REIT magazine recently spoke with five portfolio managers to discover their strategies for navigating 2023 and the opportunities and challenges they see ahead.
After REITs strong operating performance in 2022, fueled by post-pandemic reopening tailwinds, the pace of growth is expected to slow in 2023. While macro conditions are expected to remain challenging, including the possibility of a recession, fundamentals are still expected to remain sound for the REIT industry.
REIT magazine recently spoke with five portfolio managers to discover their strategies for navigating 2023 and the opportunities and challenges they see ahead.
This year has seen volatility across the markets. How do you see macro fundamentals shaping up for REITs in 2023?
Arthur Hurley: The REIT market continues to experience share price volatility from higher interest rates, higher inflation, and recession fears. Inflation continues to remain a big concern and the focus for investors remains on whether the Federal Reserve can navigate a soft landing.
If the Fed is successful, REITs should be able to continue generating attractive earnings growth on a relative basis. In this scenario, real estate would benefit from a steady demand for space with new supply growth limited by the recent increased cost of materials and labor. While the level of uncertainty and volatility remains very high in the investment marketplace, we believe there is still strong rental pricing power in many property types and that the fundamentals of the space have held up well.
As we continue to monitor inflation along with the likelihood of additional rate increases, the threat of a potential recession also remains a key theme as we look ahead to 2023. If the U.S. economy slows significantly, we still believe the property types best positioned will be the ones benefiting from secular tailwinds that will support attractive relative earnings growth. Meanwhile, management teams need to be able to operate in an environment of higher inflation and higher rates. This entails a heavy focus on cost controls and balance sheet management.
Brian Jones: For 2023, we expect the interplay between persistent inflation, slowing economic growth, and a likely hawkish stance by the Fed to remain a key consideration for real estate investors.
We view economic trends as broadly solid in the U.S. heading into 2023. Employment trends are holding up, nominal income growth is solid, and consumer and corporate balance sheets are well positioned. While this is constructive for growth and real estate operating fundamentals in 2023, it does suggest the Fed has more work to do to moderate inflation trends.
As for the possibility of a recession in 2023, one fueled by lower demand, corporate cuts, and increased unemployment could lead to lower tenant demand for space. REITs are better prepared this time around with stronger balance sheets, lower new construction activity, and diverse demand drivers that lean more defensive.
Lisa Kaufman: All eyes are on the Fed and global central banks as they try to tame inflation. The key question is no longer “if” but “how much” these actions will weaken the economy. We anticipate a recession in the U.S. sometime next year. On the positive side, we expect the Fed to be successful and scenarios of inflation spiraling ever higher are unlikely in our view.
Financial conditions have already tightened dramatically in 2022 and that has caused the downdraft we have experienced year-to-date in the REIT market. We believe the current higher rate environment will endure for the foreseeable future. That said, our outlook for REIT returns in 2023 remains constructive because of the material move in real rates and the re-pricing that has already occurred in the REIT market this year.
Rick Romano: The macro environment may remain challenging in 2023, creating continued volatility for REITs. However, 2023 should eventually bring answers to some threshold macro questions weighing on investors’ minds—what level base interest rates settle at, whether we have a soft landing, recession, or stagflation, and the outlook for inflation’s new normal.
Without those answers, investors are assigning a high risk premium. As we get those answers in 2023, we expect risk assets (including REITs) to rally as some level of certainty returns to the capital markets and the macro environment.
Jason Yablon: Our base case is that we are entering what can be deemed an average recession—shallow and moderate in length—and that inflation may have already peaked at very high levels. While growth is slowing and the odds of a recession have increased, the job market remains healthy, but we do expect it to weaken. Consumers are generally in good shape, although their savings cushion is diminishing.
We believe fundamentals generally remain sound, but slower growth and higher inflation cloud the outlook for real estate, particularly for sectors lacking pricing power. Volatility is likely to remain elevated as markets discern whether we’re in for a hard or soft landing. One big question is how high financing will go and what that means for returns and real estate asset values.
What trends are you seeing in public versus private real estate investing?
Jones: Broadly speaking, real estate transaction volumes have slowed as buyers and sellers digest the implications of higher interest rates and a potentially slowing economic environment. Both public and private real estate owners seem to be allocating incremental capital to many of the non-traditional real estate sectors including data centers, cell towers, self-storage, and single family rentals.
REITs have typically utilized less debt and more fixed rate debt, which may put them in a better position to continue deploying capital.
Romano: We are seeing a nearly unprecedented historical disconnect between public and private real estate. Public markets are discounting and maybe over-reacting to what is going on with Fed tightening, inflation, and the tight debt markets for real estate. We would expect convergence in pricing over the next 12 months, with REITs rallying and private real estate taking some mark downs. Right now there is very little transaction activity on the private side so there is little pricing transparency.
Hurley: Visibility regarding valuations in the private real estate markets has become challenging. Transactions have slowed and there is now a definitive spread between buyer and seller price expectations. Sellers still want yesterday’s pricing and buyers are hesitant to commit to a price with so much uncertainty and with borrowing costs above initial yields in many cases.
In the more liquid public markets, price reactions move much more quickly. Investors in the public markets are attempting to price in the negative effects of rising rates and the potential of a recession. As a result, we’ve seen implied cap rates move up significantly and earnings multiples move down to levels not seen in many years.
Yablon: Across both listed and private real estate, values are being repriced as investors come to grips with a new cost of capital in the form of rising rates and the prospect of economic retrenchment.
While listed real estate is down, it will take time for this price discovery to be fully reflected in private real estate markets. Against the backdrop of our base case of an average recession, we expect private real estate values to sell off as much as 15%.
Differences in the real-time pricing of listed REITs and private real estate can create significant short-term dislocations. By understanding the leading and lagging behaviors of private and listed markets, investors may be able to tactically allocate at different times across the two asset classes.
Kaufman: Historically, significant discounts to NAV, like those on offer today, have been a strong signal for REIT outperformance relative to not only private real estate but to broader equities. Although uncertainty abounds, one thing is very clear-any investor allocating new capital to real estate today should look to the public market first before considering the private market. Investors who aren’t playing in both public and private real estate are missing a real opportunity to enhance not only their opportunity set but their risk-adjusted returns.
Which property sectors are you most optimistic about heading into 2023?
Romano: We are focusing on property types that have defensive, needs-based demand characteristics, are generating revenue growth above inflation, that have limited inflation exposure on the expense side, and that trade at large discounts to NAV. Some areas that fit this box would be apartments and specialty living property types.
We see opportunities in healthcare REITs, in particular those focused on senior housing. We’re still seeing tailwinds to demand from the re-opening plus demographic trends and defensive demand characteristics that should create robust relative revenue growth in 2023.
Kaufman: We continue to like the set-up for the residential sectors, especially single family homes. We expect sector-leading growth from single family homes over the next several years as the upward pressure on rents from inflation meets the secular tailwinds from under-supply of affordable housing and an increasing population of renters maturing out of urban multi-family units.
Jones: Self-storage has benefited from households decluttering to arrange viable work from home environments. While this demand driver may have peaked, it has introduced an incremental long term customer that should support higher occupancies and positive rental rate trends.
The single family rental sector is positioned to capture demand from the millennial generation that’s beginning to form families. With home prices near recent highs and rising interest rates affecting affordability, the relative attractiveness of the single family rental offering has become more compelling for consumers. Within net lease sector we believe the durability of long term leases is attractive in an environment of economic uncertainty. Additionally, higher rates may lead to less acquisition competition from some of the more highly levered private investors.
Yablon: Sectors with pricing power will fare best in the current macro environment. We see growth potential in: self-storage; senior housing; single family rental; data centers; healthcare; alternative housing; and industrial.
Sectors with shorter lease durations can reset rents promptly as conditions change. Sectors such as cold storage or senior housing may also benefit from moderating labor strength, while cold storage could benefit from improved supply chains, and senior housing is seeing occupancies improving following early-pandemic declines. We see the residential sector benefiting from insufficient supply and home affordability issues.
Hurley: We still prefer companies benefiting from secular tailwinds. Industrial, self-storage, and assisted living facilities are still benefitting from secular growth drivers and limited threats from new supply. Residential rental properties continue to see strong demand and rising rents as demographics, migration trends, and strong employment levels still support this growth. Both multifamily and single family for-rent operators have recently reported occupancies that remain near record highs and releasing spreads in the low double digits.
Conversely, which property sectors give you pause?
Yablon: While we believe secular headwinds remain for retail, certain retail landlords with high-quality properties and strong balance sheets stand to gain market share over time. However, we are mindful of the impact of elevated inflation on the U.S. consumer and how this affects their buying habits.
We remain cautious toward offices as businesses reassess their future needs and estimate that rents will decline. We feel more confidently about offices in the Sunbelt region that saw the most impact from the great migration during Covid.
Jones: We remained concerned that some of the secular changes to how businesses and their employees interact initiated during the pandemic may have long lasting impacts. Hybrid work environments may limit demand amongst office tenants. On the hotel side, while leisure travel has recovered above pre-pandemic levels, business travel trends have not and the potential for a Zoom call to displace the marginal business trip may have lasting impacts.
Kaufman: Fundamentally, we are bearish on office given the ongoing impact on demand from the hybrid work environment and the seemingly never-ending capex burden on landlords to meet evolving corporate preferences and regulatory requirements for sustainability from municipalities. The market seems to have generally caught up to this narrative, leading to valuations that range from fair to slightly expensive.
On the other side of the coin is a sector we love fundamentally—cell towers—but where we find valuations too demanding.
What sort of landscape for REIT mergers, acquisitions, and dispositions should we expect?
Hurley: With access to capital more challenging and deal financing more difficult, it’s no surprise M&A deal volume has recently slowed. Pricing has become more attractive in the public markets relative to private. And private equity firms are still sitting on record levels of cash to invest. For those reasons, we expect private equity investors to be sharpening their pencils and in turn, more go-private transactions to be announced. Additionally, the recent sell-off could motivate smaller REITs with weaker balance sheets to look at combining with higher quality companies in the same sub-sectors.
Yablon: Rising borrowing costs have narrowed the pool of asset buyers, therefore, dealmaking may slow though institutional demand for real estate in a higher-inflationary environment should remain competitive.
Listed real estate has led private real estate in reflecting valuations of a more challenging economic environment. Private equity capital earmarked for real estate has reached over $300 billion globally. To the extent that listed valuations appear more compelling than private, we may expect private equity to target listed-company assets, in part or in whole.
Private real estate portfolios seeking to diversify away from core property types may see the listed real estate markets as an effective means to do that.
Romano: We expect a robust landscape for REIT M&A if private and public real estate pricing remains widely disconnected. We have seen a number of deals in 2022; however, given where the debt markets are today and availability of debt capital, we would expect any near term deals to be focused on public to public consolidation or privatizations from well-capitalized private equity firms.
The strength and appreciation of the U.S. dollar versus every other global currency has created a tremendous cross border consolidation and acquisition opportunity for well capitalized public and private U.S. dollar denominated real estate companies.
Kaufman: Today’s higher cost of capital, lack of price discovery for private real estate and growing macro-uncertainty has slowed transaction activity for private equity and REITs alike in 2022.
REITs have repriced while private real estate has not. As private real estate rerates lower, we could see activity accelerate again from both sides of the spectrum. A lot of private capital has been raised and is on the sidelines. Eventually this capital will be put to work.
If history is a guide, REIT prices may begin to rebound even as private real estate values correct, allowing REITs to have a cost of capital advantage and perhaps a better opportunity for external growth than we have seen in the recent past.
Jones: So far, 2022 has been an active M&A environment, with a number of REIT to REIT transactions as well as privatizations. The volatility of REIT share prices presents an opportunity for more transactions as more REITs’ share prices move to discounts to their intrinsic value.
On the flip side, higher interest rates do increase the hurdle rates for levered REIT M&A transactions. The acquisition opportunity for REITs is interesting, asset pricing has softened and bidding tents are smaller for many sectors, which should enable REITs to maintain this avenue of external growth. However, the cost of equity and debt capital has risen for REITs, suggesting higher required return hurdles for most external growth opportunities.
Do you see the focus on ESG issues shifting as you look ahead?
Romano: We would expect ESG to continue to accelerate as an area of focus for most investors; however, there is also a group of investors that believes it should be out of the scope of their investment guidelines. It will be up to investment managers to work closely with their clients to ensure that investment guidelines capture their clients’ needs when it comes to ESG considerations.
Hurley: ESG will continue to grow in importance in real estate investing. As more clients look to reduce their carbon footprints, the demand for structures with LEED certification will grow. We believe responsible investing is a key to generating long term shareholder value in real estate, especially since REITs are the landlords as well as the employers in the communities where they own properties.
REIT management teams will be expected to use quantitative measures for targeting environmental impact goals and setting specific dates for reaching these goals. Some teams have already started to do this, and we expect that many more will follow. From a social aspect, identifying actionable goals and executing on initiatives will be key to remaining competitive. While REITs have historically scored relatively well as a group on governance measures, the level of scrutiny here continues to be elevated and they will need to remain diligent.
Jones: Focus and engagement seems most pronounced around climate change and CO2 emissions reduction targets. Carbon neutrality and net zero target dates are certainly areas of focus amongst investors and REIT management teams.
The office sector is probably furthest along relative to tenants considering the environmental profile of their space and expressing a clear preference for green buildings. REITs have made significant progress around diversity on their boards and are beginning to make progress around the composition of senior management.
Yablon: While we will continue to place importance on governance issues, climate change and human capital management will likely receive heightened attention.
Carbon transition and physical climate impacts will be key facets of climate change risks and opportunities, with topics such as embodied carbon, Scope 3, net zero, and physical risk exposure and resilience likely to be growing areas of focus. Topics related to human capital management such as tenant satisfaction, employee engagement, and diversity and inclusion, will likely receive continued attention.
Investors will place an emphasis on consistent and comparable reporting, outcomes, and consideration of financial implications as they meet increasing client, regulatory, and other stakeholder demands.
Kaufman: Encouragingly, the level and quality of REIT disclosure on environmental policies, procedures, and performance has improved markedly over the last few years, making it easier for managers to evaluate and engage with management teams on the topic. Good ESG disclosure has now become tables stakes across the asset class.
Going forward, environmental initiatives will be increasingly mandated and measured by local and federal governments and demands on time and capital expenditure budgets will grow. REITs are leaders in this arena and are relatively well positioned to face and fund the challenge.