Weekend Interview: Nareit’s Abby McCarthy On Where REITs Go From Here

This series goes deep with some of the most compelling figures in commercial real estate: the deal-makers, the game-changers, the city-shapers and the larger-than-life personalities who keep CRE interesting. 

Abby McCarthy’s job has gotten a little bit easier lately.

She spends most of her days talking to financial advisers, trying to convince them that REITs are not only a good investment but the future of investing. 

McCarthy has been at Nareit, the REIT industry’s trade organization, for roughly two decades after spending a year working in Congress and realizing she was not a policy wonk. She came on as a researcher and is now senior vice president of investor affairs. 

The first half of the year might have been tough for McCarthy, as high interest rates and fears of collapsing valuations heavily weighed down REITs. But that changed last month when a weak jobs report and falling inflation boosted hopes for a rate cut, sending REITs soaring. 

While trying to read Fed tea leaves has undoubtedly helped boost REITs in the last month, McCarthy said their second-quarter results reflect a sector that is much more resilient than investors give it credit for. 

Funds from operations for all equity REITs was $20B at the end of June, up 8.5% from the previous quarter. Office, the sector that investors and analysts are most closely watching for a collapse in values, outperformed all other sectors. 

Office REITs saw funds from operations jump 15.8% from the last quarter, eking out an edge over data centers, which saw a 15.3% jump. On a total return basis, public real estate has outperformed the private market by 33% over the last six quarters, according to Nareit. 

The June rally pushed the FTSE Nareit All Equity REITS to a 3.3% gain year-to-date, as of Aug. 20, and up more than 16% in the last 12 months. 

McCarthy, perhaps unsurprisingly, believes there is still a lot of runway for growth in the space. She explained why during a broad-ranging conversation about the REITs, where they’re headed and if there are any sectors that could face challenges.

This interview has been edited for length and clarity.

Bisnow: REITs got battered in the first half of this year. It wasn’t really until July that they saw a bit of a rally. What’s going on?

Abby McCarthy: Definitely REITs got battered, but a lot of what was going on is because real estate is highly affected by interest rates. 

Now, especially since mid-July, we're seeing more optimism that there will be a rate cut. That’s the beauty of the public markets, that sentiment and optimism gets priced in in real-time. 

Some of [the rally] is due to the rate cut, but I think a lot of it has to do with the fact that REITs are coming out of second-quarter earnings with solid fundamentals. We saw a 3.5% year-over-year increase in NOI. We're seeing strong FFO performance. 

Bisnow: Can you draw a direct line between what’s said at the Fed meetings and REIT performance? Are REIT values today effectively just a reflection of investors’ sense of where the Fed sees rates going?

McCarthy: I don't think it is a complete reaction to the Fed. Yes, we can start with the interest rates, and then second-quarter earnings have wrapped up and REITs did well. 

But then you can shift to the fact that the investor sentiment towards the REIT industry is recognizing that the listed REITs in the space are really offering the best access to the modern economy, the digitized economy. 

REITs have really been innovators in creating the new structures that need to house that economy in terms of data centers, telecommunications, gaming. Those modern economic sectors now represent over 52% of the overall industry.

You've got this confluence of these three main things. They're all coming together to price in very positive returns for REITs year to date, and then hopefully going forward.

Bisnow: Has the expectation of rate cuts already been priced in during the rally or will they provide additional tailwinds to REITs?

McCarthy: That's somewhat uncertain, but I can tell you historically what's happened. Historically, when there has been a tightening in the Fed cycle, REIT performance does tend to increase once the tightening goes away.

As interest rates do start to come down, I can't predict whether all the pricing is already put into the stocks today, or if we'll see a trickle over time up to the rate cut. But I do know that, historically, when the Fed has cut rates or eased the tightening cycle, REITs have always performed well over that period. 

Bisnow: What does increased REIT investment say about how investors are viewing the value of the underlying commercial real estate assets today?

McCarthy: That really gets into the overall relationship between the public market and the private real estate market. Historically, public markets have always led private markets, and that really is a function of their overall investment structure.

We have seen a divergence [in capitalization rates] in public and private markets. As we're tracking the data, we can see that in quarter three of 2022 the divergence between public and private [cap rates] peaked at 244 basis points. Now, as of the end of the second quarter, that has come down to 129 basis points.

That convergence is happening. How long it's going to take to get to private and public markets being at a complete convergence? That we don't know. But you can look historically and see the lead-lag relationship.

Bisnow: If REITs are the leading indicator and further cap rate compression will have to happen, is it more likely that REIT values go down or private valuations go up?

McCarthy: I think we're going to see both. I think that there is a lot more run for REITs in terms of valuations. In the private market, though, we're starting to see some more transactions, there's going to be more appraisal data, so I think you're going to get forces on both sides of that, and that's where you really kind of meet.

Bisnow: Let's talk about the office REITs specifically because they had the biggest jump in year-over-year FFO in the second quarter at nearly 16%. What does that say about the office market and office valuations?

McCarthy: The key thing in the office sector that is important to note is that it really is about asset quality. There really is a bifurcation in the office market of Class-A and every other office property. 

What's important to acknowledge is that the REITs in the office sector tend to own those highly amenitized, newer properties that are Class-A in [central business districts]. 

In the office sector in particular, as we get farther away from Covid, we're seeing that work from home has become hybrid. That might be here to stay. I can't project any better than anyone else, but if you have your employees coming into the office two to three days a week,  demand for square footage is probably comparable to what it was before the pandemic. 

Bisnow: To go in the opposite direction, industrial REITs were pandemic-era darlings in many ways. There was so much demand for distribution space, but industrial activity has come down significantly. Do you think industrial REITs are in a good position today?

McCarthy: I do. This is just a normalization of the market. There was a big run-up in industrial because of what was happening in the world, and now we're just kind of level-setting back to normal. We saw something very similar happen in the self-storage space. We don't really have any concerns.

Bisnow: There are also industrial players who are also pushing into the data center space. Is the sandbox of demand big enough for all of the data center and industrial players that want to put out large capital expenditures in the next three years?

McCarthy: Data centers have been around for a long time. Many of our companies have been in data centers for a long time. What is interesting about it, is that it’s a high-barrier-to-entry business. 

It costs, on average, close to a billion dollars to create a data center. Additionally, most of our REITs that are in the data center business have networks of data centers, and that actually gives scale. It's a business that requires scale. 

Those REITs are well-positioned there because they know the space, they have an expertise in the operational platforms and everything required. It's very difficult for somebody to just throw up a shingle and decide that they're going to be in the data center industry. 

Because of all of the demand and the digitization of our economy, there will be increasing demand for data centers over time. AI is obviously just starting to come through that demand cycle.

Bisnow: What’s your bold prediction for the rest of the year?

McCarthy: My bold prediction for the rest of the year is really an homage to my husband, who's from Buffalo, New York. I think it's the year that the Bills win the Super Bowl. Josh Allen, even though he doesn't have any receivers, is going to do it. 

Bisnow: That is bold. What’s your weekend routine or favorite weekend activity?

McCarthy: I have two teenage daughters, so my life is dictated by theirs. I'm always trying to get some exercise on the weekends, but I really love to cook, and I love all things food. 

So if I'm not chasing after my teenagers or having them roll their eyes at me all weekend, I am cooking for my family. It’s how I show my love.