Motley Fool Money - 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

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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 Worth, Executive Vice President for Research and Investor Outreach for Nehreet, the National Association of Real Estate Investment Trusts. Deidre Woolard and Matt Frankel caught up with Worth 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 think, 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. And a number of the sectors are now, are now virtually all the sectors of the REIT space. And we could talk a little bit about the diversity

of property sectors within REITs later. But most of them now have total FFO that's above their pre-COVID levels. So we've really seen a very significant recovery from COVID. And frankly, that operational performance, I think if there's anything that's the surprise, it's that really we've seen this gap between this strong operational performance. In a year, like most equities, it's been a tough year for 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 kind of expand on that a little bit. We've seen, you know, the stock market, as you said, has kind of 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 sub-sectors in a lot of different ways. I mean, industrial 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? So, you know, 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, as you know, mentioned, we had some sectors that were really hard hit in the beginning of the, 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, health care was hard hit, obviously. But we had other sectors,

you know, industrial 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, you know, 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, you know, I think how are our lives going to 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. 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, right, into multi-channel shopping. And I think an embrace by consumers of a, you know, shop here, buy online, buy online, pick up in store, and that true integration of online and retail, 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. So I'd say those are some of the key, some of the key key takeaways. Interesting. One of the things that I love that Naurit puts out is that 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. We always say, well, if it's just a normal environment or just a normal recession, or just a normal bull market, but what sub-sectors are really the big performers right now? And what has really surprised you? For example, I read some of the industrial REITs earnings reports, and they're getting something like 20% releasing spreads, which is just unprecedented.

The success of industrial, even though it's a natural fit for e-commerce, a natural kind of catalyst, has really surprised me. So has anything in the real estate industry really surprised you over the past year or so? Well, I would say, you know, 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. And I think it shows in a way how the consumers are in some ways always a step ahead of the analysts, right? We understood going into COVID.

Retail was going to suffer. Health care was going to sell through this. This wasn't going to be good for hotels. We thought it was going to be good for the digital sectors. But 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 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 re-transactions volumes fall, but even with even with the current environment, we still saw about $18 billion in REAP transactions in the second

quarter. And those, you know, 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, we have been noticing that M&A activity. I mean, I just got the prologis and Duke Realty prospectus mail to me. What did, 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, you know, 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 reed to reet within the same property sector. So, you know, we've seen a number of 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 REIT 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, These are deals that are really, I think, you know, they're not opportunistic. They're strategic deals.

But I do think, you know, 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. And so 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. and I would have rather had seen the next 10 years of that growth story play out rather than just get a little, you know, 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? You know, I think that and, you know, some of these deals, they're not technically going private,

they're going into the non-listed reet space. So those are still reits that investors have access to. So, you know, I think a lot of that activity, it is still in the public reed space, but they're not listed on the stock exchange. And one of the things about REITs that I think has helped them really outperform over the long-term out. 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, you know, 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 governor. I always remind people that the cloud isn't in the cloud. It's in data centers. So many of the tech companies that we love, well, they're recliants, you know, all over the place. If you could look into the future thinking about that pie chart, is there any sector that you think is small now that's going to be really big?

You know, that's a great question. I think that, you know, 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, change the way the tenants interact with the property and continue to grow and evolve. what we think of 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 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, you know, when I was a teenager in New Jersey going to the mall. It's a totally different experience. And even, you know, strip centers, grocery stores, big box stores, the whole experience has changed and continues to change because of multi-channel retailing.

Investors need to know that when things evolve, like consumers demand different kinds of malls, that creates opportunities for REITs to adapt to changing tastes. Absolutely. And I think, you know, when you think about a property sector like office where, you know, where there's a lot of uncertainty, you know, that uncertainty is also opportunity, right? So for if 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 want to know about Mayreed or re-investing in general right now in 2022? too. You know, I'll really finish where we started, which is, you know, we think, and there's a lot of, there's a lot of empirical evidence and data that suggests, you know, having real estate as part of a portfolio is absolutely critical. You know, commercial real estate represents about 15 to 20

percent 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 yourself stocks based solely on what you can. here. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.