Commercial real estate: look beyond the headlines for opportunities within listed property
Despite the uncertainty, Portfolio Manager Greg Kuhl argues there are grounds for optimism given important differences between public and private commercial real estate.
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- While undoubtedly there are headwinds facing the commercial sector, these may not be wider systematic issues affecting the whole asset class given meaningful disparities between public and private real estate.
- The divergence in real estate fundamentals across different property types presents attractive opportunities for active managers.
- The long-term case for REITs is underpinned by attractive valuations and access to capital that enables them to take advantage of any opportunities arising from private real estate distress.
Only about 10% of the commercial real estate sector is owned by public vehicles
When we consider the recent news flow around commercial real estate, there are a few things that we think are really important to keep in mind. The first of those is that commercial real estate is a very large and broad asset class. We are focused on publicly-traded commercial real estate stocks, but within the context of broader commercial real estate, it’s actually pretty small. Only about 10% of commercial real estate is held by public vehicles. So obviously what that means is that the other 90% of commercial real estate is owned in various types of private vehicles and that’s really what drives most of the news flow that we read about commercial real estate.
There are a couple of very important distinctions between publicly held and privately held commercial real estate that are very relevant today.
Public real estate has better access to capital and lower debt
Now, when we think about the recent news flow around bank lending to commercial real estate, our understanding is that banks are less willing to lend on commercial real estate going forward because of some of the issues that we’ve all read about in the last couple of months. What’s really important to understand is that publicly-traded real estate companies really don’t use the bank lending market. Almost exclusively, the public companies are financing their debt through the corporate bond market. They can use the bank loan market, but they just don’t. That’s very different from private real estate where bank lending is the primary source of borrowing for that group of owners. So when we read about stress in the banking system hurting commercial real estate, that’s really a comment on privately held real estate and not really applicable to the public real estate companies that we invest in.
On cost of capital, which is related to access to capital, it’s important to highlight that the public real estate companies’ balance sheets are in the best shape that they’ve ever been in. If you think about a typical publicly-traded REIT in the US, for example, they’re capitalised using only about 30% debt in their capital structure. A typical private real estate owner has about twice as much debt. They’re close to 70% loan to value in their capital structure.1 Now, when you think about the credit quality of each of those borrowers just based on how much leverage [debt] they have, lenders are much more comfortable lending money to an entity that has less debt on the balance sheet and is less risky as a result. Even since all of the banking issues, we’ve seen publicly-traded REITs borrow on really good terms that make sense for the use of capital that they’re going to deploy.
Office fundamentals still weak but public REITS have less exposure
Another point I think is important to differentiate between privately held real estate and public real estate is exposure to office. We’ve observed in the media a lot of stories that talk about problems in commercial real estate fundamentals and what they really mean is office fundamentals. We would agree that office is a pretty tough property type at the moment, but I think one thing that’s very important to point out is that office is not really that significant in public markets. We think in the private markets, office accounts for up to 20% of private real estate exposure, but in the public markets where we invest, office is only about 12% of global real estate exposure and it’s far less than that from a US perspective, where it’s only about 4%.2 So in the public markets we’ve already effectively made office much less important than it used to be because of some of the issue that we’re just now hearing about.
Private versus public valuation lag: a window of opportunity
The next point is on valuation and this is a very important difference again between private real estate and public real estate. We actually think that there’s an opportunity for public REITs to take advantage of this.
The issue between the two is timing of valuation. So if you think about a public real estate company, it’s a stock that trades every day the market is open, which means those stocks get mark-to-market 250 times a year, give or take, again every day the market is open. If you think about private real estate vehicles, typically those are priced quarterly. So you might get four updates per year on valuation and the valuation that gets reported is lagged because it’s based on backward-looking appraisals. It’s really hard to know what a particular building is worth if there’s been no transactions of late, which is the case today. If you contrast that with a stock that trades every day, we could tell you exactly where the stock trades and what the stock market thinks those buildings are worth.
So the point of all that is that there has been already a significant correction in public real estate companies. Those public real estate stocks were devalued quite a bit during 2022. Once the Fed [US Federal Reserve] started hiking rates and the market figured out what was happening, we pretty quickly saw the prices of public REITs adjust downward. We have yet to see that on reported values in private real estate, which again is the majority of all commercial real estate, and that’s what drives those headlines. So if there is a correction to come, which we think there is, it’s in private real estate. The correction has already happened in public real estate.
1 Morgan Stanley, NAREIT, Green Street, Janus Henderson Investors Analysis, as at 31 December 2022.
2 Global REITs= FTSE EPRA Nareit developed Index; US REITs= FTSE EPRA Nareit North America Index as at 31 March 2023.
Attractive valuations and access to capital underpin the long-term outlook for REITs
We think the long-term opportunity for public REITs from here is just about as good as it’s ever been and there are two key factors driving that view. The first is valuation and the second is access to capital.
The bad news is already priced in
So, starting with valuation, we’ve seen publicly-traded REITs revalued downwards pretty materially in the past 12 or 18 months based on the changing rate environment. In our view, the public companies today are trading at valuation levels that make sense and if you buy into the sector today, you’re buying in at a basis that reflects higher interest rates, risk of recession, a slowing economy, and so on. That’s a really good place to invest in any vehicle. You certainly don’t want to get in front of a write-down like we think you might be if you were looking at private real estate, for instance. So the valuations make sense. They reflect the reality, in our view, that exists today.
Access to capital offers growth opportunities
The second point that we think is very important and really going to shape the potential opportunity for listed REITs in the next five or ten years is access to capital. If we think about the last economic cycle that is arguably ending at the moment, it’s been driven by very cheap debt and very high leverage being used within broader commercial real estate. That’s been to the disadvantage of publicly-traded REITs which have operated with very conservative capital structures. Because they don’t use as much leverage as their private competitors, they’ve missed out on acquisition opportunities. They haven’t been able to pay the same prices for buildings that other types of buyers who can use more very cheap debt have been able to pay, but I think that’s all changing as we think about the changing environment for borrowing today.
Public REITs have access to capital. They have a better cost of capital today than other types of real estate buyers. In our belief right now, there aren’t that many buyers of commercial real estate out there who can actually transact. The public REITs are among the only ones that can today and they can do it on an attractive basis. So we think that means we will see public companies going out and acquiring attractive real estate at attractive prices using the access to capital that they have through both the corporate bond market and also the equity market. We think this is something that investors are really going to benefit from.
We’ve actually started to think that there are a number of parallels between the environment that we see today for commercial real estate overall and the role of listed REITs. We think there are parallels between today and the early 1990s. So if you think back to that time, the 1980s had a commercial real estate crash and banks were reticent to lend on commercial real estate during the early part of the 90s. You saw a pretty significant flood of capital from private markets into public markets in those early 90s years, so much so that in 1993 alone, for example, there were 45 REIT IPOs, a lot of private capital going public.
Now, at that time there really was no public REIT industry. That was the birth of the REIT industry in the public space that we know today. The setup is different now in that we have $2 trillion1 worth of very mature, well-managed, well-capitalized public companies that already exist and are ready to take advantage of opportunities that are going to come through potential distress in other types of real estate owners. So aside from fundamentals that we think will be durable through a recession, there’s a really strong external growth opportunity for these public companies and we think we’re going to see them take advantage of that access to capital that they have to drive even more growth in the next five or ten years.
1 Bloomberg, FTSE EPRA NAREIT Developed Index (global REITs) as at 13 June 2023.
REITs or Real Estate Investment Trusts invest in real estate, through direct ownership of property assets, property shares or mortgages. As they are listed on a stock exchange, REITs are usually highly liquid and trade like shares.
Real estate securities, including Real Estate Investment Trusts (REITs) may be subject to additional risks, including interest rate, management, tax, economic, environmental and concentration risks.
Bank loans often involve borrowers with low credit ratings whose financial conditions are troubled or uncertain, including companies that are highly leveraged or in bankruptcy.