Q3 REIT Balance Sheets & Valuation Gap
REIT Balance Sheets
Less Leverage, Lower Rates, Longer Maturities
The Wall Street Journal reported earlier this week that defaults on real estate-backed mezzanine loans had ticked up. Mezzanine debt is akin to a second mortgage for commercial property; it increases the leverage of the property but comes with higher rates and an easier foreclosure process. WSJ suggested the relative increase in mezzanine foreclosures signals further trouble in the commercial real estate sector.
Mezzanine financing is more popular in private real estate than within public REITs. While distressed pricing affects all assets, the strength of REIT balance sheets should create a competitive advantage through the next cycle. This is one of the dynamics that will contribute to closing the Public-Private valuation gap we have been discussing.
Following the Great Financial Crises, REITs reduced their leverage while private market leverage increased. On average, REITs have debt-to-equity ratios less than 50%. Moreover, REITs have access to more liquid debt capital markets. As a result, they are able to issue corporate level, unsecured debt with longer maturities than are available to private owners using property level debt. Average REIT debt maturity is still beyond five years.
REITs similarly benefitted from the fall in rates in terms of dramatically reducing their cost of debt capital. The weighted average interest rate of REIT debt sits right at 4%, 40 basis points below the 10-year US Treasury. REITs have low rates locked in for longer, which should not only help them weather a property downturn but also allow them to go on the offensive, taking advantage of price dislocations.
The Valuation Gap - Good Assets, Bad Balance Sheets
When public REIT investors want to sell, they sell their equity claims into a liquid secondary market, whereas private real estate investors must sell assets in the far less liquid commercial property market. In many cases, private real estate investors hold good assets on bad balance sheets. They either purchased property with too much leverage, utilized floating rate debt, or are facing maturing loans in a much higher rate environment. Should these conditions make private real estate owners forced sellers, public REITs can benefit by adding these good assets to their comparatively strong balance sheets. We believe the dynamic of good real estate assets that have been owned within the private market, coming back into public REITs will help close the public-private valuation gap.
Quote Book
Source: The Real Deal
Hard to Price 🏢
“I don’t know how and when we get back to a place where we put a value on office buildings. You can’t value it...You are going to have office buildings worth less than zero. It’s going to be an absolute bloodbath.”
- Michael Comparato, Benefit Street Partners (TRD)
The Big Bet 📈
“Buying stocks and bonds here is a bet that the Fed will proactively ease policy which will juice asset returns.”
- Bob Elliott, Unlimited Funds (X)
Houses on the Moon? 🌑
"It’s not clear what the housing market would be like on the moon and if prices will be astronomical, as they are on parts of Earth.”
- The Real Deal (TRD)