So…It has finally happened. A mere decade later than initially expected, the real estate industry is coming to terms with the inevitable end of quantitative easing, ie, ‘normal’ rather than artificially suppressed interest rates. While we all enjoy a central bank-fuelled asset bubble, unfortunately the party must end at some stage and the real question is, how will the (listed) industry survive and in what form?

For some it will be a journey into the unknown (the cost of debt being greater than the initial unlevered yield), while for others it will be a return to the financing challenges of the 80s and early 90s, not forgetting to mix in a brief sample of the inflationary and industrial relations era of the musically superior 70s. More specifically, what factors are likely to affect valuations for listed real estate companies in the new normal era?

For the listed sector of course, there is an added layer: namely, what is currently priced in and are those implicit assumptions aligned with explicit forecasts or merely reflecting short-term sentiment? Additionally, it is important to understand whether the sector will be treated as a whole or there is substantial divergence, either by asset allocation, leverage or indeed management.

We have been fortunate enough to canvass opinion recently, by holding our series of online webinars which form part of the Understanding the REIT course at Bayes. We have had buy and sell side analysts, as well as specialist and generalist fund managers present to the course participants. There appear to be four key areas which all our expert guests broadly agree on from the series:

1. Management quality is increasingly important.
2. Growth potential is the sine qua non.
3. Alternative pricing is set to to remain between public and private markets.
4. Valuers are likely to capture much of the downward yield-based price correction by year end, enabling companies to report in February/March from a reset level. 

In summary, this is how we see these issues affecting pricing and capital raising. 

1. Management

In addition to the ‘hard’ NAV and dividend valuation measures, there is always a ‘soft’ residual element which buy and sell side analysts ascribe to a corporate valuation. Historically this has reflected a hope that management teams will not over leverage at the peak of the market or sell out of growth assets and reinvest into underperforming obsolete assets. Teams that do not suitably impress the eagle-eyed observers of the buy and sell side community are rewarded with a discount to their peer group. Increasingly, this element is being used to capture wider aspects of management. most notably ESG-related factors. To this extent, a sector which has had a proliferation of pure asset owners is now gravitating towards management operators, more in line with the other 10 equity sectors in the market and therefore the valuation dispersion between perceived good and management teams is likely to widen.

2. Growth

It might seem obvious but, in an environment where you are no longer being paid to hold assets (rental yields 2-3 x interest costs) the only way to bridge the potential deficit is a) not to have much leverage and b) invest in assets where the rental and capital value growth will produce positive free cash flows and reduce LTVs. Growth potential will remain the key driver of medium-term returns for investors. Whether this translates into a premium for growth assets or a discount for ex-growth stock remains to be seen but, again, the binary distribution of growth vs ex-growth asset types seems set to remain.

3. Parallel asset pricing

The general consensus appeared to be that for certain sectors (certainly offices) there was a distinct pricing gap between an unenthusiastic equity market audience who do not have a line of sight to positive news in the sector and the private markets where certain, particularly larger, participants have both capital to deploy and a strategy to implement which make them the obvious buyer and holder of these assets. As a result, the distinct parallel asset pricing between public and private markets is justifiable and will remain. 

4. Taking the pain in the short term

Given the inevitable upward rise in investment yields, and the uncertainty regarding tenants’ ability to pay, the general view appeared to be that companies would not resist savage write-downs for Q4 and 2022 as a whole, to reset from a sensible base for 2023 and beyond. As a result, those astonishing discounts to NAV that you saw in November may well narrow in Q1 23, not necessarily because share prices are rising, but because the stated NAV is taking the fast lift down to meet them.

Overall, therefore, a very nuanced and bifurcated valuation and returns outlook is expected for the sector as we enter the brave new (or is it old) world.