At midyear 2024, commercial real estate and REITs continue to be impacted by higher interest rates and trends unleashed in COVID. Transaction activity continues to be constricted as pricing adjusts, and property type fundamentals range widely across sectors. Below, we provide an update on the sector as we look to the balance of 2024.
- REITs have lagged so far in 2024. During the first six months of 2024, REITs posted a total return of -0.2%, lagging all of the major indices including the S&P500 (15.3%), the DJIA (4.8%), and the NASDAQ (18.6%). While the economy has held up, with sustained job growth in the face of ongoing inflation and relatively higher interest rates, REITs are facing concerns about underlying real estate valuations and uncertain transactions markets. There is also the lack of an obvious catalyst to growth until rates trend lower and transactions can prove accretive. Across the property type sectors, the winners in the first half of 2024 were Multifamily (12.3%), Health Care (10.3%) and Regional Malls (8.6%), while the laggards included Timber (-16.3%), Industrial (-12.8%), and Lodging (-6.3%).
- Earnings Momentum and Valuation. Estimates for 2024 FFO growth currently stands at 3.0%, virtually unchanged from the start of the year (2.9%). Retail, Triple Nets, Health Care and Lodging all saw growth rates increase, while Residential, Storage and Industrial saw growth rates decrease. For Office REITs, CBD portfolios saw growth rates accelerate, while the Suburban REIT growth rate decelerated. For 2025, FFO growth is now pegged at 5.3%. Currently, REITs trade at a 17.4x multiple on 2024 FFO. This compares to 18.1x at the start of the year. Only the residential and Storage REITs saw valuations expand; all other sectors saw valuations recede. REITs currently trade at 16.5x 2025 consensus FFO, roughly in line with the 10-year average forward multiple.
- Clarity on the direction of the economy will be critical to the commercial REIT performance moving forward. While slower, U.S. employment growth has remained steadily positive so far in 2024. Expectations at the start of the year for a potential recession have given way to a “soft landing” baseline. On the other hand, inflation has remained stubbornly above the Federal Reserve’s 2% target, and expectations for interest rate cuts have been pushed out at least until the fourth quarter, and perhaps 2025.For commercial real estate, valuations have been negatively impacted by higher rates, and the “higher-for-longer” mantra continues to create headwinds for commercial real estate. Price discovery has been elusive as transaction volumes have decreased considerably. In the first quarter of 2024, the cumulative volume of U.S. commercial real estate transactions declined by 28% compared to the same period in 2023. Specifically, $31.6 billion was transacted across major property types in Q1 2024, marking the slowest level of activity since early 2013. In the second quarter, year-over-year comps get easier, but the volume of transactions in April and May were still down about 18% compared to 2023.The average cap rate for CRE transactions so far in 2024 is about 6.5%, which compares to about 6.25% in 2023, and a low of 5.25% in mid-2022. U.S. REITs implied cap rates are currently approximately 6.1%, compared to 5.8% at the start of 2024, and 5.4% in mid-2022.
Sector Updates
- Residential. Despite fluctuations, residential REITs have delivered a year-to-date total return of 2.0%, following a robust 2023 total return of 7.7%. Residential REITs have maintained strong operating performance amidst the ongoing housing crunch, with demand for rental housing continuing to rise, even in the absence of significant population growth. Despite a slight dip in FFO from the previous quarter, first-quarter 2024 figures show a notable 6.8% increase over the previous year. With growing preference for renting, and the rise of single-person households, residential REITs remain well-positioned to capitalize on increasing demand for rental housing amidst constrained housing affordability and evolving demographic trends.Notably, recent trends have shown more improvement in the coastal market multifamily, exceeding expectations and driving upside in consensus for the balance of the year. Sunbelt markets continue to face higher new unit deliveries, but the wave of construction appears near the end, setting up strong multifamily trends likely into 2025. Single family rental REITs remain the star, trading at premium valuations and sustaining their leasing and rental spread momentum. With mortgage rates remaining elevated, strong demand should remain a driver through 2024 and into 2025.
- Lodging. After a robust recovery in 2023, lodging trends have generally remained steady, although some divergent patterns are emerging. The group and convention segment are where we are seeing the most demand and driving RevPAR growth. Leisure is coming off of post-Covid strength and, particularly in the lower segments, is seeing pressure from ongoing inflationary challenges. Business transient is still a somewhat unknown variable, with demand somewhat stagnant, but rate is exhibiting growth.Lodging stocks had performed well through the start of the year, but valuations have come in more recently, as industry RevPAR expectations have moderated for the year. That being said, consumers seem to continue to favor experience spending, of which travel is a big component.
- Retail. The retail segment has a positive outlook with a favorable landlord-tenant dynamic. While many malls are still struggling, open air retail has very limited new supply and demand is strong, with many retailers struggling to find quality space to meet their new store opening targets. Occupancy at well-located, high-quality centers is high, giving the owners a positive positioning and driving high leasing spreads. New supply is very muted, and with very high replacement cost will likely remain so in the near term, setting up for continued rent growth. However, with sustained inflation, consumer sentiment and spending being a potential concern, particularly at the lower end, traffic at enclosed malls remains challenged.
- Office. Post-pandemic, office has been one of the more challenged sectors. However, with more certainty in the macro outlook and more stability around working patterns, there is a set up for improvement as tenants have more confidence in their space needs. Many markets are also working through over-supply and have begun to explore alternative uses for vacant space, which should result in a healthier market over the longer term. The market seems to be expecting stabilizing occupancy with a notable flight to quality. That being said, there is still a fair amount of skepticism around the trajectory of recovery and some caution on continued unexpected move-outs. This seems to still be a wait-and-see segment with many on the sidelines until there is further clarity, despite generally lower valuations.
- Industrial. Industrial management commentary is supporting potential recovery in industrial fundamentals for 2025. This is supported by strong leasing spreads as new supply deliveries are expected to be slow going into the back half of 2024 and into 2025. Current trends are mostly aligning as anticipated, albeit with a more intricate supply and demand landscape in the short run. The market’s small-box segment is maintaining robust demand and limited supply, while larger properties (700ksf+) are experiencing significant tenant interest, including Amazon’s leasing activities. This optimism extends to other e-commerce and retail tenants. However, there is a notable weakness in mid-size properties, 150-350ksf, specifically in Southern California. Furthermore, valuation relative to growth prospects seem attractive as relative to pre-pandemic, as multiples are several turns below prior levels.
We would like to acknowledge and thank Naima Malik & Veerle Sanborn for their assistance in preparing this update.
