Challenges In First Half Of 2022
The challenges to financial markets during the first half of 2022 have been well documented and highlighted by rampant inflationary pressures, supply constraints, a central bank and political class viewed as being “behind the curve”, the rising risk that a recession may occur over the next 12-18 months and social divisiveness which is perpetuating an already glum national mood.
As is often the case during periods of severe market dislocation, many risk assets, including REITs correlated to the downside over the course of the second quarter. The REIT Index (RMZ) was down 16.9% in Q2 and modestly underperformed the broader equity market as represented by the S&P 500, which achieved a negative return of 16.1% for the period. Within the residential REIT sub-sectors, manufactured housing achieved the best relative performance (-10.9%) followed by single-family rentals (-14.7%). Traditional apartments were the laggard and underperformed the overall REIT sector with a total return of –19.6% in the quarter.
What’s To Come?
As we contemplate the upcoming earnings reporting season for our constituent companies it is important to stress that incremental “new” news could be fairly limited as it was only four weeks ago that we received 2Q updates from companies at the annual NAREIT conference in New York. The tone amongst residential landlords continued to be optimistic at the start of the spring/summer leasing season and one of the key takeaways from the pending conference calls will be to gauge what if anything has changed over the past 4-6 weeks as consumer and business confidence have begun to show some signs of weakness. Given the strength of the rental housing market which has persisted for the past year, it is our view that factors including low unemployment, solid job growth, high occupancy rates and rising homeownership affordability hurdles will keep the momentum in rents on an upward yet moderating trajectory through the balance of 2022.
Shifting to Post-Covid Economy
Many residential REITs had the confidence to raise earnings forecasts for 2022 when they reported first quarter earnings back in April/May, with a handful of earnings raises also coming through at the NAREIT conference. Thus, we would not anticipate a preponderance of earnings increases to accompany the 2Q22 reports. We do expect to hear more positive sentiment regarding bad debt expense from west coast markets, which was a drag on several company results last period. With covid-related rent moratoriums now in the rear-view mirror and most residents now back in the workforce, previously uncollected rents should shift from being a drag on results to more of a tailwind. We would also expect exceptional expense management, which has been one of the unheralded achievements in the industry over the past two years, to receive more recognition. As company leaders articulate trends for the second half of the year there will likely be an emphasis on the more difficult year-over-year comparisons in same-portfolio operating metrics which coincide with the rapid reopening of the post-covid economy in the second half of 2021.
Uncertainty Surrounding Interest Rates and Economic Outlook
Perhaps the most important topic of this quarter’s reporting season will be the investment market and whether expectations for external growth are still achievable. The first quarter saw a dearth of investment activity on the part of many constituents as interest rates had started moving higher in anticipation of the Federal Reserve taking action on interest rates. The first quarter is typically light for institutional transactions, with activity tending to increase as the year progresses, and culminating in heavy volume to end the calendar year. Given the uncertainty around interest rates and the economic outlook along with aggressive pricing on residential assets leading up to the start of 2022, it was not surprising to see disciplined investors take a “pause” earlier in the year. At the mid-point of the year, and arguably with visibility still blurred, it will be instrumental to hear what industry leaders have to say about capital allocation plans for the balance of 2022.
2Q Earnings And Beyond
The final and perhaps most important thoughts on 2Q earnings and beyond come down to valuation and how the sector might perform in coming quarters. The recent market correction coupled with a stable fundamental backdrop for the residential sectors puts the group in an attractive light. A basket of residential REITs across apartments, single-family-rental and manufactured housing are currently trading at a 19.4x multiple of 2023 funds from operation (FFO), an implied capitalization rate of 4.9% and a price-to-net-asset-value of a 16.4% discount. Public markets tend to react more quickly and often times “overreact” during periods of heightened volatility such as experienced over the course of 2Q22. As a result, public market valuations in the residential property sector are currently attractive at current valuation levels both on an absolute basis, and relative to private market pricing.
 Evercore ISI: Real Estate/REITs; Performance Trends In Q2 & 1H22 (Winners and Laggards); July 1, 2022; Steve Sakwa and Team
 PLR Analytics: (PLRAA Daily REIT Note); July7, 2022
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