As we have stated in several previous Outlooks, it is very difficult to paint a broad brush on the real estate industry due to the diversity offered both by property type and geography. However, we encountered several broad themes that should have universal impact on real estate.
A number of factors point to a gradual rise in interest rates as we go forward into 2021 and beyond. But, near term, many management teams pointed to a challenging fourth quarter lasting into the first half of 2021 due to the widespread infection rate now raging across the United States, the impact of government induced shutdowns, and the extended timeline implied to get the population inoculated with a promising COVID vaccine. The economy should begin to rebound in 2021 as ‘normalcy’ begins to return. Many REITs see the recent rise in interest rates continuing and, using the 10 yr Treasury as a benchmark, going from a current level of about 0.85% to over 1.5% by 2022. All of the CFOs we spoke with are using the decline in interest rates to refinance their debt and lengthen maturities, significantly lowering their cost of debt capital. For example, we met with Prologis (NYSE: PLD), which issued $2.4 billion in debt at a weighted average interest rate of 1.4% and term of 12 years in the third quarter. We also met with Public Storage (NYSE: PSA), which issued the lowest ever coupon on REIT perpetual preferred equity at 3.875%.
With such a move in interest rates, capitalization rates (or ‘cap rates’) on property net operating income, the primary benchmark for valuation, are slated to bottom and potentially move upward after a 10 year downward run from the Global Financial Crisis. Accordingly, this should create one of the most interesting times for participants in real estate as the ‘free ride’ from higher multiples on cash flow will come to a stop. Instead, high quality operators will distinguish themselves this cycle by growing net operating income in the face of potentially flat or rising interest rates. There should be an inevitable shakeout of many players and we see the rate of changes happening in commercial real estate to be much faster relative to the past. Because so many REIT management teams are cycle-tested and have spent the past 10 years improving portfolio quality and enhancing balance sheets with longer weighted average maturities, they should be major beneficiaries, especially relative to the higher-levered private players.
One of the most interesting property sectors is office because nobody has ever faced conditions like we are now experiencing, and technology has never been so powerful. The most common question for office REITs at the conference was, “when will employees come back?” The work from home (or WFH) and work from anywhere (or WFA) trends could represent a radical transformation of the workplace as we know it today. We participated in presentations by Boston Properties (NYSE: BXP), Cousins Properties (NYSE: CUZ), and Douglas Emmett (NYSE: DEI). We heard only speculation on the impact to office demand including such topics as how permanent the WFH/WFA trends could be, whether will we see a hybrid model that allows employees more control on location, the importance of collaboration and efficiency, urban versus suburban, and de-densification. While management teams were only able to share opinions, some have been able to point to significant leasing wins. For example, BXP signed a new lease with Microsoft in Reston, VA for 400,000 square feet (or sqft) in May, and Vornado Realty (NYSE: VNO) signed a new lease with Facebook in New York City for 730,000 sqft in August. We believe there will be some shrinkage in demand, many buildings will witness accelerating obsolescence, and capital expenditure requirements for all participants will likely increase dramatically. The lingering impacts add more uncertainty to this sector and helps to explain why we are underweight office.
The second property type that has been dealt a huge setback is retail. We met with RPT Realty (NYSE: RPT), Alexander Baldwin (NYSE: ALEX), and Regency Centers (NYSE: REG). Practically everyone knew the US had too much retail going into the pandemic. And this sector was already dealing with a contracting footprint by retailers in favor of e-commerce spending that only accelerated with COVID. E-commerce growth has been extraordinary this year and, even though the rate of growth may calm down in future years, its share of retail sales will only grow. Though many of the REITs were able to point to increasing rent collection, store openings, and leasing progress, the recent surge in COVID is threatening to reverse some of the positive trends. New government shutdowns in New York City, California, and Illinois will likely lead to slowing rent collection for landlords with exposure to such markets. The good news from the conference was that collection for non-essential retail has been extremely high (over 80%, see Figure 1) as long as the store has been able to be open. Other retailers that were pushed to the brink have seen their sales surge upon reopening. For example, the stock price of Bed Bath and Beyond (NYSE: BBBY) has increased 489% from April 2 to November 30. The biggest problem tenants currently are fitness and movie theaters. Even as they have been allowed to reopen, they have not seen a return in demand enough to become profitable. These spaces are not easily re-leased to different uses, and it could be awhile (if at all) before a new fitness or theater tenant would want to take over the space.
Within the healthcare sector, we met with Welltower (NYSE: WELL), Ventas (NYSE: VTR), Healthpeak (NYSE: PEAK), Community Healthcare Trust (NYSE: CHCT), and Sabra Healthcare (NYSE: SBRA). Senior housing and skilled nursing are the most at risk to COVID, while life science, medical office buildings, and hospitals are unaffected by the virus. Senior housing was showing positive news each month with a deceleration of occupancy declines through September, and VTR reported a gain of 50 basis points (or bps) in October (as shown in Figure 2), the first since COVID started in March. Unfortunately, the recent surge in COVID is once again preventing move-ins to some of their properties, making November occupancy decline again. The positive news from the healthcare REITs across the board was that the transaction market is healthy, particularly because so much of their growth comes from acquisitions. In the past few months, PEAK announced agreements to sell $1.6 billion in senior housing assets, VTR announced $1.9 billion of life science acquisitions, CHCT acquired $68 million (approximately 6% of its enterprise value as of November 30), WELL sold $1.4 billion of senior housing properties, and SBRA acquired $20 million in senior housing.
Within the self storage sector, we met with Extra Space (NYSE: EXR), Life Storage (NYSE: LSI), and Public Storage (NYSE: PSA). Self storage demand has been nothing short of extraordinary. However, supply is still an issue in markets where permitting is easy. These markets, such as Orlando, Dallas, New York, and Seattle, while exceeding company expectations, will likely finish the year with negative same store revenue growth. The strong fundamentals have not stopped transactions, as most of the developers are merchant builders who do not want to own and operate, especially in the first few years when the yield is negative. The REITs are confident that they will be able to manage exposure to oversupplied markets through the healthy transaction market.
Within the residential sector, we met with American Campus Communities (NYSE: ACC), Equity Lifestyle (NYSE: ELS), and Sun Communities (NYSE: SUI). ELS and SUI are the largest owners of manufactured home and recreational vehicle (or RV) parks in the world. This ‘alternative’ property type has been gaining in popularity over the past 20 years due to the lack of new supply (permitting nearly impossible) and the growing demand for affordable housing. As a result, the CEO of SUI quoted that they passed on an acquisition in California being offered at a low 3% cap rate with no land for expansion. This is evidence that ELS and SUI should trade at a cap rate below 4%, which would’ve been unfathomable 20 years ago when these same parks were being sold for 10% to 12% cap rates. Furthermore, the gap between RV parks and manufactured home communities has closed almost completely, which would have similarly seemed impossible just five years ago. Helped by COVID restrictions, the boom in RV travel in 2020 has caused both companies to raise their expectations for the business this year. ACC unveiled a new ‘strategic capital platform’ that will optimize FFO per share growth over the next five years, driven by fees and new private public partnerships with universities forced to upgrade old and obsolete campus housing.
We met with industrial REITs Prologis and Americold (NYSE: COLD). Business is nothing short of spectacular for industrial warehouses today. Prologis reported that it is essentially fully leased on properties over 100,000 sqft, showing the strength of large tenants with access to capital. The company expects the momentum to continue when a vaccine becomes available as approximately 40% of its tenant base has flat-lined due to COVID. Due to uncertainty with the economy, the inventory levels of companies are at record lows, which means that they will need to significantly increase their space when they feel confident to return first to historical inventory levels, but then to benefit from the improvements in the supply chain that are needed. Finally, rent growth should continue as rent is only 0.25% to 0.50% of the sales price of an item, and only 4.5% of the supply chain cost. COLD’s business has been steady in 2020, as the company has maintained their original guidance issued at the start of 2020. The company, a leader in consolidating the fragmented cold storage business, has also been able to execute on acquisitions, announcing a $480 million portfolio in New Jersey and a $1.7 billion expansion of its European operations. COLD typically increases the yield on properties acquired by 100-200 bps by implementing best practices and its service pricing system.
Finally, we met with diversified/specialty REITs VICI Properties (NYSE: VICI), CTO Realty Growth (NYSE: CTO), Armada Hoffler (NYSE: AHH), American Assets Trust (NYSE: AAT), and Howard Hughes Corporation (NYSE: HHC). Each of these names is unique in its geographic exposure, property type mix, tenant roster, and capital structure. However, they were all among the hardest hit at the start of COVID, dropping by an average of 54% from February 20 to March 23 (versus -44% for the MSCI US REIT Index). On a positive note, they have been the most responsive to news on a vaccine and fiscal stimulus, rising by an average of 64% from March 23 to November 30 (versus +50% for the MSCI US REIT Index). A broad economic recovery and a new real estate cycle will be the most positive news for these names. The most notable announcement came from HHC, which presented its plan for land by the South Street Seaport in New York City. HHC is asking the city to move air rights to allow for the construction of two residential towers that will cost approximately $1.4 billion.
While the conference didn’t present too many noteworthy new items, it further gave us confidence that the new real estate cycle is beginning, and that a vaccine will cure many of the sicknesses in the economy. The conference followed a similarly upbeat earnings season, capping a historic comeback for some companies between 2Q and 3Q. We look forward to presenting our 2021 Chilton REIT Outlook next month, and wish all of our readers a happy and healthy holiday season.
Matthew R. Werner, CFA
Bruce G. Garrison, CFA
RMS: 2148 (11.30.2020) vs 2402 (12.31.2019) vs 346 (3.6.2009) and 1330 (2.7.2007)
Previous editions of the Chilton Capital REIT Outlook are available at www.chiltonreit.com/category/library/reit-outlook/.
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