By Lewis Braham
No other stock sector illustrates the differences between the old and new economy quite like real estate. So far this year, the average real estate investment trust leasing and developing artificial-intelligence data centers is up 37%, while the average office REIT is up only 0.2%.
In the past, such extreme bifurcations in REIT returns were rare. “On one hand, we have sectors with secular tailwinds, like data centers and senior housing, where fundamentals have been really strong,” says Ji Zhang, co-manager of the Cohen & Steers Real Estate Active exchange-traded fund. “But we also have sectors that were quite challenged coming out of the pandemic, with a lot of supply. The office sector is the poster child as a pretty dramatic underperformer for many years now.”
This value-versus-growth split creates a challenge for fund investors. Do you favor the strong growth of data-center and healthcare REITs, which seem richly valued now? Or do you invest in economically challenged but undervalued sectors? The latter are cheap enough that some trade at discounts to their underlying properties’ values.
Such discounts have sparked a buying wave. Since the 2020 pandemic, there have been 56 public REIT acquisitions, 22 of those by private-equity buyers. According to the REIT analysts at Chilton Capital Management, who expect the acquisition trend to continue, the 86 publicly traded REITs they cover range from a 55% discount to an 87% premium. The median REIT, by contrast, recently traded at a 15% discount to NAV.
Most real estate index funds don’t make such growth/value distinctions. The largest REIT ETF, the $70 billion Vanguard Real Estate, tracks the MSCI Investable Market Real Estate 25/50 Index, which holds real estate stocks of all types and sizes.
Yet because the Vanguard ETF’s benchmark is market-cap-weighted, healthcare and data-center REITs recently comprised 16% and 11% of its portfolio, respectively, while office REITs were 2.5%. One healthcare REIT, Welltower, accounts for almost 8% of the fund. Although Welltower doesn’t publish a formal NAV, analysts at Green Street estimate it to be $87 a share, with the stock trading at $218 — a steep 151% premium. In 2020, its premium was only 22%, and it went as low as 13% in the 2022 bear market.
Interested in playing the value side of real estate? Active management makes more sense now. Third Avenue Real Estate Value’s holdings were trading at an average discount of nearly 30% at the end of the first quarter, according to co-manager Ryan Dobratz, a level that has been reached only three other times in the past 15 years — 2011, 2020, and 2022. Its discount to NAV is currently in the mid-20s range, he says.
While Dobratz acknowledges office REITs are cheap, he cites “the very high levels of tenant improvements and capex and leasing costs” needed to keep properties occupied. Instead, the fund is focused on real estate service companies such as CBRE Group and Jones Lang LaSalle, which have also underperformed but have less operating risk. “They act as a toll booth on the real estate markets, and especially the office markets, because they’re getting paid to lease, to finance, to sell those properties without the capex associated with owning the assets,” he says.
Dobratz also tends to favor non-REIT real estate operating companies such as Brookdale Senior Living in healthcare and U-Haul Holding in storage, as unlike REITs they aren’t required to pay out most of their income in the form of dividends. He also likes manufactured housing REIT Sun Communities, which trades at a 15% discount to his estimate of NAV, and storage REIT Big Yellow Group, which is the largest owner of self storage in the U.K., “and it’s trading at about a 40% discount to our estimate of NAV.”
Cohen & Steers’ Zhang is currently on the growth side of the spectrum, with a 13.7% weighting in Welltower and 8.4% in data-center giant Digital Realty Trust, yet she’s dipping her toe back into offices. “We have had almost zero weight in office in our portfolios since 2018, but have been increasing our exposure selectively,” she says. (Though Zhang’s ETF is only a little over a year old, it is run much like an older successful mutual fund, Cohen & Steers Real Estate Securities, yet the ETF has a lower 0.70% expense ratio.)
Zhang says the market for office space has improved in the premiere coastal cities, especially San Francisco, where she’s seen a surprising amount of job growth. She likes Hudson Pacific Properties for that market. Offices now comprise 3.7% of her fund.
One possible compromise between the two strategies would be to focus more on higher-yielding REITs, which tend to be cheaper. PGIM runs a number of successful real estate funds, for example, but the portfolio differences are stark between the growth-focused PGIM US Real Estate and the income-oriented PGIM Real Estate Income.
PGIM Real Estate Income has an 11.3% weighting in higher-yielding office REITs like the preferred shares of Vornado Realty Trust, which currently yield 7.4%, but it also holds data-center plays like Iron Mountain, yielding 2.7%. PGIM US Real Estate has a 12% weighting in Welltower, yielding 1.4%, and 10% in Equinix, yielding 1.8%.
The income-oriented fund might well offer a better balance for today’s environment.
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