This is an abridged version of the full report published on Hoya Capital Income Builder Marketplace on May 17th.
Amid mounting concerns over soaring interest rates, stagflation, and even outright recession, it's helpful to review high-level REIT fundamentals to chart the likely path forward for the real estate industry. At the height of the COVID-related market uncertainty in March 2020, we published This Time Is Different which pushed back on the linkages to the Great Financial Crisis ("GFC") and calls for deep and lasting pain across the real estate industry. Indeed, despite the nearly 45% drawdown during that volatile month, the Vanguard Real Estate ETF (VNQ) was able to fully recover to pre-pandemic levels on a total return basis less than a year later. By comparison, equity REITs took nearly eight years to recover to prior highs after the GFC.
A timely discussion once again, we highlighted the fact that owing to the harsh lessons learned during the financial crisis, most REITs have been exceedingly conservative with their balance sheet and strategic decisions over the past decade. In doing so, REITs ceded some ground to private market players and non-traded REIT platforms that were willing to take on more leverage and finance operations with short-term debt. Amid the more challenging capital raising environment, we believe that the pendulum has quickly swung in favor of REITs over private players and that the "true" competitive advantage of REITs is revealed in times of mild distress. Perhaps most critically, publicly-traded REITs have far more ample access to longer-term, unsecured debt that has allowed REITs to push their average debt maturities to over 7 years - avoiding the need to refinance during unfavorable market conditions.
With the scars of the Great Financial Crisis still visible enough to be reminders of more dismal times, REITs have been "preparing for winter" for the last decade, perhaps to the frustration of some investors that turned to higher-leveraged and riskier alternatives in recent years. REITs entered 2022 with historically strong balance sheets across essentially every metric. Even when incorporating the recent 15% drawdown in 2022, debt as a percent of Enterprise Value still accounts for less than 30% of the REITs' capital stack, down from an average of roughly 45% in the pre-recession period - and substantially below the 60-80% Loan-to-Value ratios that are typical in the private commercial real estate space. Meanwhile, EBITDA coverage ratios have continued to rebound to fresh record-highs after the pandemic-driven dip.
REITs have taken full advantage of lower interest rates in prior years to lower their average long-term interest rate to around 3.50% - the lowest level on record. Much like the cost of essentially all other goods and services in 2022, however, the incremental cost of capital has no doubt become far more expensive this year. The BofA BBB US Corporate Index Effective Yield - a proxy for the incremental cost of real estate debt capital - has surged from as low as 2.20% last September to 4.68% this week while financing rates across most other maturities have seen a similar 150-250bps jump in rates. Unlike many private market players with limited access to long-term debt capital, the long-term nature of REIT debt will allow most REITs to recognize very modest increases in interest expenses in the near- and medium-term.
The ability to avoid "forced" capital raising events has been the cornerstone of REIT balance sheet management since the GFC - a time in which many REITs were forced to raise equity through secondary offerings at "firesale" valuations just to keep the lights on, resulting in substantial shareholder dilution which ultimately led to a "lost decade" for REITs. As we'll discuss throughout this report, while REITs enter this period on very solid footing and deeper access to capital, the same can't necessarily be said about many private market players that rely on more short-term borrowing and continuous equity inflows to keep the wheels spinning. Much the opposite of their role during the GFC, we believe that many well-capitalized REITs are equipped to "play offense" and take advantage of compelling acquisition opportunities if we do indeed see some degree of distress in private markets from higher rates.
REIT company-level metrics have exhibited a substantial rebound over the last six quarters as REIT FFO ("Funds From Operations") has now fully recovered the sharp declines from early in the pandemic. In the first quarter, REIT FFO was nearly 10% above its 4Q19 pre-pandemic level on an absolute basis, and 3% above pre-pandemic levels on a per-share basis. Driven by a 8.41% rise in same-store Net Operating Income ("NOI") - the strongest quarter of property-level growth on record. Meanwhile, FFO/share rose 30.3% year-over-year from 1Q21 as REITs in the more COVID-sensitive property sectors saw an added boost from the collection of unpaid rents from the prior year.
Powered by more than 130 REIT dividend hikes in 2021 and nearly 70 so far in 2022, dividends per share rose by 19.9% from last year, but total dividend payouts remain roughly 16% below pre-pandemic levels as many REITs have been exceedingly conservative in their dividend distribution policy. With FFO growth significantly outpacing dividend growth, REIT dividend payout ratios declined to just 68.8% in Q1 - well below the 20-year average of 80%. With a historically low dividend payout ratio, we believe that REITs are well-equipped to deliver another year of robust dividend growth that may meet or exceed the record year in 2021 - even despite the challenging macro environment.
During the worst of the pandemic in 2020, REITs reported a decline in property-level metrics that dwarfed that of the prior crisis, driven by a sharp plunge from retail REITs resulting from difficulty in collecting rents. Driven by the normalization in rent collection across the hardest-hit sectors, same-store NOI jumped 4.1% in full-year 2021 following declines of 4.6% the prior year. The residential, industrial, and technology sectors have been the upside standouts throughout the pandemic with most REITs reporting NOI levels that were 5-20% above pre-pandemic levels. On the other hand, most shopping centers, office, and mall REITs - with some exceptions - ended 2021 with NOI levels that were still 10-25% below pre-pandemic levels.
After recording the largest year-over-year decline on record in 2020 which dragged the sector-wide occupancy rate to 89.8%, REIT occupancy rates have rebounded since mid-2020 back to 92.7%. By comparison, occupancy levels dipped as low as 88% during the Financial Crisis and took three years to recover back above 90%. Apartment and industrial REITs reported record-high occupancy rates in Q1 while retail REITs noted a solid sequential improvement. Office REIT occupancy, however, has seen substantial declines since the start of 2020 and remained 390 basis points below pre-pandemic levels at 89.6%.
As discussed in our REIT Earnings Recap & Ratings Updates, first quarter earnings results were generally better-than-expected with roughly 85% of equity REITs beating consensus FFO estimates while nearly 70% of the REITs that provide forward guidance raised their full-year outlook, reflecting a high degree of confidence among REIT executives that the growth momentum will be sustained beyond the initial post-pandemic recovery and amid the rising rate environment.. Consistent with a theme of recent quarters, results from residential and shopping center REITs were most impressive, followed closely behind by industrial and storage REITs. Mortgage REITs have also been a bright spot amid the carnage over the past several weeks.
While the sell-off in early 2022 has pulled REITs back into "cheap" territory as the "Rates Up, REITs Down" paradigm has weighed on valuations, much of the sector traded at premium valuations throughout 2021 which revived the "animal spirits" and facilitated external growth opportunities that were relatively few-and-far-between over the last half-decade. Equity REITs currently trade at an average Price/FFO multiple of 19.4x using a market-cap weighted average. The market-cap-weighted average, however, is somewhat distorted by the massive weight of richly-valued technology REITs, and on an equal-weight basis, REITs trade at a 16.4x P/FFO multiple, which is once again approaching the "cheap" range based on post-GFC valuations.
Private market real estate valuations didn't exhibit the upside nor downside volatility of the public markets throughout the pandemic but have mirrored the overall trends seen in the REIT sector. Green Street Advisors' data shows that private-market values of commercial real estate properties declined by roughly 15% at the lows last year, but are now 18% above their pre-pandemic levels. Valuations have been flat over the past quarter, however, as the impact of rising rates is beginning to show up in real estate pricing. We estimate that office, hotels, and malls have seen a 20-25% decline in private market values due to the pandemic. Residential, industrial, shopping center, and technology real estate prices are higher by 5-25% during this time.
Favorable valuations in 2021 sparked a wave of external growth through M&A, IPOs, development, and property acquisitions. We've seen REITs "pump the breaks" in early 2022, but opportunities should emerge as over-levered private players seek an exit. REIT external growth comes in two forms - buying and building. Acquisitions have historically been a key component of FFO/share growth, accounting for more than half of the REIT sector's FFO growth over the past three decades with the balance coming from "organic" same-store growth and through development. REITs had again become active buyers in 2021, propelled by favorable valuations and ample access to capital markets, acquiring $133B in assets over the past year - the highest on record. Likely reflecting some impact from higher rates, buying activity cooled to just $18.9B in Q1 which was the lowest since Q2 2020.
The "animal spirits" - which were very much alive in the REIT world last year - are also likely to calm over the coming quarters following the spur of activity in early 2022. Blackstone (BX) took its buying spree into another gear with three more major REIT acquisitions in early 2022 - student housing REIT American Campus (ACC), PS Business Parks (PSB), and Preferred Apartment (APTS), which followed a pair of deals last year for Bluerock Residential (BRG), and QTS Realty (QTS). We've seen M&A in the healthcare space as well as potential new bidders who emerged for medical office REIT Healthcare Realty (HR), which had agreed to merge with Healthcare Trust of America (HTA) back in March, and in the data center sector as DigitalBridge (DBRG) beat-out private equity competition to buy data center operator Switch (SWCH) - which had planned to convert to a REIT next year.
REITs have also become some of the most active builders in the country over the past decade and expanded the pipeline in Q1 back to levels essentially in-line with the prior record set just before the pandemic in 4Q19 at $48.5B. Self-storage REITs have seen their pipelines swell the most significantly - up more than 68% from last year while industrial and healthcare REITs have also been very active. New development in retail has started to rebounded modestly after very limited activity in the past half-decade while residential has also seen relatively limited supply growth despite the boom in home prices and rents over the past two years.
REIT IPOs had been relatively few-and-far-between over the past half-decade, but we did a notable uptick in 2021 with seven public listings, the most since 2013 and we've seen one more REIT IPO this year with net lease REIT Modiv (MDV) listing on the NYSE. Another two REITs have recently filed for public offerings including self-storage operator SmartStop Self-Storage which filed in late April to raise up to $100 million in an initial public offering under the ticker symbol SMST. SmartStop is an internally-managed REIT that is the eleventh largest owner and operator of self-storage properties in the United States. In March, Strawberry Fields filed for a $15M direct listing on the Nasdaq under ticker symbol STRW. Strawberry Fields is a healthcare REIT with a portfolio of 79 properties located primarily in the U.S. Southeast.
Reflecting the more challenging capital raising environment, however, four recent REIT IPO filings have been either postponed or canceled including the listing for office owner Priam Properties, net lease REIT Four Springs Capital, and cannabis-focused Freehold Properties. As discussed above, access to capital - or lack thereof - was the accelerant that turned a bad situation into a dire one for REITs during the Financial Crisis. REITs entered this period of volatility with a "war chest" relative to their position in 2008 as REITs raised more capital from 2019-2021 than in any prior three-year period on record with most REITs able to lock in low-interest rates on long-term debt while still maintaining a relatively "equity-rich" capital stack.
That said - not all REITs are created equal, and the broad-based sector average does mask some of the ongoing issues in several of the more at-risk sectors and among REITs that have been more aggressive in their balance sheet management. While all REIT sectors are now out of the Debt Ratio "danger-zone" above 50%, a pair of REIT sectors - hotel and office REITs - still operate with debt ratios above 40% while roughly two dozen REITs - primarily in the retail and hotel sector - operate with debt levels above 50%. On the flip side, many of the "essential" property sectors - housing, industrial, and technology - continue to operate with debt ratios below 20%.
Owing to the harsh lessons from the Great Financial Crisis, most REITs have been exceedingly conservative with their balance sheet and strategic decisions. Amid the more challenging capital raising environment, the pendulum has quickly swung in favor of REITs over private players. We've seen REITs "pump the breaks" on external growth in early 2022, but opportunities will emerge as over-levered private players seek an exit. REITs enter this period of economic uncertainty on solid footing and balance sheets as strong as they've been. Meanwhile, the "REIT Recovery" from the pandemic is now complete as FFO levels are back to pre-pandemic levels. With dividend payout ratios still near record-lows, REITs should be able to offset some of the impact of higher inflation through increased dividend distributions.
For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Apartments, Homebuilders, Manufactured Housing, Student Housing, Single-Family Rentals, Cell Towers, Casinos, Industrial, Data Center, Malls, Healthcare, Net Lease, Shopping Centers, Hotels, Billboards, Office, Farmland, Storage, Timber, Mortgage, and Cannabis.
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Disclosure: I/we have a beneficial long position in the shares of RIET, HOMZ, STOR, NLY, AGNC, SRC, BXMT, UBA, GTY, MGP, ACC, NNN, STWD, HIW, CCI, SPG, SBRA, DOC, ILPT, SUI, INVH, AMT, REG, DRE, CUBE, IIPR, ARE, FR, CPT, EQIX, APLE, MAA, PCH, PLD, DLR, LAMR, MDC, KRG, CTT, CVX, DHI, EOG, FCX, FPI, JOE, KMI, LAND, LEN, NEM, O, PSA, RYN, SAFE, WY either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Hoya Capital Real Estate ("Hoya Capital") is a research-focused Registered Investment Advisor headquartered in Rowayton, Connecticut. Founded with a mission to make real estate more accessible to all investors, Hoya Capital specializes in managing institutional and individual portfolios of publicly traded real estate securities, focused on delivering sustainable income, diversification, and attractive total returns.
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Data quoted represents past performance, which is no guarantee of future results. It is not possible to invest directly in an index. Index performance cited in this commentary does not reflect the performance of any fund or other account managed or serviced by Hoya Capital Real Estate. Investing involves risk. Loss of principal is possible. Investments in companies involved in the real estate and housing industries involve unique risks, as do investments in ETFs, mutual funds, and other securities.
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