited as the economy shifted online. But we’ve seen those areas slow down a little bit. Can you talk about maybe what’s happening there and what your outlook is?

Kuhl: Two of the darling sectors in public markets, for sure. We look at them each a little bit differently today. I think in both cases, the pricing in public markets just got ahead of itself towards the end of 2021 and during the pandemic. The difference to us is industrial REITs have a much stronger growth profile than data centers, and, actually, in our view, we think the industrial REITs have grown into those valuations – again, following some underperformance last year – to where they actually look really interesting to us again. Within real estate, industrial is still by far the strongest fundamental story from an occupancy and a rent growth perspective. It is slowing, from a rent growth perspective, but you’re slowing from levels that we’ve never seen before, so it’s still quite strong for industrial.

Data centers are a bit different. There’s plenty of demand for data centers, as I think we all know; there’s certainly some longer-term positives. The data center landlords are the biggest fans of ChatGPT because they’re trying to say this is going to drive all sorts of computing needs, which is probably true. But the problem for data centers has been there has historically been a ton of supply growth. If you’re a real estate owner, supply is your enemy. That means that you’re not going to be able to push rents as much as you would without it. The reason there’s so much supply in data centers is because even still, the returns that you can make on developing a data center are the highest returns that you can make developing just about any type of real estate. I think that’s going to continue until that return profile gets low enough that it’s no longer attractive for so many developers.

Bigda: What’s underpinning the long-term growth in industrials, in your opinion?

Kuhl: It’s a couple of things. A big one that’s still going on is e-commerce. You think about your own shopping habits and you might think how could I possibly do anything more on e-commerce than I’m already doing? But you can. For instance, one of the biggest categories that people spend on is grocery. That business doesn’t even exist right now from an e-commerce perspective, effectively, in the U.S. It does elsewhere in the world, and I think we’ll probably get there eventually and that’ll drive a lot more demand for warehouse space.

And then other areas that continue to expand from an e-commerce perspective. When you think about Amazon, who’s obviously the leader, there’s still a ton of retailers that are way, way behind them in terms of building out a network, having the ability to deliver your goods in two days or less, which is now the expectation you’ve been trained to have. There’s a ton of infrastructure that has to go behind that type of industrial leasing. And the supply environment is a lot more benign, even though it has picked up in industrial, it’s a lot more benign than data centers.

Peron: So, staying on the string of positive subsectors, we have to talk about residential. It had eye-popping rental growth, didn’t it? I think that’s rolling over now, so that gets more complex. How are you thinking about that sector?

Kuhl: To your point, I would think that the for-rent residential sector broadly probably had the best fundamental year in its history last year. It’s hard to think that it was ever better than that.

Bigda: That’s a big statement.

Kuhl: Yes, it is. Unfortunately, as equity investors, we don’t care about what just happened, we’re looking at what’s about to happen. You can’t really follow that up, I don’t think. Look, the buildings were basically full. Some of these professionally managed apartment buildings in the public markets, 97%, 98% occupied. That’s even hard to manage logistically when you’re trying to think about move-ins and move-outs and how many empty units do you have, that’s an impressive occupancy stat. At the same time, they were pushing rents really aggressively. Obviously, full occupancy means it’s a landlord’s market, and you had the inflation to push through, so they were very successful with that.

I think, as we sit now, we think, look the economy is looking shakier. If we head into a downturn, I think what you would expect is occupancy to fall. People might get roommates, people might move back home with mom and dad, stuff like that. People might move out to less expensive areas, so you see occupancy start to fall. That means pricing power starts to fall as well. I think it’s still a fine business, but it is decelerating and it could decelerate rapidly if we actually do see a recession.

The other thing we’re thinking about there that we’ve seen a lot more of, is regulation. With that really successful year I just talked about, you started to hear a lot more about rent control in a lot of different markets. For sure, in some of the big cities around the country, but you also started to hear about it in some of the areas you might not expect. Places in Florida and the Southeast have been talking about it. There’s talk about different regulations on single-family rental, which is a sector that we like long term, but I think that’s at risk of more regulation, too. That’s hard for us to underwrite; we just know that the risk is out there and we perceive it to be building, to a certain extent.

Bigda:  One follow-up question to that, though, is we’ve heard so long about a shortage of supply of housing. The supply and demand imbalance, is there enough of a lack of supply to help counteract a drop-off in demand if we do have a recession?

Kuhl: It’s a really interesting question because there has been very little supply being delivered. That is actually changing, especially in some of the big urban centers. There actually is a lot of supply that’s going to be coming on over the next 12 to18 months for apartments. Again, developers in real estate track success. You see how good apartments did, and then developers want to go build more apartments. That’s the natural equilibrium of how these things sort themselves out. That supply is coming on the next 12, 18, 24 months, arguably just when you would least like to see it into a recession. That’s going to take some of the wind out of the sails.

But I think what you’re talking about, too, you need to think about it by price point. There is not enough supply of, kind of, middle and affordable housing. That’s an issue that’s driving a lot of the regulatory construct that we’re talking about, about rent control. The problem is, kind of, by definition anything that gets built is going to be at the higher end. That’s where the economics make the most sense from a development perspective. All this new supply, high-end rental, and there’s still not a lot being done about the more affordable side of the equation. Not sure how that works out, but at some point, regardless, more supply across the system means prices are going to go down, rents are going to go down.

Peron: Putting it all together.

Bigda: Yes, let’s put it all together.

Peron: The setup here, I’ll let Greg put it together, but it looks interesting. The valuation reset is largely behind us, it sounds like. Fundamentals are good, especially on a relative basis to the rest of the market during late-cycle dynamics where you’ll see that slowdown. REITs seem like maybe they’ll be a thing again in 2023. Greg, are we missing something?

Kuhl: No, I think that’s kind of it. It’s a good and bad. It doesn’t feel great to have just been through the year that we just went through from a returns perspective, but I think the good news is that that’s just reality. The rate environment that everyone exists in today is vastly different than the rate environment that we all lived in a year ago. We reflect that today and we’re ready to move forward, and we have good fundamentals, as you said. That feels like a better place to be on a forward-looking basis.

Bigda: Well, sounds like there’s a lot of potential there. Greg, we really appreciate you joining us today. We’ve covered a lot of ground, so thank you very much for that.

Kuhl: Thank you, appreciate it.

Bigda: Next month, we will hear from one of our analysts from the industrials sector with an update on battery technology and what to think about when investing in the space, especially as capital floods into the fast-growing industry. We hope you’ll join. Until then, I’m Carolyn Bigda.

Peron: I’m Matt Peron.

Bigda: You’ve been listening to Research in Action.