- Earnings season concluded last week in the real estate sector. Overall, 4Q17 results were slightly better than expected (80% beat or met estimates), but REITs raised caution heading into 2018.
- As supply growth has intensified, fundamentals continue to moderate across the real estate sector as rental markets approach supply/demand equilibrium after nearly a decade of above-trend rent growth.
- Same-store NOI grew 2.6% in 2017, the slowest rate of growth since 2011. Occupancy levels remain near record highs, however, as real estate demand growth continues to be robust.
- Justified or not, REITs continue to be pressured by rising interest rates. Private real estate values remain firm, which has created a wide NAV discount, making external growth more difficult.
- REIT balance sheets have never been healthier and better prepared to deal with rising rates. We analyze newly released data from NAREIT’s 4Q17 T-Tracker.
Real Estate Earnings Review
Amid the interest rate-driven volatility in the real estate markets, it's easy to lose sight of the underlying real estate fundamentals, which remain healthier than the 15%+ recent decline in REIT valuations would otherwise suggest. In this report, we look past recent price movements and analyze the recently released NAREIT T-Tracker data to review 4Q17 earnings from a purely fundamentals perspective.
The post-recession period was particularly favorable for real estate owners. Until recent years, demand growth significantly outpaced supply growth, as development activity was stymied by tight credit conditions, limited risk appetite, rising construction costs, and burdensome financial and zoning regulations. This disequilibrium resulted in tight rental markets, allowing REITs to realize robust rent growth - more than double the rate of inflation - for most of this decade.
A Battle Between Supply And Demand
Spurred by development yields that were too attractive to pass up, construction activity has picked up considerably since 2015, and supply growth has approached nearly 2% of existing inventory across most major sectors. As supply growth has intensified, fundamentals have moderated across the real estate sector as rental markets approach supply/demand equilibrium after nearly a decade of above-trend rent growth. Same-store NOI grew 2.6% in 2017, the slowest rate of growth since 2011.
Demand, however, is certainly not the issue. Occupancy rates remain near record highs and have shown no sign of retreating. At 93.8%, average REIT occupancy reached a new record in 4Q17, led by new all-time highs in the industrial and apartment sectors. Despite the gloom-and-doom narrative surrounding the retail sector, retail REITs remain nearly 96% occupied.
Perhaps the best indication of the robust supply growth (and continued supply overhang) in the real estate sectors comes from the REITs themselves. The REIT development pipeline has exploded in size since bottoming in 2011 at roughly $10 billion. We estimate that REITs have delivered more than $100 billion in new product since the start of 2015. In 4Q17, nearly $45 billion in construction remains in the pipeline, roughly even with 2016 levels. On earnings calls this quarter, many REIT executives expect supply growth to tail off by 2019 as development yields become less attractive.
Acquisitions Cool As Equity Valuations Remain Impaired
Combined with the effects of moderating fundamentals, rising interest rates have impaired REIT valuations since peaking in July 2016 as the 10-year yield dipped below 1.40%. The REIT ETFs (VNQ and IYR) are lower by roughly 20%, as the 10-year yield has climbed nearly 150 bps.
Equity valuations play an important role in the underlying operating fundamentals of the REIT business. The sharp sell-off across the REIT sector has forced many external growth-oriented REITs to reconsider the acquisition plans for 2018. Private market real estate valuations have remained firm in recent quarters, creating a dislocation between public and private markets. Based on our estimates, the sector now trades at a 10% NAV discount, down from a 5-10% NAV premium from 2014 through 2015. Mirroring the NAV discount, Price/FFO multiples are also at the lowest level since 2011.
As a result of lower equity valuations, many REITs are having more difficulty funding acquisitions with the same accretive spreads as in the past. REITs acquired just $8.1 billion in assets over the last year, down from $64 billion in the four months ending 3Q15.
Only the storage, hotel, and healthcare sectors were net acquirers in 4Q17, while retail, industrial, and office REITs sold a combined $1 billion in assets in the most recent quarter.
The effects of diminished external growth, combined with moderating organic growth and several significant one-off dilutive events, have caused FFO/share growth to dip into negative territory for the first time since late 2010. For 2018, REITs are projected to realize low- to mid-single digit FFO and AFFO growth rates. Combined with a dividend yield of 4%, investors should reasonably expect a 6-8% total return assuming constant valuations.
REIT Balance Sheets Remain Strong
The good news is that REIT balance sheets have never been healthier and better prepared to deal with rising rates or a sustained slowdown in fundamentals. Debt accounts for less than 35% of the REIT's capital stack, down from an average of roughly 45% in the pre-recession period.
As a percent of NOI, interest accounts for less than 25%, near the lowest level on record. As more REITs have obtained investment-grade bond ratings, they have been able to issue longer-term unsecured debt, pushing the average term to maturity on debt to more than 6 years.
More than 100 REITs reported earnings over the past six weeks. While 2017 finished fairly strong for REITs, as indicated by the 80% of REITs that either meet or beat expectations, 2018 is widely expected to be a slightly tougher year. Nearly 50% of REITs provided guidance below analyst expectations, while 20% provided 2018 guidance above expectations.
Same-store NOI growth remains strongest in the single-family rental, manufactured housing, industrial, and storage sectors. Retail REITs are seeing the slowest rate of SS NOI growth.
We analyze the recent quarter for each sector in our REIT Rankings series. So far, we have updated up REIT Rankings on the Apartment, Mall, Single-Family Rental, Manufactured Housing, Net Lease, Data Center, Storage, and Student Housing sectors. We will continue our updates over the coming weeks.
Please add your comments if you have additional insight or opinions. We encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the real estate and income sectors.
This article was written by
Real Estate • High Yield • Dividend Growth
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