Ahmad Bilal
News of a looming commercial real estate (CRE) collapse has been in the news for over a year now.
The bottom line is that something in the financial system will break in the near future, causing a domino effect that will result in huge losses for both commercial real estate (VNQ) and the regional banks (KRE), which hold roughly half of the outstanding CRE loans.
Perhaps this is why these two sectors have significantly underperformed the S&P 500 (SPY) since the Federal Reserve began raising interest rates in early 2022.
Data by YCharts
The disconnect between CRE and regional banks and the S&P 500 is currently at an all-time high.
I don't believe this divergence will continue forever. In fact, I believe it may be nearing an end, as there are indications that the next move from the Fed this year will be a rate cut rather than a rate hike. Like many trends in the market, I believe this one will end with a reversion to the mean.
Specifically, we believe the market will wake up to the fact that a major CRE crash isn't happening, which will lead to a sustained rally for real estate investment trusts (REITs) and regional banks that hold CRE loans.
The collapse of CRE has already happened for the most part. The only area where the collapse could continue a little longer and perhaps get worse is the office.
Let's explore the CRE crash that happened quietly without anyone noticing, and then look at some opportunities to profit from this rare divergence in the market.
The crash has already happened
Most arguments that a CRE collapse is imminent start with a variation of this graph, which shows CRE debt maturities (regardless of lender type) by year.
Wow! A huge number of loans are maturing this year! Given the decline in real estate valuations over the past few years, it seems that these debt maturities will be the catalyst for borrowers to either forcefully sell, sell the property at a large loss, or simply foreclose and hand the keys over to the lender.
However, defaults in the CRE space have not increased significantly (so far) this year, and the current increase in defaults is very moderate when compared to the default cycle experienced during the 2008-2009 global financial crisis.
why is that?
There are several reasons why backlogs have been minimal so far.
Banks have been granting 9, 12, and sometimes 18-month loan extensions to give borrowers time to improve operations, build up equity, and wait for interest rates to fall. This is also why there are so many loan maturities in 2024. Many of these are maturities from last year that have been extended to this year. Mountains of unpaid capital are waiting for opportunities to get into CRE. Borrowers have done so when it is cheaper to build up equity than to refinance debt. The average LTV for CRE debt is now lower than it was before the global financial crisis. The average LTV for non-multifamily CRE mortgages is now about 58%. In other words, the property would have to fall in value by 42% or more for the lender to incur a loss. In most cases, it makes more sense for borrowers to simply sell, even at a loss, than to be unable to repay the loan. In some specific cases, banks are selling delinquent loans to distressed debt investors to quickly get them off their books.
Also, keep in mind that outside of the office, the CRE industry is not experiencing any major distress or even stress. Most sectors of CRE are performing very well from an operational standpoint. Occupancy rates are still very high and rents continue to rise.
Outside the office, most of the delinquencies we've seen in the CRE industry have been due to borrowers who overpaid for properties during a time of ultra-low interest rates, not because they were on poor operating fundamentals. Interest rates and real estate prices have fluctuated wildly over the past five years, and the effects are now being felt in the lending industry.
Also keep in mind that publicly traded real estate investment trusts (REITs) have very little bank financing or secured debt. Their debt consists mostly of unsecured bonds with weighted average maturities of more than six years.
A few REITs have been caught off guard by looming debt maturities in 2023 and 2024. But for the most part, REITs have fundamentally performed much better than the average private landlord.
That's why it's so puzzling to see how REITs are disliked by the investment community: as of June, fund managers are underestimating them more than any other investment area.
What's particularly striking is that the fund manager is 10% overweight banks, which hold a lot of CRE loans to less stable private borrowers, while underweight REITs, which are better capitalized and hold higher quality properties than their private peers.
Additionally, REITs tend to lead both declines and increases in commercial real estate prices. So far, REITs have led CRE prices to decline, but according to Green Street, CRE prices as a whole are likely to remain flat this year and even rise slightly again.
This is likely due to growing confidence that the Fed will begin a rate-cutting cycle later this year.
Even though publicly traded stocks, including REITs, are forward-looking financial instruments, REITs have not yet begun to rise.
As noted at the beginning of the article, the overall real estate index is down about 28%, but there is a large divergence between the weakest and strongest sectors within the index.
Industrial REITs have maintained their greatest strength, while office REITs have shown the greatest weakness.
While it is natural that there will be divergences between sectors, we would have expected to see gains across most REIT sectors at this point.
The one exception, of course, is office space, where weak demand and oversupply are occurring at the same time, with average vacancy rates in office buildings running at around 20%.
While office REITs are down an average of just over 50% from pre-COVID-19 levels, the price per square foot of office real estate is down 43% so far this year.
The office industry apocalypse doesn't seem to be over yet. More pain is likely to come, which is why office REIT stock prices may be properly pricing in more pain.
But the rest of the REIT space looks rife with opportunistic valuations for long-term investors.
Two great buying opportunities
Two REITs look especially lucrative today.
Agri Real Estate Co., Ltd. (ADC)
ADC owns one of the highest quality single tenant retail net lease portfolios in the country, with anchor tenants including Walmart (WMT), Tractor Supply (TSCO), Kroger (KR), Costco (COST) and AutoZone (AZO).
REITs create a virtuous cycle by lowering their cost of capital through the quality of their portfolios and balance sheets, which they then use to strengthen and grow the quality of their portfolios and balance sheets, resulting in steadily growing earnings and dividends.
Even though ADC has demonstrated to the market that it can enhance acquisition yields even in the current high cost of capital environment, the market continues to shy away from this powerhouse.
ADC hasn't been this cheap since 2016, with its operating cash flow multiple being very close to its adjusted operating cash flow (AFFO).
Data by YCharts
We believe ADC's long-term fair valuation is approximately 17-18 times AFFO, which means the REIT has room for at least 15-20% upside at current prices.
Along with a roughly 5% dividend yield and mid-range single-digit growth, I believe ADC can easily achieve double-digit total earnings going forward.
BSR REIT (OTCPK:BSRTF)
BSR is a lesser known multifamily REIT that is listed primarily on the Toronto Stock Exchange but also trades over-the-counter in the U.S. The company owns a high-quality portfolio of garden-style, new vintage, Class B and suburban apartment communities located almost exclusively in Texas.
BSR rents are affordable and well below the asking rents of new apartment complexes being supplied to these markets, giving the company significant leeway to increase rents.
In the image above, we can see that BSR's same-community revenue and NOI have grown by 5.9% and 7.8%, respectively, in 2023. These are best-in-class results that demonstrate the attractiveness and resilience of BSR's Class B portfolio.
This strength continued in the first quarter of 2024, with share repurchases helping to increase same-community NOI by 4.4% and AFFO per share by 9.1%. The REIT is paying out only 54% of its AFFO, leaving it with a large amount of cash reserved to pay down debt, repurchase stock, or make selective investments.
Additionally, insiders own over 40% of the common stock, and it's rare to find a management team more aligned with shareholders across the stock market.
BSR's valuation has fully recovered to pre-pandemic levels.
Data by YCharts
This chart is similar in direction to BSR's price-to-AFFO multiple, but unlike Agree Realty, BSR has a lot of ongoing capital expenditures to consider. BSR's price-to-AFFO multiple is currently around 11.5x.
That's surprisingly cheap, considering BSR's larger Sunbelt multifamily peers, MidAmerica Apartment Communities (MAA) and Camden Property Trust (CPT), are trading at AFFO multiples of 18-19x.
Even if BSR were to achieve a valuation of only 15 times AFFO, we would still expect a 30% upside.
BSR's 4.5% dividend yield, mid-single-digit bottom-line growth, and expanding multiples point to double-digit total returns going forward.
Conclusion
There are some incredible buying opportunities currently available in the public real estate sector. The market appears to be applying an “office” discount to the entire sector. This isn't all that surprising given how often “office” is equated with “commercial real estate” in the news media.
But the CRE market is as broad and diverse as the economy itself, so this broad REIT sale means a lot of “pile of gold” has gone to waste, so to speak. ADC and BSR are good examples.
Additionally, ADC and BSR have in common that they both pay dividends monthly.
We intend to take advantage of the current selling pressure and buy as long as these opportunities persist.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.