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Portfolio > Alternative Investments > Real Estate

Why Are REIT Values Below the Private Market?

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NEWPORT BEACH, CA—The public market is a bit more concerned about rising interest rates and what might be happening to fundamentals in gateway markets like New York and San Francisco than the private market is, Green Street Advisors’ president of advisory and consulting Jim Sullivan tells Sullivan, a 22-year veteran of the firm, was one of two key members of the its executive team to be promoted recently, following his leadership and contributions as managing director of Green Street’s Advisory Group since 2014.

In addition, Craig Leupold has been promoted to CEO following his accomplishments as president of Green Street Advisors. A 23-year veteran of the firm, Leupold will continue to bring best practices to all segments of the company, as well as explore strategic opportunities to support the firm’s growth. We spoke exclusively with both executives about their new positions as well as some of the bigger trends they are noticing with commercial-property valuations. What are your goals in your new positions at Green Street?

Leupold: My goals in my new position are fairly consistent with goals of Green Street for the last few years. The company has been around for 30-plus years, and initially its focus was providing research, analytics and valuations around publicly traded securities. If you look at the performance of our buy-rated versus sell-rated stocks, in every year our buy-rated stocks have greatly outperformed our sell-rated stocks. My takeaway from that is that Green Street does a great job with real estate analytics in any environment: expansion or contraction, interest rates increasing or decreasing. We’ve done a good job year in and year out understanding what’s driving those real estate companies, and that means we need to do a good job within private-market real estate.

The difference between buy- and sell-rated companies is 20 percentage points per year. We want to leverage off that, so my goal is to take Green Street and the expertise we’ve developed and expand our research offerings and products. Five years ago, we started a new product line called Real Estate Analytics, which is focused on private-market real estate. We recently expanded our market coverage from 35 to 50 markets, and we now cover the 50 largest markets across different product types of interest to real estate investors. We’re now leveraging our expertise from the public market, and we’ll do the same in the private market.

Private-market participants’ concerns are allocating capital, and our job is to help clients allocate capital in the most efficient way possible. They need to ask, “Should I be owning apartments, industrial, office or malls?” And within those, should I be owning apartments in San Jose or Atlanta, and how should I be allocating those dollars and adjusting my portfolio based on where those risk-adjusted returns lie?

One of my goals is to expand the Green Street brand and become a market standard in the private market in the same way we are in the public market. It’s not our intention to compete from a data standpoint. Our intention has always been analytics above the data. There’s lots of proprietary data within Green Street; the real value is analyzing it and providing conclusions for clients to help them allocate capital.

Leupold: “One of my goals is to expand the Green Street brand and become a market standard in the private market in the same way we are in the public market.”

Sullivan: My primary goal is to continue educating the market that Green Street has an advisory group and to help the market understand what we do and how we add value. What are some of the bigger trends you’re noticing with commercial-property valuations?

Leupold: Going back to the depths of the Great Recession, there’s been a tremendous upward run in commercial real estate values. Although the pace has slowed significantly in the past year, CRE prices continue to increase if you’re looking at returns from CRE relative to other capital-market alternatives. We’re quite comfortable with where we are today. The bond and other market yields have declined at the same time that real estate prices have increased. We’re still comfortable with the relationship between returns from real estate and the returns from other capital-market alternatives. We see a balance of funds, not much change in current valuations, and we see valuations as fair among CRE broadly,

Sullivan: We’re at a point where real estate prices are at all-time highs, and that’s naturally creating a lot of strategic questions for owners: Should I buy more, sell what I have, put more chips on the table, take some chips off the table?

One interesting trend: retailers and restaurant companies are not in the real estate business per se, but a lot of them own much of the real estate where they operate, and a lot of them are struggling. Historically, they’ve thought about real estate as a great location to sell sweaters or perfume or chicken wings, but—especially for publicly owned companies who own a lot of real estate, with prices at all-time highs, why don’t you monetize that? Our advisory group works with them to help them develop a strategy to extract some of that value for shareholders. When do you predict valuations may start to decline, and which sectors will be first?

Leupold: It’s hard at this point to call the timing of any change in valuation. Some of the things we’re looking at to get a clue as to when valuations may change are fundamentals: What does the economic environment look like? Are we still in a period of economic expansion? Do we have reasonably healthy job growth and on the supply side are we relatively constrained for new supply so the backdrop for fundamentals continues to be strong for real estate? I don’t have from a demand or supply perspective an idea of when valuations may decrease. I’m also looking at interest rates, and I can’t tell you where they are going, but they’re certainly something to watch. A significant increase in interest rates would be concerning to real estate. It one of the things we’re always looking at and monitoring in terms of potential concerns. Given the current interest rates, we’re comfortable with where real estate valuations are today.

We are seeing on the apartment side more supply than we see in other sectors. We see slowing growth in apartment fundamentals or NOI growth, but not to the point where it’s concerning. It’s priced into apartment assets today. When you look at apartment returns, you see reasonable returns, even in light of decreasing rent growth and occupancy gains. But some sectors may appear more overvalued compared to others. I do have concerns about valuations in office versus apartments or self-storage. It’s a matter of separating fundamentals from valuation. The fundamentals don’t look as good for apartments as for other sectors, but this is appropriately reflected on apartment cap rates as compared to other sectors.

Sullivan:  It’s hard to predict where values are going to go. Real estate values are really tied to two things: the overall economy and, very importantly, what’s going to happen to interest rates. Real estate is a very capital-intensive industry. Interest rates affect the valuations of CRE, and a lot of people are concerned about rising interest rates having a negative effect on real estate values. I’m a little more open-minded. If rates rise because the economy is growing at a rapid rate, then things will be OK for real estate valuations. The scenario I worry about is rising interest rates without economic growth. That’s a tough scenario for real estate or any capital-intensive business. What else should our readers know about commercial-property valuations?

Leupold: I think there are two things to highlight. One is where we’ve done a lot of work. Part of Green Street’s value add is thought-leadership research, and on that front we’re doing a ton of work on potential disruptors to real estate over the long term. Too many real estate practitioners are focused on spreadsheets over the next five years that don’t always have a long enough horizon. They don’t think about what is changing that could impact the value of CRE 10 to 20 years from now that will have an impact on capital flows and valuations for those sectors. I would caution that real estate participants should expand their view to look beyond some investment horizon that might be measured in five to seven years to longer-term trends that might impact their portfolio.

What is the impact of something like driverless cars?  What does that mean for the demand for apartment buildings with excess parking? What does that mean for suburban versus urban demand? Will it reverse the trend of urbanization so that suburban properties become more attractive than urban properties because people can get in a car and it will drive them where they need to go? What does it mean for storage facilities? That’s an example of something that’s not impacting real estate today but will at some point in the future. To what extent? That’s the type of forward thinking and thought leadership that Green Street prides itself on, and the real estate industry should look at these macro trends that could have an impact on them.

Sullivan: It’s interesting to look at how the public REIT market is pricing real estate versus the private market. Great public companies like Boston Properties, which owns office buildings in New York, Boston, DC and San Francisco, and Equity Residential, which is in the apartment business, are trading at very large discounts to private-market value on their real estate. So, either real estate is cheap on Wall St. or expensive on Main St. It will be interesting for readers to think about that: Why is the public market ascribing lower values to the market than the private market is right now? I think the public market is a bit more concerned about rising interest rates, and in some of the gateway markets like New York and San Francisco in particular, the public market is concerned about what might be happening to occupancy rates, rental-rate growth and the demand for real estate.




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