The REIT idea
According to The European Real Estate Association (“EPRA”), listed real estate prices in Europe decreased by 78% from their maximum to their minimum during the global financial crisis. The extent of these significant price fluctuations are a major concern for investors, as they have a disproportionate impact on volatility and downside risk which are important considerations when constructing a portfolio. Speed is sine qua non in the listed space. Michael Lewis’s expose of the High Frequency Trading (“HFT”) cadre in “Flash Boys: A Wall Street Revolt” demonstrates how speed – a transatlantic cable gives a 5.2 millisecond advantage to those looking to profit from the spread trade between New York and London – and automation, have cooperated so that the stock market is being rigged in favour of front-running traders, and that “mom and pop investors” are being screwed for having slower connections. Virtu Financial, one of the largest high-frequency trading firms, boasts that in five and a half years, it had only one day when it failed to make money, and that was the result of “human error.” As Lewis writes, “‘liquidity’ was one of those words Wall Street people threw around when they wanted the conversation to end, and for brains to go dead, and for all questioning to cease.” Liquidity in the private market space is scarce at the moment, so observing activity in the liquid space would be sensible.?
The Financial Conduct Authority (FCA) has approved the most significant overhaul of the UK's listing regime in 40 years. This reform aims to revitalise the London Stock Exchange (LSE), which has seen a decline in IPOs and an increase in companies opting for take-private deals. FCA chief executive Nikhil Rathi cautioned last week that these changes could create “potential for failure” as well as “great opportunity” for companies seeking to list.
Currently, REITs may seem closer to failure than a great opportunity due to their exceptionally poor performance. Nonetheless, Bfinance strongly supports incorporating liquid real assets into diversified portfolios, noting their potential for portfolio 'completion'. In the U.S., listed real asset markets offer exposure to sectors and geographies often under-represented in private market portfolios. While private real estate is dominated by four core sectors, two-thirds of the REIT market includes 'other' sectors, driven by demographic and secular trends; such as cell towers, data centres, healthcare, self-storage, triple net lease, and niche residential. Bfinance highlights that effective manager selection is crucial, with active managers consistently demonstrating strong median outperformance versus benchmarks (net of fees).
For now though, the REIT sector in London is shrinking, burdened by falling asset values and high discounts. Analysis by Bryan Cave Leighton Paisner revealed that the number of London-listed REITs has dropped 20% from 83 at the start of 2019 to 48 in May 2023. Data from the Association of Investment Companies indicates that only seven UK-listed property trusts have shown positive one-year share price performance, while 17 funds have posted double-digit declines.
In response, merger and acquisition activity among UK REITs has increased since 2019, with expectations for continued consolidation. Some analysts believe this consolidation could bode well for the sector's future prospects. Analysts at Principal Asset Management noted, "REITs are trading at historically significant discounts relative to broader equity markets, thanks mainly to the interest rate sensitivity of the REIT market." The majority of London-listed property companies have less than ￡1bn in total assets, according to AIC data, making the sector significantly smaller than its US counterparts. John Moore, senior investment manager at RBC Brewin Dolphin, observed, "At their current scale, the UK's REITs are limited by their size. This affects the capital they can attract, the terms on which they can borrow, and ultimately the deals they can do."
Cohen & Steers present a strong case for owning listed U.S. real estate arguing that the unusual earnings multiple discount of U.S. REITs compared to stocks represents a rare and compelling opportunity. Traditionally, REITs traded at a premium due to their stable, rent-based cash flows, averaging a 2.7x earnings multiple premium over stocks. Currently, REITs are trading at a -1.7x discount, a situation seen only after the global financial crisis and during the pandemic. This unusual discount suggests potential for substantial future performance, as similar valuation gaps in the past have often preceded REIT outperformance. For example, in 2003, 2009, and 2020, REITs outperformed stocks by an average of 29.8% over the following year and by 10.4% over three years.
They also address the recent divergence in performance between listed Real Estate Investment Trusts (REITs) and private real estate in the U.S. The NCREIF ODCE index, which tracks 25 open-ended funds investing in core commercial real estate, has experienced a decline for six consecutive quarters, showing a total return of -18.4% since its peak in the third quarter of 2022. In the first quarter of 2024, the index reported a total return of -2.4%, with capital returns of -3.3% offset by income returns of approximately 1%. In contrast, listed REITs have seen total returns rise by 14.4% since the third quarter of 2022, outperforming private real estate by nearly 33% over this period.
Recent performance might be improving: the FTSE Nareit All Equity Index saw a 2.2% rise in June, marking the second consecutive month of growth for equity REITs, with the index nearly recovering from a low point of nearly 10% down this spring.
Although listed and private real estate returns are generally correlated over the long term due to the similar nature of the underlying assets, shorter time horizons reveal a lead/lag relationship. This divergence is notable for investors as it underscores the benefits of embracing the short-term volatility of listed REITs for diversification. Historically, listed REITs have served as a leading indicator for private CRE, often rebounding before private real estate does.
Cohen & Steers estimate that incorporating listed REITs into private real estate portfolios can enhance returns, reduce volatility, and mitigate drawdown risk. For example, a portfolio with a 10% allocation to listed REITs can increase annualised total returns by 60 basis points, reduce the standard deviation of returns, and lessen the maximum drawdown. In an academic paper published by EPRA earlier this year, entitled The Volatility of Listed Real ?Estate in Europe and Portfolio Implications,?concerning the optimal allocation to Listed Real Estate (“LRE”) in a mixed-asset portfolio, studies conclude that LRE’s weight should be between 10 and 18% for the U.S. In Europe, the average allocation to LRE is about 20%.
Morgan Stanley highlights that, as of the summer of 2023, major European listed real estate companies are trading at a discount to NAV exceeding 40%. Such steep discounts have not been seen since the 2008-2009 financial crisis and the 1992 ERM crisis. Historically, these significant discounts have often led to substantial returns, with previous instances showing gains ranging from 100% to 200% over five years. The analysis indicates a 100% success rate of positive five-year total returns when the initial NAV discount falls between 40% and 50%. At the current discount levels, a cumulative return of nearly 120% over the next five years is predicted, translating to a compound annual growth rate of over 17%. Even at lower discount levels, between 30% and 40%, the five-year success rate remains robust at 82%.
However, such wide discounts can also signal anticipated declines in underlying real estate values, often influenced by rising interest rates. Some companies might face financial strain, potentially leading to dilutive capital raises. Despite these risks, Morgan Stanley's analysis suggests that investors with a medium-term horizon could still find attractive returns.
Hedge fund Muddy Waters are looking to the downside, recently disclosing a bet against a publicly listed real estate investment trust managed by private equity giant Blackstone. Blackstone Mortgage Trust, which manages $22bn in assets. Carson Block, the chief investment officer of US-based Muddy Waters, expressed concerns about the trust during the Sohn Investment Conference in London. Block criticised the trust's portfolio, claiming there is “a lot of rot in its book” and that many of the borrowers whose loans make up the trust’s holdings might struggle to make payments. He predicted that the trust would need to “substantially cut its dividend” by mid-next year and warned of a “real risk of a liquidity crisis.” In an interview with the Financial Times following his presentation, Block said, “I feel it’s an inevitability that the cash flow gets significantly diminished by this macro environment.” He added, “[The] only thing they have going for them is being able to spread out the days of reckoning. I would not be sanguine on the office market in the US.”
Muddy Waters has also scrutinised valuations supporting CPI Property Group (CPIPG). Carson Block highlighted the subjective nature of valuation, noting, “At the end of the day, real estate is highly subjectively valued, even if you intend to produce a good-faith estimate of an asset’s worth. Now, when you bring in third-party capital, there can be an incentive to overvalue real estate. Companies often hide behind the names of the lawyers, valuers, and auditors they use. I think they do this to give themselves more credibility… But we’ve found that valuation reports in particular can be highly manipulated, especially because they don’t have statutory duties to shareholders.”
UBS reported from the EPRA Corporate Access Day that UK companies generally struck a more bullish tone as values were widely reported to be at, or very close to the bottom. And with healthier balance sheets the scope to grow the portfolios into a rising market is much clearer. On the Continent it is more of a mixed bag, some companies are looking to call the bottom in 2H24 whilst others are pointing towards 2025. So it looks like the UK may be heading towards more of a "V" shaped recovery, whilst the Continent will look more like a "L" as values bottom but don't recover.
Goldman Sachs introduced an underweight rating on UK real estate in June last year, only for strategists more recently advising their clients to stop shorting the sector altogether. On the back of positive interest rate sentiment movements from US Federal Reserve chair Jerome Powell, the pan-European Stoxx 600 gained 0.9%, buoyed by a 2.1% rise in real estate shares.?
John Coates was, until 2016, a research fellow in neuroscience and finance at the University of Cambridge, studying the biology of risk-taking. Previously, he traded on Wall Street for Goldman Sachs, Merrill Lynch, and Deutsche Bank, developing novel techniques for analysing and trading financial crises. In 2012, Coates published the best-selling book “The Hour Between Dog and Wolf: How Risk-Taking Transforms Us, Body and Mind.” In it, he discusses a famous study by Benjamin Libet, a physiologist at the University of California, conducted in the 1970s. Libet's experiments showed that participants' brains prepared actions 300 milliseconds before they consciously decided to move, indicating that “their conscious decision to move came almost a third of a second after their brain had initiated the movement.” Coates notes, “It is not often appreciated that financial decision-making is a lot more than a purely cognitive activity. It is also physical activity, and demands certain physical traits.” Listed markets are more complex than private markets, and the speed of execution poses challenges, but also provides a benchmark often ignored by private markets. Real estate executives in private markets, who rely on instinct and physiological inputs, should pay more attention to how listed markets are performing, and the signal bodes well for private markets.