VNQ: Commercial Real Estate Troubles Are Accelerating In 2024 (2024)

Last year, the REIT market was particularly volatile as many commercial properties lost considerable value amid the rise in interest rates. For the most part, REITs were very popular before recent years as they were seen as a soft hedge against inflation with decent yields. Commercial properties also rose extremely quickly in value before 2022 due to ultra-low interest rates and steady rent growth for many properties.

Since 2022, the commercial property market has nearly collapsed. The Green Street Commercial Property Price Index, which broadly measures property selling prices, has fallen by around 20% since its 2022 peak. The index is about where it was in 2014, erasing ten years of appreciation, but still around 20% above its 2007 cyclical peak.

The pace of declines in commercial property prices has not slowed. That said, large REITs, such as those in the ETF, Vanguard Real Estate Index Fund (NYSEARCA:VNQ), have rebounded as investors hope the declines will end. I have held a bearish view of VNQ for several years. For the most part, VNQ has declined over this period, but it is up around 12% since I covered it last September. Analysts' outlooks on VNQ remain very split, with a wide range of positive, negative, and neutral opinions. In my view, that makes for a great analysis opportunity, as ongoing changes in the commercial property market are likely to alter VNQ's performance throughout the rest of 2024.

Will CRE Prices Stop Crashing Soon?

Commercial property prices are crashing at the fastest pace since 2008. Indeed, the pace of declines throughout much of 2023 was faster than during the initial wave of declines in 2007. The causes for the declines are both similar and different. Similarly, CRE prices are inflated due to a prolonged period of lower interest rates that encouraged high leverage usage for many commercial properties.

That issue does not necessarily directly impact VNQ, as many of its holdings are of higher quality than typical property portfolios. However, it has an indirect impact because many banks are looking to reduce CRE loan exposure as falling prices result in higher loan LTVs and more significant nonperforming loans. Thus, declines in financial flows to the CRE sector are resulting in lower property prices for virtually all buildings, mainly offices.

The critical difference between today and 2007-2008 is that commercial property performance differs more between segments. In the middle of 2023, CBRE (CBRE) found that most commercial property owners expected more significant cap-rate increases for offices (~80% expecting increases), while multifamily and hotels were generally expected not to see cap-rate increases.

Office REITs lost immense value in 2023 as many contain significant "underwater" assets. As such, the portion of VNQ's office holdings has shrunk to just ~4.7% as the ETF sells those REITs as they lose relative market value. Conversely, residential (SFR and MF) (~13%), retail (12.9%), industrials (12.7%), and telecom (12.2%) have seen an increase in exposure as they've not seen nearly as significant NAV declines as have offices.

Personally, I see that as a flaw in VNQ's approach, as its model will cause it to sell REITs that lose value and buy those that gain value. Like many dividend-focused equities, REITs seem prone to mean-reversion as investors usually price REITs around estimated NAV levels. Thus, selling losers and buying winners will more often be a value-reducing approach. As one example, many office REITs, such as Vornado (VNO), have risen by ~30% YoY after becoming oversold last spring. VNQ had limited exposure to this rebound because its office exposure fell.

Although I am not bullish on most office REITs, I am more bearish on the "safe" segments, such as residential. For one, multifamily properties face the risk of increased supply as failing offices are converted to residential, a practice that is surging today. Rental vacancy rates are now rising, and asking rents are beginning to plunge. We're seeing similar issues in other "safe" REITs like Public Storage (PSA), which accounts for around 3% of VNQ's assets. As detailed in "Public Storage: The Self-Storage Glut Is Coming In 2024," PSA faces significant loss risk due to rising vacancies and falling rents. Dollar General's (DG) growing competitive strains are also an example of the growing issues in the retail market to which VNQ is highly exposed.

Overall, I expect NOIs for non-office REITs to decline over the coming year. Offices likely remain at the most excellent chance of NOI declines as leases expire without being replaced. That said, office REITs are valued according to this risk, while most are not. The direct approach of REIT values to NAVs is not useful because NAV data is based on backward-looking property prices. That said, some segments, such as data centers, trade materially above even those "overestimated" (in my opinion) NAV levels. Again, I believe backward-looking prices are of little value because CRE transaction volumes are still down over 50%, and we're primarily only seeing sales for higher-quality properties, skewing price measures.

The simple fact remains that one cannot profit by investing in a property with a 5-6% capitalization rate (around today's backward-looking level) while borrowing at 7% (today's CMBS mortgage rate). The only way that investment would work is by significantly increasing NOIs. While NOIs have been rising for non-offices, I believe rising vacancy rates in some segments suggest the opposite will be true over the coming two years, exacerbating CRE NAV declines. Thus, I emphasize the decreased importance of today's average capitalization rates because, for the most part, commercial properties are still selling at prices that are not competitive compared to bonds.

What is VNQ Worth Today?

Some investors and analysts may argue that NAVs are unimportant for VNQ's value. In the short term, that is potentially true, as VNQ often fluctuates dramatically around REIT NAVs. Realistically, VNQ likely discounts expected changes in NAVs better than property prices because it is tied to a far more liquid market. Problematically, the commercial property market is very illiquid today, mainly as banks pull out of it.

In my view, this creates a "doom loop" for some REITs as banks reduce lending, resulting in lower property sales, harming prices, and eventually reducing overall urban investment, leading to the NOI decay of many non-office properties. Of course, alternative REITs like telecom and data centers, which, in total, account for at least a quarter of VNQ, are less exposed to that risk. Still, all REITs remain exposed to the impact of higher interest rates.

Theoretically, VNQ's dividend should strongly correlate to the real interest rate on Treasury bonds. That is the interest rate, which is indexed to inflation. Mostly, we can expect property NOIs to rise and fall with inflation. Of course, my speculative view is that property NOIs will soon fall compared to inflation after rising faster than inflation in recent years (excluding offices). That possibility only worsens VNQ's prospects.

Still, VNQ is likely overvalued even if we assume no change in REIT NOI's compared to inflation. This is determined by measuring VNQ's dividend against the 10-year real interest rate. Historically, the two are closely correlated, with VNQ's yield usually being around 2.1% to 3% above the real Treasury rate but occasionally 4% higher during periods of NOI strain, such as 2020. See below:

The mid-point of the normal range is ~2.55%, with the spread currently being at the very low end of that range. Thus, if we assume the real Treasury rate will remain constant and VNQ's holdings' NOI will rise with inflation, VNQ's dividend should be about 35 bps higher. A 35 bps increase in VNQ's yield from ~4.15% to ~4.5% implies a ~8% decline in VNQ's price. In other words, if VNQ's yield is not at 4.5%, investors will likely receive a better risk-reward investment in inflation-indexed bonds like (TIP). That gives VNQ an estimated fair-value target of ~$77.50.

The Bottom Line

That simple value target is based on the assumption that VNQ's income will remain steady to inflation. As detailed, I believe property NOI's will likely decline compared to inflation over the coming year. Specific segments, such as residential, appear at exceptionally high risk as more offices are converted, creating a glut of multifamily properties. Further, I expect the US economy to slow as consumer spending reaches unsustainable levels compared to wages, lowering my outlook for most cyclical REITs.

At this point, VNQ's downside risk is not so significant that I believe the ETF is a short opportunity. However, specific REITs that are more overvalued may be. Personally, I would not bet against VNQ until we see greater evidence of NOI losses in CRE properties. My bearish speculative outlook is sufficient that I believe VNQ may fall by 20-30% in 2024. However, if NOI continues to rise faster than inflation, VNQ would likely be perfectly valued today. Thus, I see VNQ as best avoided, although it may not yet be an ideal bearish opportunity.

Harrison Schwartz