Unprecedented Valuation Disparities in REITs Creates Opportunities for Active Managers
November 27, 2019
Unprecedented Valuation Disparities in REITs Creates Opportunities for Active Managers
November 27, 2019
As passive investing grows, stock picking becomes all the more important. REITs have surged in value so far in 2019, but that recovery has not been uniform.
Many REITs are trading at significant discounts relative to the index and comparable privately-held real estate assets.
We believe several factors could cause these valuation gaps to narrow, including renewed interest in fundamentals, activist investing and take-private transactions.
The rise of passive investing and private real estate funds has created unprecedented valuation disparities in REITs, but these gaps tend not to last indefinitely. Now may be an opportune time for investors to consider actively-managed real estate strategies that have the potential to capitalize on this situation.
Over the last several decades commercial real estate has gone from a nascent asset class to a portfolio staple, with U.S. institutions now allocating an average of 10.6% of assets to real estate as shown in Display 1.
Among the biggest beneficiaries of this shift are passively-managed funds, which have grown to represent roughly 25% of assets allocated to real estate investment trusts (REITs),1 and private real estate funds, which have accumulated record levels of undeployed capital as seen in Display 2.
These trends have helped contribute to unprecedented valuation disparities among REITs, both relative to their net asset values (NAVs) and comparable privately-held assets—and therein lies the opportunity.
Source: Hodes Weill and Associates, IREI. Yearly data as of December 31. 2019 data as of September 30.
Source: Preqin. Yearly data as of December 31. October 2019 data as of October 1st.
Passive Fuels Valuation Gap
Index-based investing has made its mark on virtually every asset class, and real estate is no exception. Passively-managed strategies recently accounted for one in four dollars invested in REITs,1 and that share is steadily growing.
Yet, as has been the case with other asset classes, this has created a unique dynamic in which assets tend to flow into the largest entities with little differentiation for company fundamentals or valuations.
As more assets flow into market-cap weighted index funds it only serves to exacerbate this disconnect—creating what we think could be passive bubbles. These disparities are evident in market segments globally, but are particularly pronounced in the U.S. REIT market. The overall U.S. Real Estate sector ended the third quarter trading at a +15% premium to net asset values, and yet many segments—including retail, hotel assets and central business district (CBD) office—continued to trade at deeply-discounted valuations. (See Display 3 and the sidebar on New York City office space.)
Data as of September 30, 2019. Based on FTSE EPRA Nareit U.S. Index. Source: Morgan Stanley Investment Management.
Past performance is not indicative of future results. This should not be deemed as a recommendation or offer to buy or sell any security within the sectors referenced, or to participate in any trading strategy.
Private Assets Add to the Schism
Coincident with the increased interest in passive funds, institutional investors have shifted a greater share of their real estate allocation to private investments in search of higher yields and lower correlations to equity markets. As a result, private real estate equity funds recently held $266 billion of committed but uninvested capital, with approximately 61% of this “dry powder” earmarked for North American real estate.2
This is notable for a couple of reasons. First, it shows a disconnect between how investors view active investing strategies in the public and private markets. While private investments have potential benefits, they typically come with the tradeoff of higher fees, more leverage and less liquidity.
It also underscores differences in how investors in private and public markets size up real estate. In recent years, generalist investors—who represent the marginal REIT investor today—have placed a great deal of focus on traditional stock market metrics, such as earnings multiples, dividend yields and earnings growth rates when evaluating publicly traded REITs. In our view, these investors have not been looking through to the underlying real estate assets held by REITs and evaluating them on real estate-specific metrics such as occupancy rates, net operating income growth, etc., which private market investors tend to focus on. Generalist investors have also bid up REITs with perceived defensive characteristics or ties to secular investment themes, such as the growth of cloud computing and e-commerce. As a result, the value of real estate assets held in publicly traded vehicles has become unmoored from the private market valuation of similar assets.
NEW YORK OFFICE SPACE: A TALE OF TWO CITIES
To understand the stark differences in how public and private markets are pricing real estate, consider New York City (NYC) office space. This segment of the market has been enveloped in a cloud of worry as investors assume that new inventory, such as at Hudson Yards, and more flexible work arrangements will likely put downward pressure on rents. Consequently, public NYC office REITs were recently trading anywhere from 30% to 40% less than what private investors are paying.
Private investors appear to have a very different outlook and have had a healthy appetite for NYC office assets. In 2018 they acquired nearly $19 billion in assets and year to date through September 2019 they acquired over $12 billion in assets. Moreover, private buyers have been buying ‘Big Apple’ office space at par value—versus a 32% discount to NAVs for NYC office REITs.
We believe this dislocation offers an attractive investment opportunity.
Based on FTSE EPRA Nareit U.S. Index. Source: Morgan Stanley Investment Management. NYC Office Implied Cap Rate (Public) provided by MSIM as implied by company cash flows and share prices. NYC Office Private Market Cap Rate provided by MSIM and based on transactional evidence.
Source: Morgan Stanley Investment Management and Green Street Advisors, Inc. Past performance is not indicative of future results. This should not be deemed as a recommendation or offer to buy or sell any security or to participate in any trading strategy.
Closing the Valuation Gap
History has shown that valuation disparities rarely last. Eventually, markets tend to catch on and as Display 4 shows, REIT values have in the past reverted to their long-term mean. Several factors could help close the current valuation gap, including: take-private transactions, share buybacks and a renewed appreciation for traditional real estate fundamentals.
Increase in Private Acquisitions
With private real estate funds having raised record levels of capital—and publicly-traded firms trading at compelling discounted valuations—it’s not out of the question that many REITs have the potential to be taken private.
Given the substantial disparities between public and private market valuations that exist within certain market segments, we think there may be increased take-private activity as the private funds look to access real estate at more attractive valuations by buying the public real estate companies instead of buying comparable assets in the private market.
In 2018, investment transaction volume totaled $964 billion on a global basis and represented the third highest annual total on record behind only 2007 and 2015, according to Real Capital Analytics.
U.S. transaction volume, meanwhile, reached a post-Global Financial Crisis peak of $576 billion in 2018, representing an 18% increase over the year prior.
Fundamentals Back in Favor
Meanwhile, high-quality REITs continue to make meaningful improvements that ultimately benefit shareholders. They have been strengthening their balance sheets, improving operations, disposing of non-core assets—in many cases selling these assets to private investors at full intrinsic value—and using the proceeds to buy back shares at significant discounts to their associated NAVs.
We’ve also seen an uptick in activist investors taking long positions in discounted REITs that are underperforming. They are nudging these companies to take meaningful steps toward improvement and, in many cases, put themselves on the auction block for take-private activity.
These activities could prompt generalist investors to pay closer attention to the underlying private market valuations of REITs, recognizing that in real estate, intrinsic value does matter. At present they appear willing to ignore the distinction in multiples used to value assets in the private real estate sector and, therefore, are indifferent about the quality of the real estate cash flow when buying stocks.
Benefitting from Active Management
In any market environment, active management can play a prominent role in helping to improve overall returns while managing downside risk. Given the significant differences in macroeconomic and secular trends across regional markets, most investors will likely want to seek broad exposure across a wide range of sectors, while understanding the importance of liquidity in an asset class that is in and of itself not liquid.
This is likely true for any market environment, but in light of current valuation disparities we think there is a strong case to be made for active management. Now may be an opportune time for investors to shift their allocations into actively-managed REIT strategies that focus on high-quality assets trading at discounted valuations.
To be sure, certain market segments are exceptionally discounted, opening the door for active management to take advantage of wider than typical valuation disparities. We believe investors stand to benefit from multiple expansions—as the broader market spots these disparities—and potential take-private activities.
Meanwhile, a focus on quality and attractive entry points can serve as a buffer in market declines. Actively-managed REIT strategies have the leeway to tilt portfolios away from overvalued segments and toward those trading at significant discounts.
BUILD: CONSIDER INVESTING IN MSIM’S GLRA STAND ALONE FUNDS
The Global Real Estate Portfolio seeks attractive long-term, risk-adjusted returns by investing in publicly traded real estate securities, primarily in developed countries worldwide. The fund combines a value-oriented, bottomup-driven investment strategy and a global top-down allocation that seeks diversified exposure to all major asset classes with an overweighting to property markets that the team believes offer the best relative valuation.
AVAILABLE SHARE CLASSES
CONSIDER: MSIM’S TURNKEY SOLUTION
The Real Assets Portfolio seeks total return, targeted to be in excess of inflation, through capital appreciation and current income. Investments primarily include global listed real estate and infrastructure securities, inflation sensitive equities, inflation-linked fixed income securities and commodity-linked investments.
AVAILABLE SHARE CLASSES
REAL ESTATE FINDS A PLACE IN INVESTOR PORTFOLIOS
In any market, we believe REITs can help improve risk-adjusted returns in a portfolio. That said, in the current environment of low—and in some cases negative—interest rates, they are particularly appealing as income-generating assets that don’t typically move in lock step with stocks and bonds.
Over the medium to long term, we expect returns for REITs to fall between equities and fixed income while offering an attractive income component.
Data as of September 30, 2019. Sources: FTSE Nareit, Bloomberg Barclays, S&P Dow Jones, and MSIM. Past performance is not indicative of future results. Diversification does not eliminate the risk of loss. In general, equity securities are move volatile than fixed income securities. For additional risk considerations, refer to the disclosure section.
At the same time, REITs should continue to provide diversification benefits—thanks to historically low correlations with stocks and bonds—while offering a buffer against inflation. In fact, dividend returns for the sector have outpaced inflation over the last 15 years. Meanwhile, different global markets and sectors provide no shortage of options for active managers to achieve above-average returns and income.
Source: Vendor, FactSet on behalf of FTSE Nareit, S&P and Citigroup. Past performance is not indicative of future results.
Source: Vendor, FactSet on behalf of FTSE Nareit and the U.S. Department of Labor (CPI through 3/31/2019). Past performance is not indicative of future results.
Please consider the investment objective, risks, charges and expenses of the portfolio carefully before investing. The prospectus for any of the funds referenced above contains this and other information about the portfolio. To obtain a prospectus, download one at morganstanley.com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.