We continue to monitor the decline in value of public apartment REIT shares as a market indicator. Throughout periods of dislocation in the broader capital markets, Origin has evaluated and monitored public apartment REITs and their implied cap rates. With 2023 year-to-date apartment sales volumes down 62% from 2022, this is one of the most opaque capital markets environments since the onset of the COVID-19 pandemic—and when factoring in current uncertainty surrounding monetary policy, it’s arguably one of the most opaque periods since the Great Recession.
When there is a lack of private market transaction data, evaluating public REIT performance can shed some light on the potential direction of private market pricing. However, when using implied REIT cap rates and return performance as a stand-in for private market cap rates and returns, there’s a caveat: A number of research reports have concluded that, in periods of market dislocation, REIT stocks tend to overcorrect to the downside and then experience a sharp upside reversal in recovery. Those swings must be taken into account when attempting any comparison to potential movements in the private markets.
Deriving an implied REIT cap rate requires making some adjustments to the net operating income (NOI) reported by public REITs. This adjusted NOI is then divided by the current market value of the respective REIT. Market value is determined by adding the total market capitalization (current share price times total shares outstanding) and debt/liabilities, and then subtracting cash.
We evaluated recent share price declines of a number of apartment REITs, some of which fell 10% to 11% in October and 16% to 22% over the past three months. Based on our internal modeling, some apartment REITs are trading above an implied 7.0% cap rate, with others trading near 7.5%. In our continual evaluation of limited private market trades, from which we derive our own cap rate data, private market cap rates in our target Sunbelt and Mountain markets are hovering around 5.0%. That is producing a 200 to 250 basis point spread. We saw a similar spread in late 2022. That spread is reflected in the chart below (the NFI-ODCE transaction cap rate is a stand-in for the private market).
Public/Private Cap Rates, Apartments
Source: NCREIF, NAREIT T-Tracker
As of 2Q 2023 (see chart above)—although not reflective of REIT price declines of 10% and more over the past quarter—it is clear that REIT cap rates and private market cap rates were approaching a more normalized spread, with implied REIT cap rates at 5.8% and private market cap rates at 5.0%.
This recent expansion of the spread between public and private market cap rates requires us to consider what these recent moves may portend for private market cap rates. While we do not anticipate that the public/private cap rate spread will narrow to the level observed in 2Q 2023—which would suggest that private market cap rates top 6.0%—the gap could narrow from current levels. This could also be achieved through a combination of a reduction in public cap rates (increase in REIT values from current levels) and an expansion of private market cap rates (decrease in private values from current levels).
Cap rates are not the sole driver of total investment returns; the other is returns generated from cash flow. But it is worth noting that the divergence between private and public market returns reached a historic peak in 3Q 2022. The FTSE NAREIT All Equity Index and the NFI-ODCE posted rolling four-quarter total returns of -16.3% and 22.1%, respectively—a difference of -38.4%. This inflection point marked the most significant degree of REIT relative underperformance in the history of these indices, surpassing the 2009 peak of -34.8%.
However, over the past 20 years, there have been six periods of nearly one year each when negative differences greater than 10% between these two benchmarks occurred. Only two of those periods produced recessions: 2009 and 2020. Will this be the third? Stay tuned.