The wide gap between the pricing of real estate in the public and private markets that drove disruption in 2022 is seen by analysts as tempering the outlook for real estate investment trusts going into 2023.

The likely outcome, they say, is a pricing reset that will bring valuations closer together, creating winners and losers among the world’s largest real estate investors.

The pricing gap resulted from publicly traded REITs posting one of their worst years ever while privately owned real estate funds reported rising values. The divergence, combined with fears about the economy, caused investors in some private funds to rush and cash out some of their investments in recent months.

The surge of redemption calls overwhelmed nontraded REITs Blackstone Real Estate Income Trust and Starwood Real Estate Income Trust. Both REITs received billions of dollars more in redemption requests than their bylaws allowed, forcing each to limit share redemptions in moves that left some investors unable to get their money.

REITs are entering 2023 amid projections of slower economic growth and higher interest rates. On the bright side, some have posted strong operating performances, mainly because of lease terms already in place on the property investments before borrowing rates started increasing and leasing demand slowed. This confluence of factors has resulted in increased uncertainty surrounding the outlook for publicly traded REITs, according to the industry trade group Nareit.

At the heart of the cloudy vision that’s tempering the outlook is what will happen to the wide valuation gap that exists between publicly traded REITs and privately owned real estate. While the common stock of publicly traded REITs is easily bought and sold on major stock exchanges, each nontraded REIT has differing repurchase policies that limit the ability of shareholders to sell their shares.

As of the third quarter, the Financial Times Stock Exchange Nareit All Equity REITs Index, which measures publicly traded real estate values, posted year-to-date returns of negative 28.2%. The National Council of Real Estate Investment Fiduciaries Open-End Diversified Core Equity Index, which measures private real estate valuations, posted a year-to-date total return of 13.1%. That is a gap of 41.3%.

“We typically see [publicly traded] REITs really leading in terms of valuation changes by anywhere from 12 to 18 months. And our expectation is what we’re going to see in 2023 is that those valuations start coming back together,” John Worth, executive vice president, research and investor outreach, told CoStar News in discussing Nareit’s 2023 outlook.

So, as publicly traded REIT values are coming out of a down year, Nareit’s expectation is that private real estate valuations will probably decline in 2023 if past performance trends persist, according to Worth.

At the same time, the presumption from Nareit and other analysts and industry executives is that publicly traded REIT values should rebound, maybe not early in the year but more likely in the second half.

Publicly traded REITs are already showing signs of a comeback. Many companies posted positive results for the second consecutive quarter in November, and their stocks outperformed the market for the first time since April, according to Nareit data.

“What we see is that [publicly traded] REITs lag private real estate going into recessions, they outperform private real estate during recessions even as private real estate still has positive returns, and then [publicly traded] REITs outperform coming out of recessions,” Worth said.

Publicly traded REIT valuations look relatively inexpensive at a negative 4% discount to the S&P 500 versus a positive 9% 10-year average, according to Morgan Stanley research led by Ronald Kamden in its 2023 REIT outlook.

“We maintain our in-line view of the industry in 2023 with expected total return of +5%,” Kamden said. “Underneath the surface, we expect the REIT market to retest the pandemic lows in the first half of 2023 (15% to 20% downside). The setup in second half of 2023 is more favorable, and we would look to add exposure.”

At the same time, private market valuations have to reset lower, according to Morgan Stanley.

A sharp decline in transaction activity and the lack of forced distress selling is leading to revised pricing for real estate.

“Indeed, commercial real estate prices are still up +7.3% year over year and we see prices falling 15% over the next 12 to 24 months for apartment and industrial, [falling] 27% for lower quality retail, and [falling] 37% for office,” Kamden said.

The prospect of repricing in public and private markets is what has driven the recent surge of redemptions among some nontraded REITs, according to Mitch Rosen, managing director, head of real estate at Yieldstreet, an alternative investments firm with $3 billion funded on its investment platform.

He predicted investors will stay focused on real estate though, looking for so-called arbitage plays, when they can buy and sell the same asset in different markets, looking to profit from the pricing gap.

“The public REIT market has had one of its worst years in a very long time and has vastly underperformed when compared to private vehicles,” Rosen said in an email to CoStar News.

“It would make sense that investors would look at that disparity and seek to arbitrage it by selling the private REIT shares and investing in the public markets. This is highlighting folks’ desire to gain liquidity where they can on investments that are up for 2022, which are few and far between.”

The prospects of a pricing reset come with other challenging economic and financial trends, at best putting a damper on fundamentals for recently better-performing sectors, and at worst further damaging credit profiles for REITs that had already been under pressure, according to Fitch Ratings.

Nonetheless, for most REITs rated by Fitch, decelerating fundamentals will not drive deteriorating credit profiles overall in 2023, given the insulation created by longer-term leases and good debt management.

“Fitch expects slower growth for sectors that had been experiencing solid demand, including industrial and open-air shopping, and more difficult conditions for others that have been challenged, including office,” Chris Wimmer, senior director in Fitch’s U.S. corporates group, said in a report.