Motley Fool Hidden Gems Investing - What Do Higher Interest Rates Mean for REITs?

Episode Date: September 25, 2022

Stock prices don’t always reflect business performance. That’s the case for many real estate investment trusts (where some occupancies are above pre-pandemic highs) but the effects of rising interest rates may be in its early innings.  John Worth is the executive vice president for research and investor outreach at the National Association of Real Estate Investment Trusts, or Nareit. Deidre Woollard and Matt Frankel caught up with Worth to talk about: - Strong REIT business performances and sliding stock prices - The lasting effects of COVID on commercial real estate - Why private equity firms are buying up public REITs Companies mentioned: PLD, DRE Hosts: Deidre Woollard, Matt Frankel Guest: John Worth Producer: Ricky Mulvey Engineers: Dan Boyd, Brandon Gentry Learn more about your ad choices. Visit megaphone.fm/adchoices

This family is on the brink of civil war. On September 18th, Mobland, the hit original series, is back on Paramount+. We are the Hartigans! Don't know them yet? Then Google us. From the underworld of Guy Ritchie... Do you want to step up the ladder? I want Comet dead. Starring Tom Hardy, Pierce Brosnan, and Helen Mirren.

Do I have to do everything myself? You want more? I'll give you more! Mobland, new season hits September 18th on Paramount+. So one of the things we've seen is that as rates have risen, we've seen REITs really actually reduce the amount of debt they're issuing because they don't have a lot of debt coming due immediately. So they've got a lot of flexibility to deal with a higher rate environment. I'm Chris Hill, and that's John Wirth, Executive Vice President for Research and Investor Outreach for NAREIT, the National Association of Real Estate Investment Trusts.

Deidre Woollard and Matt Frankel caught up with Wirth to talk about how REITs are feeling the effects of rising interest rates, why more of them could be taken private, and which sectors are showing some promise in a challenging environment. We're long-term investors here, but we're reaching the end of another earnings season. Was there anything in this quarter that surprised you about overall REIT performance? I wouldn't necessarily say it's a surprise, but we've seen this consistent, strong operational performance where REITs are delivering earnings. So for the second quarter, REITs had total FFO, which is the REIT measure of earnings, funds from operation. And they had total FFO over $19 billion.

So that was a record high. Um, and, and, and a number of the sectors, uh, are now, are now virtually all the sectors of the REIT space. And we can talk a little bit about the diversity of property sectors within REITs later, but, but most of them are now, now have total FFO that's above their pre COVID levels. So we've really seen a very significant recovery from COVID. Um, and frankly, that operational performance, I think if there's anything that's the surprise, it's really we've seen this gap between the strong operational performance in a year like most equities. It's been a tough year for REITs. REITs are down about 12% for the year.

So there's really a divide between what we're seeing coming through the earnings statements and, again, how REITs are getting valued in the stock market today. You mentioned the COVID pandemic, and I wanted to expand on that a little bit. We've seen the stock market, as you said, has been on a downtrend lately. And kind of the short way to say what you just said is that the business results don't always match the stock price performance. That's what we're seeing in the real estate. So COVID affected real estate subsectors in a lot of different ways. I mean, demand for industrial properties is off the chart because of e-commerce. Some other ones like retail had to shut down for a while

because of COVID. What do you think are the lasting effects of the COVID pandemic on the real estate space? And what were, as opposed to the kind of temporary effects like the retail shutdowns? I think there's going to be a couple lasting effects. One, I think, I'm not sure if it's an effect, but I put it down under lessons, is really the critical role of having a well diversified portfolio of real estate. As you mentioned, we had some sectors that were really hard hit at the beginning of the pandemic as we were essentially shutting down a lot of in-person activity in the economy. So hotels and leisure, retail, healthcare was hard hit, obviously. But we had other sectors, industrial and logistics properties, which are participating in e-commerce,

data centers, cell phone towers, and interestingly, self-storage, that really were picking up some of that activity. As parts of the economy were shutting down and we were increasingly living digital lives in our homes, that was actually encouraging the use of other types of real estate. So I think one lesson is it's really important to have a broad-based portfolio of commercial real estate and one that really maps to what the economy is today, that embraces the digital aspects of our economy today. And that's one of the things where REITs have really been sort of on the front foot

and have been leaders in terms of innovating in data centers, cell phone towers, integrated logistics centers. As we look forward, I think, how are our lives gonna change permanently because of COVID? I think the most obvious is the role of the office in our lives and the impact of work from home

And as people, I think, at least for the near term, we're going to continue to see a lot of experimentation around how people use offices. And ultimately, I think it's going to be, it's an open question how that's going to impact demand or how negatively it's going to impact demand over the long term. You know, I think we're also going to see some sectors like retail that originally were really hard hit. But over the longer term, what we've really seen is more innovation into multi-channel shopping, and I think an embrace by consumers of a shop here, buy online, buy online, pick up in store, and that true integration of online and the retail shopping experience. The last piece is just, you know, I think we did see a jump ahead in terms of our digital

lives, you know, the increased use of video conferencing. You know, we've got, you know, my 80-year-old mother is doing Zoom calls all the time. I never would have predicted that three years ago. It's become part and parcel of daily life. And, you know, all of that activity actually resides in real estate. Uh, so, so I'd say those, those are some of the, the key, some of the key, key takeaways. Interesting. One of the things that I love that, that Narit puts out is that, uh, pie chart.

That's got all of the different types of REITs as they changed from, you know, 10 years ago to now, it's fascinating to see how everything's changing. I wanted to ask you about the two, the two eyes that are troubling consumers right now, right? We've got inflation and interest rates. we're seeing that impact really heavily on the residential side. What are you seeing on the commercial end of things? Well, I think that we're seeing, you know, certainly in Q2 earnings, we saw REIT earnings, you know, keep up and we saw REIT net operating income, sort of the measure of

the revenues that they're bringing in through their properties. Net operating income actually grew on a year-on-year basis faster than the rate of inflation, and even on a same store basis where we hold the number of properties constant, almost kept up with the rate of inflation. And that's really important because one of the ways that real estate has historically provided inflation protection is by having the ability to pass through increases and pass through rent increases that allow total revenue to rise, you know, as fast or faster than the rate of inflation. And so we think the evidence is pretty good that like in previous inflation cycles, REITs are going to provide good inflation protection in this cycle. We've gone back

and looked at the historic data and historically REITs, like other types of real estate, do provide some nice inflation protection, and tend to meaningfully outperform the broader stock market during periods of moderate and high inflation. And I think the operational performance suggests that we'll see the same in this cycle. And then on interest rates, higher interest rates are not going to be good for any part of the economy. And I think we've got a real risk of an economic slowdown. But in terms of how the higher interest rates are going to impact REITs directly, they're in a very good place in terms of how they've managed their balance sheets.

They're coming into this rate-tightening cycle with leverage near historic lows, with interest expense at historic lows, and with the debt they do have very well termed out on their balance sheets. So the term structure of that debt is out more than seven years now. So one of the things we've seen is that as rates have risen, we've seen REITs really actually reduce the amount of debt they're issuing because they don't have a lot of debt coming due immediately. So they've got a lot of flexibility to deal with a higher rate environment. So one thing I wanted to ask is, this is not a normal market environment right now. I don't really know when it is a normal market environment or if there is such a thing.

I don't, we always say, well, if it was off just normal environment or just the normal recession or just, just the normal bull market or, you know, um, but what subsectors are really the big performers right now. And what has really surprised you? For example, like I read some of the industrial REITs earnings reports and they're getting something like 20% releasing spreads, which is just unprecedented. The, the, the success of industrial, even though it's a natural fit for e-commerce and natural catalyst, has really surprised me. Has anything in the real estate industry really

surprised you over the past year or so? I would say one of the big surprises over the entirety of the COVID period, to me, has been the fact that if you look and you ask, what is the sector with the best stock market performance over the entirety of the COVID period, really from, you know, from early March, 2020 through today. And it's actually self-storage, right? So, so, and I think it's a, it's a, it, it shows in a way how, you know, the consumers are some, some, in some ways always a step ahead of the analysts, right? We, we understood going into COVID retail was going to suffer. Healthcare was going to sell through. This wasn't going to be good for hotels. We thought it was going to be good for the digital sectors, but the, the impact

on self-storage was really the second order effect, right? As people started spending more time in their homes, cleaning out the garage, teaching their kids in their basement, all the things we went through, they needed to use that real estate in a different way. And that required them to go use self-storage to house some of their belongings. But the persistence has been really strong. And self-storage actually had very strong FFO growth in the second quarter. So self-storage, I think, has been one of those really, really interesting stories. You know, I think some of the other surprises, I would say, was across the board. I was a little bit surprised out of the Q2 earnings, the degree to which REIT acquisitions

actually held up. In a higher rate environment, we knew transactions in commercial real estate generally were falling as buyers and sellers were really, in a way, taking time to coalesce around some new equilibrium pricing and cap rates in a higher rate environment. And we certainly saw REIT transactions volumes fall. But even with the current environment, we still saw about $18 billion in REIT transactions in the second quarter. And those transactions end up being the driver of future earnings growth. So it was good to see that hold up. Yeah. I wanted to ask you about that because we have been noticing that M&A activity. I mean, I just got the Prologis and Duke Realty Prospectus mailed to me.

So you mentioned some of the factors that are driving this, but is it going to keep happening and are we going to see more of these types of deals? Well, I think that over time we're likely to continue to see deals of the type that I think Prologis and Duke is a good example. And these are actually the majority of deals by deal volume over the last couple of years are transactions that are from REIT to REIT within the same property sector. So we've seen a number of deals where REITs are focused on getting bigger, growing their operating platform, lowering costs, slowing their cost of capital, and really getting prepared for future growth by creating more size and scope. And I do think that, I think it's one

of the most interesting trends in re-mergers and acquisitions. And my guess is it's something that over time, when it's strategically appropriate, we'll see more of this. And these are deals that are really, I think, they're not opportunistic. They're strategic deals. But I do think we've seen these across a number of sectors. And my guess is that over the coming years, we're going to see more of this because as real estate modernizes, as you're dealing with more real estate that is engaging with the modern digital economy, I think that the value of that operating platform and the ability for REITs to have world-class operating platforms that add significant value to shareholders becomes a more and more important part of the business. Scale and scope

really can help in that way. I hope you're right that we see more of that type of M&A. We've also seen a lot of REITs being taken private by private equity, a trend that I'm not personally a fan of because just to name one, American Campus Communities was recently taken private. I would have rather had seen the next 10 years of that growth story play out rather than just get a little quick bump from the premium of the buyout. What's fueling that trend? Is there just a lot of investor money sitting on the sidelines? Is it a more attractive way to invest in real estate than just buying properties? Some of these deals, they're not technically going private. They're going into the non-listed REIT space. Those are still REITs that investors

have access to. I think a lot of that activity, it is still in the public REIT space, but they're not listed on the stock exchange. One of the things about REITs that I think has helped them really outperform over the long-term and to be one of the, if not the best performing vehicle for commercial real estate has been the strong corporate governance and having shareholder control. And one side of that coin is when there's a bid out there, the leadership and the board has to respond to that. And so when a bid comes in that values a REIT significantly above where they're trading, they need to take a close look at that and do what's in the shareholder best interest. And so, you know, I think that when you see these deals and virtually all of these deals

that we've seen over the last couple of years have happened at very significant premiums to where the stock is trading, you really have to look at that and say, well, that's what we expect from good corporate governance. I always remind people that the cloud isn't in the cloud. It's it's in data centers. So many of the tech companies that we love, well, they're re-clients all over the place. If you could look into the future, think about that pie chart. Is there any sector that you think is small now that's going to be really big? That's a great question. I think that one of the sectors we've seen some growth in, it's not even an independent sector yet, they're in specialty right now, is gaming and leisure properties. So properties that are

having triple net leases with gaming companies. I think that's an area where we'll see continued growth. I think that we're going to also see the property sectors that we have continue to evolve. So if you think about industrial, which is a traditional property sector. But what we call industrial properties today, which are really, you know, logistics facilities, they're very different from the warehouses of 20 years ago. And I think we're going to see throughout our property sectors, continued innovation and change and continued uptake of a lot of interesting prop tech that is going to, you know, change the way the tenants interact with, with the property and continue to grow and evolve what we think of as, as real

estate. Really, really interesting to kind of think of the future of real estate and what's evolved just kind of by looking back when you think you mentioned industrial, I mean, today's industrial properties don't look anything like they used to, even with malls. I would, I would go so far as to say today's malls don't look anything like the malls of, you know, 20, 30 years ago. Absolutely. It's a totally different, totally different shopping experience today than, than, uh, you know, when I was a teenager in New Jersey, going to the mall, it's a totally different experience. And, and, uh, and even, even, you know, strip centers, grocery stores, uh, big box stores, the whole experience has changed through, uh, and continues to change

because of, because of multi-channel multi-channel retailing. Investors need to know that when things evolve, like the, you know, consumers demand different kinds of malls that creates opportunities for REITs to adapt to changing tastes. Absolutely. And I think when you think about a property sector like office where there's a lot of uncertainty, that uncertainty is also opportunity. When you get the model right and you get the pricing right, that creates a real opportunity and a lot of upside potential. What would you like people to know about Mayreit or REIT investing in general right now in 2022? I'll really finish where we started, which is we think, and there's a lot of empirical evidence and data that suggests

having real estate as part of a portfolio is absolutely critical. Commercial real estate represents about 15% to 20% of the investable universe in the United States. We've done a lot of portfolio optimizations that actually suggest somewhere in that range is the exposure to commercial real estate that is appropriate in an optimal portfolio. And REITs are the way that the vast majority of investors are actually getting that exposure in the U.S. So they're really worth exploring. And there's a lot of different active and passive strategies to bring them into a portfolio. As always, people on the program may have interest in the stocks they talk about, and

The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.