One’s from Venus, the other Mars. Commercial real estate is bifurcated into two universes with buyers and sellers working from diametrically different data sets. The result is a vast spread in asset values, which makes your search for a late-cycle “safe haven” more challenging. Pricing discrepancies across public and private markets have grown wider and lasted longer than if capital flowed more freely between the two. Instead, you must make sense of an expensive private market experiencing outsized demand from record capital flows and a public market trading at a premium on the heels of a recent “yield grab” that proliferated through everything from Exxon Mobile to Phillip Morris International. The question remains, “which is right?”
Understanding public market valuation
Public real estate markets trade on next year’s net asset value (NAV), which is usually a premium to current NAV coming out of a downturn and usually a discount to NAV when moving later into the cycle. In today’s late-cycle environment, we believe that public REITs are fairly valued at roughly a 2-to-5 percent discount to NAV. Yet, billions piled into the public markets this year as rates plummeted and mega pension funds rebalanced. While this glut of demand temporarily inflated values, we believe public market was efficient in the long run – and should soon adjust (remember this to guard against your frequent, market-driven impulses).
Yet, it’s important to note that only core assets like retail, multifamily, hotel, and industrial trade on NAV. Non-core or alternative assets like healthcare and net lease have less private equity alternatives and will perpetually trade at varying levels above NAV in the public markets.
Public markets historically send signals to private markets
Over the last three decades, REITs have traded at a two percent premium to Green Street’s assessment of NAV.1 Now, with many sectors trading at steeper-than-normal discounts, is the public market sending unusually pessimistic signals about where it thinks some real estate sectors will be priced a year from now? Perhaps, but conversely, industrial continues to price at a premium to NAV, meaning there may be an even longer runaway for growth.
History highlights that public market signals have been helpful in forecasting private market returns. Consider this: property prices have almost always appreciated in the 12 months after listed REITs traded at a premium – 96 percent of the time since 1998! It works the other way as well – with property prices declining on average by two percent following periods when public REITs traded at discounts.1
We currently sit in an environment of robust private market demand across core sectors. Leveraging historical patterns, inflows focused on high NAV-premium sectors may make sense, while other capital flows have looked out of place. Office, for instance, is flush with cash, perhaps because it’s easier to buy scale in core, but the public markets currently offer a far cheaper access point to this heavily-discounted sector.
Even if private market investors never purchase a REIT, they may want to monitor public market valuations to find a divergence between perceived and real risk. That’s the time to act.
Perfect example of the disconnect: core Manhattan office
We’ve laid the foundation for the office paradigm, so let’s dig a bit deeper. Public REITs that own Manhattan office properties are trading at substantial discounts to private market values – office overall is trading at nearly a 14 percent discount to NAV!
Net effective rent growth and cash leasing spreads in Manhattan office have declined as Class A asking rents have flatlined amidst an influx of new supply.2
Evolving tenant preferences are also at odds with the older floorplans prevalent in Manhattan. Tech tenants and co-working firms are mandating open floor plans and floor-to-ceiling windows, an onerous capital expenditure requirement that stifles growth. Co-working tenants, especially WeWork, are exploding in Manhattan, which yields a dilemma beyond cap-ex. This tenant profile broadly consists of corporate overflow, consultancies, and start-ups, which are typically the first to fold in a Recession. Now, not only are these property owners up against it with higher upfront costs, but vacancy rates may jump at the sign of a downturn.
The result is reduced cash flow to the landlord, making it difficult to justify those high valuations, even if it’s easier to deploy mass capital in the private markets. We believe this formula isn’t the best way to achieve late-cycle value.
Historically, the private market is best served following the public market’s lead. Private market values can be distorted in the short-term by transaction or appraisal lag or even appraisal error. Over time, as the investment horizon lengthens, private markets tend to gravitate towards public markets. In the search for a “safe haven”, public market values may offer a truer look at future investment value.