According to Hazelview Investments’ 2023 Global Public Real Estate Outlook Report (the “Report“), after an exceptionally harsh year, global real estate investment trusts (“REITs“) are currently trading at significant discounts, with tailwinds that could materialize in 2023 to offer significant positive mean reversion.
“Fundamentals went out the door in 2022 as markets focused on high-inflation and hawkish monetary policy,” says Corrado Russo, Senior Managing Director, Investments & Head of Public Real Estate Investments. “And, while this can be frustrating for us as active managers, we know this can present exceptional opportunities in 2023 which we believe will be more about weaker growth, moderating inflation, and an end to rate hikes or a partial reversal. The best long-term returns are generated when buying at discounts to intrinsic value and investor sentiment is at its lowest, both of which are true today.”
This year (2022) is on pace to be the second worst performance year ever, since the start of the global REIT era over 30 years ago. Only the global financial crisis in 2008 was worse, and only four times (1990, 1992, 1994 and 2008) have global REITs declined by more than 10 per cent. REIT valuations currently sit at significant discounts to private real estate benchmarks (-26 per cent) and below their pre-COVID trading levels (-14 per cent) which is a stark comparison to global equities that trade 9 per cent above their February 2020 high.
Relative performance by company property type has been even more unusual, according to the Report. The top performers (companies with strong balance sheets, best in class real estate portfolios, superior earnings potential and high-quality cycle tested management teams) and property types that are structured to benefit from rising inflation (apartments, single family rentals and self-storage) performed the worst. In other words, REITs are exceptionally cheap right now, especially the higher quality companies.
What Shifts the Valuation Paradigm?
Potential tailwinds in 2023 that could help REITs close the current valuation discount include a slowing pace of interest rate increases, corporate earnings that exceed market expectations and the possibility that mergers and acquisitions could provide a floor for valuations.
Interest Rates – Stabilization in the cost of capital will provide more clarity for the markets and benefit valuations. The report points to the REIT rally this fall, that was triggered by the first sign that the pace of inflation may be slowing, and rate hikes could begin to moderate, as proof.
“It’s the anticipation of rate hikes that hurts REITs most. With uncertainty around the cost of borrowing, it is very difficult for markets to assess the value of the underlying real estate owned by REITs,” said Samuel Sahn, Portfolio Manager, Public Real Estate Investments. “Rates hikes don’t necessarily even need to reverse to shift the valuation paradigm, they just need to moderate or stop going up and be more predictable.”
The report explains that with clarity around interest rates, fundamentals should drive share price performance and the best-in-class portfolios that have been unjustly punished should start to separate themselves from the pack once again.
Corporate Earnings – Although economic growth is expected to slow in 2023, Hazelview believes REIT earnings will hold up. They point to contractual leases with embedded lease bumps, and/or the ability to mark-to-market upon expiry, as strong support for earnings relative to other industries.
As a yield-oriented investment product, the prospect of lower earnings sends fear into the market that companies may need to cut their dividends. Payout ratios for global REITs are sitting at approximately 65 per cent today which implies earnings can decline by over 20 per cent before dividends are at risk.
Mergers and Acquisitions – In the real estate industry, private investors dwarf the size of the public market, making it ripe for M&A activity. These private investors often look to acquire REITs as a way to access larger portfolios. Historically, these acquisitions transact at or around net asset value (“NAV”), which is why public real estate typically trades in-line with private real estate values. The current dislocation in the market presents an even more attractive opportunity where these private investors can take advantage of large discounts to portfolio value while still offering premiums to share price.
“Even more than other markets, the private real estate investor pool in Europe far exceeds the European REIT market and a spread in valuations frequently results in M&A activity,” says Claudia Reich Floyd, Portfolio Manager, Public Real Estate Investments. “We believe the current market discrepancy will lead to continuous M&A transactions in Europe in 2023 providing a floor to valuations.”
How Can Investors Capitalize on this Opportunity?
While the variability of outcomes entering 2023 are as wide as Hazelview has seen in nearly 20 years of managing REITs, the key to outperforming in 2023 will be to identify which REITs can close their embedded valuation discount through company specific initiatives, rather than relying on overall market appreciation.
“Cheaper valuations due to this year’s poor performance is a big part of the REIT story entering 2023,” says Russo. “We believe, through active management, we can position our portfolios to take advantage of the downdraft in share prices this year and aim to concentrate our portfolios in companies that trade at larger discounts than the overall market.”
Hazelview Investments has been an active investor, owner, and manager of global real estate investments since 1999 and remains committed to creating value for people and places. The company employs a global investment and asset management team of more than 80 people in its offices in Toronto, New York, Hong Kong, and Hamburg and manages 11.6 billion (CAD) in real estate assets. To learn more visit hazelview.com.