Global Real Estate Securities

This week we had visits from two Global Property Securities teams to our office pitching their wares. In terms of this asset class’s recent(ish) history, Real Estate Investment Trusts (REITs) performed dreadfully during the 2008/09 the financial crisis, thanks, in part, to a combination of being over-leveraged and owning poor quality assets. Many fell by more than 50%, some were forced into heavily discounted and highly dilutive rights issues at the bottom of the crash and some didn’t survive. Since those lows, however, property shares have been among the best performing investments we have owned. So why should we continue to own them?

Firstly, there are useful diversification benefits from including commercial property in combination with equities, bonds, commodities and cash within private and institutional portfolios is a definite risk and return enhancer.

Secondly, by virtue of their performance characteristics (i.e. equity-like over short periods and property-like in the long-term), when held alongside traditional “bricks & mortar” vehicles, REITs provide diversification benefits within the property component of a multi-asset portfolio. The trick from a multi asset portfolio management business like ours, therefore, is how best to allocate between unlisted real estate, with its obvious liquidity negatives and vs the generally liquid, but more volatile, listed REITs.

The above chart shows the significant outperformance of property shares (the S&P Global Property USD TR Index) versus the broader equity market (MSCI World TR index) since March 2009 – the beginning of the post-crisis recovery. Ordinarily, after such an extended period of big outperformance, one would argue that the time would be right to take profits (c.f. the rule of mean reversion) and rotate back into unlisted property funds, which generally have much less leverage. Moreover, from a valuation perspective, the significant discounts at which REITs were trading relative to their underlying Net Asset Value (NAV) have disappeared. Add to that the fact that we are (allegedly) about to enter a rising interest rate environment in the US and UK, which isn’t good news for property valuations or the cost of debt financing, and the argument becomes even more compelling.

Nevertheless, one of the teams that visited us is forecasting a total return of 17% from their listed REIT portfolio over the next 12 months(!), so clearly they still see lots of upside. This is with a relatively modest 2.8% dividend yield on their portfolio (lower than the 3.7% on the aforementioned S&P index, but still attractive compared to other yield assets such as cash, government bonds and corporate loans); so where is the extra 14.2% going to come from?

As stated above, REIT share prices are now flat relative to NAV in the developed world and whilst Asia is cheaper (on a discount), Europe, New Zealand and Japan trade at quite large premiums, so on that basis, further meaningful appreciation appears unlikely. Meanwhile, although interest rates may not be rising any time soon, further falls in yields to increase values seems unlikely. That leaves only value enhancement from asset management or growth in earnings / rental income (forecast at “only” 6% for the broad index) to deliver the 14% shortfall.

So to achieve a forecast total return of 17% over the next 12 months, one needs equity market stability, no hectic interest rate moves, superior income growth drivers and unique real estate that significantly outperforms the market average. Oh, and alpha generation by a high performing stock-picking fund management team (which they both were apparently!)