Remarkable Signals from the Listed Market
Two Different Universes
The commercial real estate market is bifurcated into two universes with buyers working from different sets of data. There are many investors who buy buildings directly or invest in funds that buy buildings. There is also a smaller, but rapidly growing group of investors who buy their real estate via Real Estate Investment Trusts (REITs). The fact that the first group is so large means that many important real estate market participants are often in the dark when it comes to the goings-on in public real estate markets. As a result, pricing discrepancies across private and public markets grow wider and last longer than would be the case if capital flowed more freely between the two. I am going to make the case that all real estate investors should look to the public market for signals on operating fundamentals and valuation.
Unprecedented Discounts for Public REITs
First, reliable market information on public REITs is readily available. Every 90 days, some of the biggest and best real estate owners and operators release data that tell us exactly what’s happening in the marketplace. Equity Residential (EQR), Simon Property Group (SPG), and Prologis (PLD) are just a few of the best-in-class companies that give investors a treasure trove of information for free every quarter. Why not take advantage of that?
Second, the market is sending some remarkable valuation signals. At Green Street, we look at how REITs trade relative to the private market value of their underlying assets. In the apartment sector, the average REIT is trading at a 14% discount to the current market value of its assets as of July 2018. The discount is 12% for neighborhood shopping centers and 16% for the office sector. And in the mall business, REITs are priced at a 17% discount.
These discounts are unprecedented. For nearly 30 years, REITs have traded at a 2% premium, on average, compared to Green Street’s assessment of net asset values (NAVs). The public market is sending unusually pessimistic signals about where it thinks some real estate sectors will be priced six months or a year from now.
Conversely, in the industrial sector, the public market is pricing REITs at a premium to the market value of their assets. What does that say? It says that public market investors think that as good as everyone knows industrial is, the future is even better than that.
REITs Serve as a Crystal Ball
Historical data shows that signals from the public market have been helpful in forecasting private-market returns across property sectors, so private-market participants can benefit from paying close attention to where REITs are trading. Property prices have almost always (96% of the time since 1998) appreciated in the 12 months after listed REITs traded at NAV premiums. They have declined by an average of 2% following periods when REITs traded at discounts.
The signals work at the property-sector level as well. Sectors that trade at the largest NAV premiums have delivered higher total returns in the private market than sectors trading at NAV discounts. The relationship has been particularly robust over the last 10 years, during which the predictive power embedded in sector NAV premiums has proven directionally correct 86% of the time, and appreciation in the two highest-premium sectors has outpaced that of the two lowest-premium sectors by more than 400 basis points per year (Green Street's Heard on the Beach: Giving Thanks for Dual Markets).
Finding Value and Yield in Today’s Market
Opportunity exists for savvy investors to take advantage of the divergence in valuation across markets. Private-market appetite for sectors like apartments remains robust, despite higher interest rates and, in many markets, further cap rate compression. It is a headscratcher that private-market participants remain so eager to deploy capital in the higher-priced private market when prices for large, high-quality apartment portfolios are ‘on sale’ in the REIT market.
Private-market vehicles focused on high NAV-premium sectors can benefit directly if they use the public market as an exit strategy, or indirectly because those sectors tend to have the best property appreciation. It seems like a no-brainer that a private fund operator would prefer to focus on self-storage (10% premium to NAV) in today’s market, rather than office (16% discount to NAV), but private capital flows into the latter sector have been massive. Granted, it’s easier to buy assets in scale within those core property sectors, but it’s far from clear that investors are even thinking about the question in that way. Further, it’s obvious that the public market provides far cheaper access to the heavily discounted sectors at the moment, yet investment committees around the globe are signing off on multiple large-property purchases. That’s a hard path to follow if optimizing returns is the objective.
Nimble Investors Capitalize on Pricing Discrepancies
So as a direct investor, why not understand the public market’s enthusiasm for industrial property? Why not understand the mall REITs and the public market’s extraordinary pessimism? The best real estate investment opportunities emerge when perceived risk differs from actual risk. The public market is very helpful in sending signals when perceived risk and real risk diverge, and nimble investors in commercial real estate take advantage of that. Because of those opportunities, Green Street strongly believes investors should pay attention to the public market, even if they have no intention of ever buying a REIT.
Green Street has over 700 research and advisory clients, including chief executives at some of America’s largest companies and fund managers focused on commercial real estate. As a group, our customers own and control trillions of dollars of real estate investments in the United States and Europe. Green Street clients include hundreds of real estate companies, more than 100 of the largest REITs, 20 of the 25 largest global private real estate companies, 22 of the top 25 investment banks, and 78 of the top 100 investment management firms active in REITs. In a recent survey, 99% of clients were likely or extremely likely to recommend Green Street to an industry colleague.¹ Contact us to be part of the conversation.
- Play Video: Green Street’s Approach to Commercial Real Estate Research
- Download: Relative Valuation in Public and Private Real Estate Markets
- Green Street’s Track Record on Forecasting Commercial Real Estate Prices
- Blog: Commercial Property Outlook - Are Cap Rates Headed Up?
¹ Source: PERE (Capital Raised), Big Dough (REIT Holdings), S&P Global (Offering Amount), and NAREIT (Market Cap). Survey results presented feedback from 101 users representing 59 Green Street clients across 12 segments from November 2017. Participants had downloaded at least 5% of reports in the prior year. The survey question was: “How likely are you to recommend Green Street to an industry colleague?” Responses were: “Extremely Likely,” “Likely,” “Not Likely,” and “Extremely Unlikely.”
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