Mean Reversion in Real Estate Markets: Unlocking Value in Undervalued Public REITs

The widening valuation gap between public real estate investment trusts (REITs) and private real estate markets has created a compelling case for mean reversion-a phenomenon where asset prices return to their intrinsic value over time. As of mid-2025, the spread between public REIT cap rates and private appraisal cap rates stands at 132 basis points, a historically unusual divergence that has persisted for three years. This gap, driven by structural differences in pricing mechanisms and the Federal Reserve's monetary policy, has left public REITs trading at significant discounts to private real estate values. For investors, this dislocation represents a rare opportunity to capitalize on undervalued assets with strong historical precedents for outperformance.

Structural Drivers of the Valuation Gap

Public REITs adjust rapidly to shifting market conditions, including interest rate changes and economic uncertainty, while private real estate appraisals remain stubbornly anchored to long-term trends, such as 10-year Treasury yields according to analysis. This asymmetry has been exacerbated by the Fed's recent 25-basis-point rate cut in 2025, which has lowered borrowing costs and spurred optimism about capital inflows into public real estate. Uma Moriarity of CenterSquare Investment Management notes that REITs historically outperform private real estate during rate-cutting cycles due to their faster pricing adjustments as research shows.

The current gap is one of the most extreme in modern history, comparable to peaks seen in 2000, 2009, and 2018. Historically, such dislocations have been followed by periods of strong REIT outperformance. For instance, after the 2009 global financial crisis, public REITs surged 106.7% in the subsequent year, erasing a prior 34.8% underperformance according to data. Similarly, in 2025, despite both public and private real estate experiencing negative returns due to rising interest rates, REITs outperformed private assets by over 50% as market commentary indicates.

Undervalued Public REITs: A Case for Mean Reversion

The apartment sector, in particular, has seen significant valuation gaps. High-quality REITs like CAPREIT (TSX: CAR.UN), Allied Properties REIT (TSX: AP.UN), and Killam Apartment REIT (TSX: KMP.UN) trade at discounts of 12.67%, 8.64%, and 0.37%, respectively. These discounts suggest undervaluation, especially when compared to private market appraisals.

Killam Apartment REIT, for example, reported a 5.5% increase in same-property net operating income in Q3-2025, with apartment occupancy at 97.2%. Despite a temporary net income decline due to fair value losses on properties, its debt-to-total assets ratio improved to 40.5%, and its dividend yield rose to 4.43%-well above historical averages according to financial data. A discounted cash flow (DCF) model estimates its fair value at CA$29.39, compared to its current price of CA$16.69 as market analysis shows. Such metrics underscore its potential for mean reversion as market conditions normalize.

The Role of Monetary Policy in Convergence

The Fed's rate-cutting cycle is a critical catalyst for closing the valuation gap. Lower Treasury yields, a direct consequence of easing monetary policy, could narrow the cap rate spread and lift REIT valuations. Institutional investors are already using REITs as benchmarks to assess true market values, a trend that may accelerate as private appraisals lag in adjusting to new interest rate environments as market trends indicate.

Historical patterns reinforce this outlook. After the 2020 pandemic-induced dislocation, public REITs traded at discounts as low as –20.8% to net asset value (NAV) but rebounded with an average 21% return over the following 12 months. If the Fed continues to cut rates, as widely anticipated, similar rebounds could materialize in 2025–2026.

Conclusion: Strategic Entry Points for Investors

The current valuation gap between public and private real estate is a structural anomaly, not a permanent state. For investors, this represents a strategic entry point into undervalued public REITs, particularly in the apartment sector, where fundamentals remain strong. As the Fed's rate cuts begin to flow through the system, expect a narrowing of the cap rate spread and a reversion of public REIT prices toward their intrinsic values. The historical record is clear: when dislocations are driven by market sentiment rather than fundamentals, mean reversion follows.