A tale of two...worlds: The great divide in today’s global real estate market
Sept. 12, 2014
Bob Zenouzi on:
The global real estate market’s evolution in recent years...
Monetary-easing regimes around the globe have played a big part in real estate’s recovery in the past five-plus years. Today, many real estate investment trusts (REITs) are raising equity and debt capital allowing them to acquire, develop, and redevelop properties.
Credit markets were in a frenzy leading up to the financial crisis. Debt, in general, was high. Lending standards were overly easy in our opinion, which led to bad practices. Many companies made poor investments and were overleveraged, with too much development on their balance sheets. As the economy slowed, credit became less available and more costly, creating a serious headwind and causing a decline in stock prices globally.
Now, we view the global real estate market as a “tale of two cities” or worlds, if you like. Developed markets generally are more leveraged as they have all instituted some form of quantitative easing (QE). These policies have created a tailwind, flooding markets with cheap debt that enables companies to either pay down higher-cost debt or term it out into longer-term maturities. This has helped companies reliquify their balance sheets and has been a boon to stock prices.
On the other side are emerging markets, which historically have seen tremendous growth. That growth is slowing, however, because of excessive credit buildup. As credit becomes less available in places like Brazil, Indonesia, China, Hong Kong, and Singapore, the cost of capital is rising. And as this has taken place, growth has slowed down.
Today’s supply-demand dynamic...
The global financial crisis slowed both growth and supply. Today, there’s little supply in Continental Europe. In the United States, supply in apartments, and maybe a little in industrial space, is ebbing. Five years into this cycle, overall supply is at about 1% of total U.S. inventory across all property categories, compared to the historical average of about 2.1%. (Data: CBRE and Citi.)
With lower gross domestic product, demand isn't as strong. But with less supply, you don’t need as much demand. So, as supply has been held in check, demand is improving. In aggregate, occupancies are at about 94.5%. Net operating income in the U.S. is growing at 4%. We hope to see a steadier and longer cycle. (Data: Citi.)
In overall office space, there isn’t much development aside from build-to-suit properties. Very few malls or shopping centers are being built. We think real estate companies learned their lesson in the last cycle, when many firms had pipelines equaling 20–25% of their total market cap, versus 13–14% at the high end today (source: Delaware Investments).
Because of onerous lending restrictions, lenders are extending credit only to the highest-quality companies, which tend to be publicly listed. This has kept the lid on supply.
REITs’ performance relative to the broader equities markets...
Rates have remained low for the past several years and this has been a great tailwind for real estate investors. But even if rates were to rise, an advantage of owning hard assets is that they’re indexed to some form of inflation. In other words, contractually, leases generally rise every year. So leases in place can help cash flows rise if inflation rises.
Historically, when rates have risen as they did in 2004 or 2013, U.S. real estate stocks have tended to underperform. But investors also historically have taken a more positive view of REITs, perhaps realizing they may be inexpensive, have solid cash flows, and are indexed to inflation. In the current cycle, the MSCI U.S. REIT Index is up 15% year-to-date through May 21, meaning it has made up half of the underperformance of last year. (Data: Morningstar.)
We're currently in a lower-churn, lower-yield, lower-growth environment. When you're starting with a 4% dividend yield and can get 6-7% long-term dividend growth, this historically has produced a high-single-digit, maybe low-double-digit, return potential.
Which regions look attractive or unattractive at the moment...
We still see attractive opportunities in the U.S., where we believe the credit environment remains favorable. REITs are raising capital at 4.5% on 10-year money, which they can reinvest in acquisitions at 5.5–6.0% and developments at 6.5–7.0% — a positive spread, making for an attractive long-term investment (data: Bloomberg). We currently see opportunity in hotels, malls, shopping centers, and apartments. We are avoiding healthcare REITs because we believe the large-cap ones are expensive and growth is slowing. We are no longer bullish on the United Kingdom as valuations appear to have become full recently. Continental Europe still has many leveraged companies, and we believe there would be downside if this liquidity were taken away.
In addition, we are not bullish on emerging markets, as growth is slowing and the cost of money has risen — a classic case of stagflation, which is the worst type of environment for real estate. Authorities in Hong Kong, Singapore, and China are trying to slow down housing markets in which price appreciation has been rapid over the past four years. They are increasing land supply in Hong Kong and Singapore to increase development. More supply would also decrease prices. We think investors should be underweight in China over time because, according to our analysis, volumes have dropped by 35–40% in secondary and tertiary cities, and such a change has typically preceded a price drop.
As far as the divergence between developed and emerging markets that we see today, we have come to a place over the last 10 years in which capital has been increasingly crossing borders. Australian companies had the cost-of-capital advantage from 2003 to 2007, when 26%, according to our analysis, of their REIT properties were in the U.S., because they could buy at high cap rates and create a positive spread. Today, U.S. REITs have the cost-of-capital advantage, and many have taken advantage of the stress in Europe to look for opportunities there. Almost every developed region in the world is now trying to lower its cost of capital. In the developing markets, we’re seeing the opposite. They're trying to slow their economies due to inflation of credit and wages, and house price appreciation.
What indicators we’re watching now, our outlook for the sector...
The main drivers for real estate are fundamentals and the cost and availability of debt and equity capital. If we were to see the fundamentals driven by supply starting to increase in any region, it would be cause for worry. If we were to see the cost of capital rising in any region, we would worry. We're not seeing that to any degree in the U.S. Even when Treasury rates went up last year, spreads came down — so the cost of money never really went up for REITs.
Europe has seen declining cost of money and very little supply. The U.K. could see a rise in cost of capital as the Bank of England has hinted, and some supply is now coming on. Australia is still favorable, in our opinion. Rates were lowered and the economy appears steady, so we're bullish on office and certain residential regions there.
Regarding our outlook for global REITs, we think what has changed over the last five to six years is hopefully less of a boom-bust cycle for real estate. Steady rental growth and less supply potentially could make for less volatile returns. In our opinion, gradually rising rates actually would be a good environment for real estate because it would mean the economy is getting better, and with that, growth could pick up and rents could rise. We worry more about getting a short-term spike in rates, which would not be good for income-generating securities. Also, we are watching the duration of leases during rising rates, because shorter-duration leases can reprice their rents more quickly than longer-duration leases.
Heading into the last crisis, many REIT CEOs were the founders of their companies, which they built over 30 years. Almost losing their companies was an “aha” moment. Since then, they have learned to be more conservative. They have raised equity, termed-out debt, and limited supply. Developers are entrepreneurial and aggressive, but we think the public markets have acted as a governor on their expansionist outlook in the current cycle.
Real estate’s current payouts and valuations...
Payouts are currently at 74% of cash flow, lower than the historical average of 81% (source: Citi Research and company reports). They are a little higher in certain European and Asian jurisdictions where companies must pay out almost all their cash flow. Many REITs had to cut dividends in 2008. But since the market bottom in 2009, we’ve seen outsized dividend growth in the midteens. However, we think that should slow to the high single-digits.
Coming into 2014, valuations in the U.S. were at a 7-8% discount to net asset value (NAV). Now they are at a 3-4% premium. Healthcare REITs are at a 36-37% premium to NAV; self-storage REITs are at a 35% premium; apartments are still at or slightly below NAV; and enclosed mall REITs are below NAV, while shopping centers are at NAV. REITs closer to or below NAV look more attractive to us. (Source: Green Street Advisors.)
Real estate’s potential role in a broadly diversified portfolio...
In our opinion, an allocation to real estate, whether direct real estate or real estate securities, can add a yield component, income growth, and an inflation hedge to a portfolio. As rate moves differ across regions and correlations are coming down, a real estate allocation can also provide diversification to equities and bonds.
The views expressed represent the Manager's assessment of the market environment as of September 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
The MSCI U.S. REIT Index is a free float-adjusted market capitalization index that consists of equity REITs that are included in the MSCI US Investable Market 2500 Index, except for specialty equity REITs that do not generate a majority of their revenue and income from real estate rental and leasing operations.
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Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
Narrowly focused investments may exhibit higher volatility than investments in multiple industry sectors. "Nondiversified" funds may allocate more of their net assets to investments in single securities than "diversified" Funds. Resulting adverse effects may subject these Funds to greater risks and volatility.
REIT investments are subject to many of the risks associated with direct real estate ownership, including changes in economic conditions, credit risk, and interest rate fluctuations.
A REIT fund's tax status as a regulated investment company could be jeopardized if it holds real estate directly, as a result of defaults, or receives rental income from real estate holdings.
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Diversification may not protect against market risk.