Beyond The Headlines: Dissecting Key Trends Influencing Real Estate Investment

SusanneB

This article was coproduced with Leo Nelissen.

The big picture matters a lot, which is why we at iREIT® care so much about macroeconomic developments that impact the investments we hold and monitor.

Especially when dealing with multi-billion-dollar investments like Realty Income (O), VICI Properties (VICI), or Prologis (PLD), it is important to be on top of ongoing developments.

Hence, in this article, we’ll shed some light on the most important numbers, discuss what we’re monitoring, how this impacts the stock we invest in, and what it could mean going forward.

So, as we have a lot to discuss, let’s get right to it!

Resilience In 2023 And Beyond

Wells Fargo, which has extensive real estate research, just published its Q4 2023 Commercial Real Estate overview that included a lot of valuable information.

For example, it essentially confirms what most sell-side researchers have found as well: the economy continues to be resilient.

In 2023, real GDP saw a 2.5% increase, which exceeds the growth rate of 2022 and consensus estimates.

This growth was primarily driven by strong real disposable income growth fueled by a strong labor market and moderating inflation, leading to increased consumer spending.

Looking at the chart below, we see a number of key indicators, including consistent GDP growth, robust personal consumption growth, and a moderating PCE price index, an indicator often used by the Fed.

Bloomberg

Looking ahead to 2024, these positive economic indicators are expected to persist, reducing the likelihood of a recession.

While we’re not fans of longer-term economic forecasts, as it is dependent on so many factors, below we see that the U.S. is expected to remain one of the strongest developed economies in 2024, with consistent growth beyond 2024.

Bloomberg

This is what the IMF had to say with regard to its longer-term outlook:

“Tighter central-bank policy to fight inflation and public-spending cuts in some countries are among the reasons why growth is expected to be slower than in the two decades before the pandemic when it averaged 3.8%. Still, given the scale of the Covid-19 price shocks and the interest-rate hikes that followed, the IMF suggested things could have gone much worse.”

With that said, and going back to the Wells Fargo report, there’s a lot more to unpack here, as we are witnessing quite a few differences among REIT sectors.

Between Headwinds And Tailwinds

Before we continue, it needs to be said that even weaker real estate segments still have some great REIT players. When we are downbeat on certain areas, it by no means indicates that we suggest selling everything with similar exposure.

For example, as much as we dislike high-risk office exposure (see this article), we like high-quality stocks like Alexandria Real Estate (ARE), which caters to healthcare companies, not companies in need of “generic” offices.

Speaking of offices, according to Wells Fargo, demand for office space remains subdued, with vacancy rates reaching a record high of 13.5% in Q4 2023.

While net absorption improved slightly, it remained negative, which reflects the ongoing trend of firms downsizing office space due to pandemic-related work-from-home arrangements that are really hard to roll back.

The bad news continues, as despite recent growth in office-using employment, overall demand remains weak, which doesn’t do the demand/supply imbalance any favors.

Looking at the chart below, we see that vacancy rates continue to rise, now exceeding Great Financial Crisis highs, supported by consistent net completions and weak absorption rates.

Wells Fargo

Unfortunately, this confirms everything we have written about office real estate in recent quarters.

Residential real estate is doing a bit better, although there are some pitfalls to keep in mind.

Residential is one of our favorite areas and it is seeing a stabilizing net absorption rate for the first time since the end of 2022, with rental demand benefitting from limited resale supply and increasing single-family home affordability issues.

Essentially, because of elevated rates, it is harder to build new homes, which limits new supply.

However, elevated rates also keep people who either have no mortgages or mortgages with low rates from selling. This further pressures supply and keeps home prices elevated despite higher rates.

That’s why the Fed has failed to pressure housing inflation so far!

Unfortunately, there are hidden risks, which include regional supply issues caused by the migration from “blue” to “red” states.

Wells Fargo noted that in this segment, vacancy rates rose to 7.6%, mainly driven by higher deliveries in the Sunbelt region.

Wells Fargo

One of our favorites in this area is Mid-America Apartment Communities (MAA), which hasn’t cut its dividend since 1994, including the Great Financial Crisis.

It’s a company that – despite supply pressure in the Sunbelt – continues to shine with consistent (adjusted) funds from operations (“AFFO”) growth and dividend growth.

As we can see below, analysts expect 6% AFFO growth in 2025 and 12% growth in 2026, which hints at a theoretical annual return north of 15% for MAA.

FAST Graphs

Then there’s retail real estate, one of the largest sectors in the world.

Earlier this month, we wrote an article titled “NNN REIT: 6% Yield And Up To 37% Undervalued.”

One of the biggest takeaways was the surprising strength (in light of elevated rates) of the retail real estate market.

“According to a report from Marcus & Millichap, retail is poised to become the leading category in U.S. commercial real estate occupancy.

The forecast is supported by an expected increase of over 4.8 million households from 2024 to 2028.

Urban retail has seen a resurgence with strong tenant demand, high occupancy rates, and steady rent growth.

Meanwhile, retailers are capitalizing on consumer resilience, with more store openings than closures last year, a trend that is expected to continue, with minimal vacancy adjustments projected for 2024.”

As a result, like MAA, NNN REIT (NNN) continues to offer a great risk/reward – just like its larger peer, Realty Income (O).

(See latest article on NNN and O.)

FAST Graphs

Wells Fargo confirmed all of these developments, as the net absorption rate improved in the fourth quarter, with vacancy rates falling to a new low of 4.0%!

Wells Fargo

With that said, industrial space, which is home to giants like Prologis and Rexford Industrial Realty (REXR), is seeing healthy demand yet moderating conditions.

Since the pandemic, this industry has benefited from massive demand for warehouses and secular tailwinds, including economic re-shoring, where higher economic demand in the U.S. requires industrial real estate.

However, this also caused a wave of completions, which is now hurting vacancy rates, albeit at subdued levels compared to historical numbers.

Wells Fargo

Hence, in this sector, we like players with limited supply risks, which include Rexford and Prologis.

Rexford is 100% focused on Southern California, which has severe supply shortages, while Prologis is focused on advanced warehousing real estate with elevated exposure in California as well.

Rexford Industrial Realty

As we can see below, Rexford is expected to grow its AFFO by 11% this year, potentially followed by accelerating growth to 17% in 2026. This is based on strong internal growth opportunities and favorable conditions in the market it serves.

FAST Graphs

It also has a BBB+ credit rating, one of the best ratings in the REIT sector, and one step below the A range.

Recently, we discussed REXR in an in-depth article, which included the following quote with regard to the health of its industry:

“Essentially, rent growth is anticipated to decelerate in 2024, accompanied by an increase in vacancy rates due to the influx of new supply entering the market.

However, and this applies to REXR, despite Mexico surpassing China as the top trading partner of the United States in 2023, coastal port markets, especially those in Southern California, are still expected to lead in rent growth, although at a slower pace than previous years.”

And then there’s the hotel sector, a sector that got crushed during the pandemic, as it was briefly illegal to be open for guests.

According to Wells Fargo, hotel occupancy rates continue to lag pre-pandemic levels due to slower international and business travel despite an initial surge in leisure travel post-pandemic.

Even worse, average daily rates and room revenues have cooled, reflecting the normalization of travel patterns.

The good news is that hotel construction has slowed due to elevated interest rates and lending constraints, with limited-service hotels dominating new developments.

In light of these developments, while we like some pure-play hotel stocks, we prefer a well-diversified leisure REIT like VICI Properties (VICI), which has consistent growth expectations and an attractive valuation that hints at double-digit annual returns.

FAST Graphs

With that said, there’s more to it.

Prices & Lending

Like most industries, real estate is a debt-fueled industry, which means lending conditions and pricing are very important.

Especially in light of elevated rates, the pressure on debt quality is rising.

Below is an example from Arbor Realty Trust (ABR), which reported to have non-performing loans worth $263 million in 4Q23, up from $151 million in the quarter before that.

Globest.com

These numbers are quite something and a good indication of what we may expect to see more of in the future if the Fed is not able to cut rates with inflation falling to and remaining close to 2%.

Furthermore:

“He said CMBS loan delinquencies are expected to double from 2.25% in November 2023 to November 2024 with the US CMBS office delinquency rate alone, rising 64 basis points in November 2023, the largest increase since November 2020 signaling the impact of COVID-19.” – Globest.com.

Wells Fargo reported that overall CRE fundamentals remain strong, but property prices have been impacted by higher interest rates. MSCI’s all-property price index decreased by 4.7% year-over-year, primarily due to rising cap rates across property types.

Wells Fargo

However, the bank also confirms our own findings, which are that while lending standards have slightly eased compared to the previous quarter, the lending environment remains restrictive overall.

Commercial and multifamily mortgage originations declined, with a notable increase in office delinquency rates. This trend could potentially lead to higher overall delinquency rates in the future.

Wells Fargo

All things considered; we are not in a great situation for REITs.

Elevated rates continue to be a problem, the Fed hasn’t won the battle against elevated inflation, and economic growth may disappoint as a result.

However, there’s plenty of good news.

For example, industrial real estate isn’t weak. It’s normalizing. Retail demand is surprisingly strong, and despite elevated supply risks, there’s still money to be made in the residential sector.

Overall, we continue to focus on REITs with stellar balance sheets, growth opportunities, and attractive valuations.

For example:

We like residential Sunbelt REITs in areas with subdued supply growth like MAA. We like retail REITs with benefits like sale-leaseback opportunities, which include NNN and Realty Income. We like industrial real estate with advanced assets and/or significant supply tailwinds like PLD and REXR. We like leisure/hotel assets with a competitive edge, including VICI. We even like diversified office real estate if it comes with a wide-moat business model like ARE, which solely caters to advanced healthcare companies (Biolabs).

Even if the situation continues to deteriorate, we believe this is a great way to put money to work and build long-term wealth/income.

Takeaway

Understanding the macroeconomic forces at play is essential when managing money, regardless of whether you manage thousands, hundreds of thousands, millions, or billions.

In our analysis, we’ve observed resilient economic indicators, particularly in sectors like retail and industrial real estate, despite challenges in others such as office spaces.

While elevated rates and economic uncertainties persist, opportunities exist in REITs with solid balance sheets and growth potential.

By focusing on areas with limited supply risks and competitive advantages, investors can position themselves for long-term wealth accumulation.

Despite the current landscape, strategic investment in the right sectors remains a viable path forward for building income and capital growth.

We also made a little cheat sheet for headwinds and tailwinds we are seeing in real estate.

Headwinds & Tailwinds

Headwinds:

Elevated Interest Rates: Higher interest rates are impacting property prices and lending conditions, which could potentially lead to higher delinquency rates. Sluggish Office Demand: Remote work trends continue to pressure demand for office space. Regional Supply Issues: Migration from “blue” to “red” states is causing supply imbalances in certain regions. Hotel Sector Challenges: The slow recovery in international and business travel is limiting hotel occupancy rates and revenue growth.

Tailwinds:

Residential Real Estate Stability: Limited resale supply and affordability issues are stabilizing net absorption rates in the residential sector, supporting rental demand and home prices. Surging Retail Demand: Strong tenant demand and steady rent growth in urban retail spaces indicate strength in the retail real estate market. Industrial Sector Growth: Demand for warehouses remains strong, driven by economic re-shoring and e-commerce growth. Leisure/Hospitality Recovery: Despite challenges, leisure travel remains solid, which benefits diversified leisure REITs like VICI Properties. This REIT offers growth potential without the headwinds most hotel-focused leisure REITs face. iREIT® “Data Duel”

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