Two-Speed Property Market Unsustainable: Different Prices in the Same Building

If two identical houses were priced differently, home buyers would understandably be confused. Similarly, investors can be confused when looking at commercial real estate.

In recent weeks, private property funds like Blackstone's nontraded, semiliquid BREIT vehicle have had to explain their strong performance relative to listed stocks. BREIT has reported returns of 8.4% so far this year, compared with around minus 25% for publicly traded U.S. real-estate investment trusts. The fund was forced to freeze redemptions after a number of clients asked to cash out at its seemingly rosy valuations. Another big nontraded fund, Starwood Real Estate Income Trust, has also closed its gates.

Other private landlords besides Blackstone have valuations that appear optimistic. The NCREIF Property Index, which tracks commercial real estate owned by institutional investors, returned 16% in 2022, although gains slowed in the third quarter.

There is bound to be a convergence between REITs and private funds, as both will be impacted by the same underlying factors. It is unclear at this point whether REITs will rebound or if landlords will have to accept lower valuations.

Blackstone believes that property values won't fall as much as share prices currently imply. For example, U.S. residential REITs are trading at a 26% discount to net asset value, and office stocks are at a 39% discount, according to data from real-estate research firm Green Street. This indicates where shareholders think the underlying value of the property is headed in reaction to rising interest rates and expectations of a recession.

If shareholders are right, it is not good news for BREIT, which has more than half of its fund in residential property. The news is slightly better for e-commerce warehouses, which make up more than a fifth of BREIT’s holdings. Listed industrial landlords such as e-commerce warehouse owner Prologis are trading at a smaller discount to their NAVs, averaging 6.5%. Shareholders seem more confident that rents can be raised in warehouses than in housing.

One explanation for the gap between the two types of REITs is timing. While shares in listed REITs react to new information in real time, nontraded funds may only be repriced monthly or quarterly based on valuation estimates. This means that the data on recent transactions that property appraisers use for these estimates is out of date, according to Lonnie Hendry, head of advisory services at real-estate firm Trepp. Hendry explains that “deals that occur today were probably agreed up to six months ago…and don’t reflect what the price would be today.”

There are fewer buildings changing hands at the moment, making it even harder to understand what is going on with prices. In the third quarter, the volume of U.S. commercial real estate deals was down a quarter compared with a year ago, according to CBRE.

However, the transactions that are taking place suggest that values are heading south. For example, multifamily residential property, which both the Starwood and Blackstone funds are very exposed to, has seen values peak in June and then decline by 3.6% through October according to the CoStar index.

There is still a significant gap to close, as deals in October were priced 28% above the current values implied by stocks, according to an analysis by Brad Case, chief economist at rental housing investor and developer Middleburg Communities. He says trough prices may not be reflected in the data that private funds use to value their portfolios until May of next year, assuming that the slight recovery in residential REIT stocks in December is a sign of the bottom.

Property stocks could rebound if the economy and housing market perform better than expected. However, it is more likely that by the time most investors are able to get their money out of private funds, the value of the investment will have decreased.