Andrew Parsons, the CIO of Resolution Capital, discusses some of the fundamental concepts to consider when investing in global real estate.
He explores the drivers of this asset class, whether these are different in the current environment and if REITs are still a good long-term diversification tool alongside other asset classes. Also highlighting the importance of ESG factors in the real estate universe.
What to consider when investing in global real estate
We don’t think that the way we look at things should fundamentally change because of a pandemic. We continue to focus on what’s important for all investments, i.e. the quality of the cash flow. We look for the most amount of cash that is generated by the real estate for the least amount of risk. The three key factors that we take into account are firstly, the best quality real estate where there is robust tenant demand and limited supply so that you have some pricing power. Secondly, we look for robust balance sheets and thirdly, outstanding management who are capable of delivering excess cash that the market is under appreciating.
Assessing the factors
The data shows a reasonable outlook for the sector. Occupancy levels remain elevated, above the long-term average, with limited amounts of excessive supply, which is good for the rental outlook. While some construction has been put on hold due to Covid, this sets up a scenario of future undersupply. The balance sheets of the industry are in pretty good shape, better than when they went into the global financial crisis (GFC). Despite continued low interest rates and moderate supply, with prudently reduced leverage many REITs are positioned to take advantage of any distress resulting from the current economic challenges.
What leverage levels are acceptable?
It’s more about the quality of the cash flow, so we look at debt to EBIT, which is more objective. We like balance sheets that are less than six times, which equates in today’s terms to about 30% loan to value. We will invest in stocks above this provided they have very favourable cash flow and very favourable debt terms in terms of maturities and without restrictive covenants, such as very tight loan to debt values.
What are you doing differently thanks to Covid?
The environment is certainly more challenging. We’re looking at measures like replacement cost more closely and that’s where we’re starting to see some outstanding value. We’ve had a bias against retail for a number of years, but we’re finding some retail that is valued at the equivalent of industrial space and is better located. It is going to be challenging for retail platforms regardless even if they’re in good locations because a transition to another use won’t be a smooth transition.
We’re buying US apartments at the moment where you can factor in very little premium to replacement cost. US hotels are trading at massive discounts to replacement costs, but they don’t have cash flow. Covid has been worse for hotels than the GFC because they are now generating operating cash losses and can’t cover their overheads or interest costs. The challenge when you’re looking at a price to replacement cost is that if you’re generating cash flow losses, you run the risk of breaching a number of covenants. We’re thinking 2-3 years ahead at how things will look and who is most at risk of breaching covenants or running out of liquidity. We’ve taken some exposure to student housing with the view that Colleges would return. The replacement cost for student housing was trading at or below replacement cost for a cash flow we thought would be reasonably durable thus making this an enticing dynamic. Well located real estate with durable cash flow should weather the Covid storm.
How the different sub-sectors have reacted
Heading into the pandemic, we were reasonably well positioned in areas that were beneficiaries of the pandemic. We have 28% exposure to digital and e-commerce and could see the long-term secular trends that would support them. We have 23% exposure to residential, which encompasses a range of different types of residential property in multiple different markets. We had good exposure to German apartments in particular, which performed well. Healthcare makes up 8%. This sector will be interesting over the next few years given that this has been a healthcare crisis. Retail and office make up 13% and 8% respectively and we have a meaningful exposure to self-storage.
Life science space is different type of real estate. It is usually leased for drug research for up to 8-10 years and where the company leasing the space takes responsibility for all repairs and maintenance over the term of the lease. The demand for life science space has been incredibly resilient and stable. Our portfolio has a great array of relevant and durable real estate that we think will demonstrate fantastic returns over the next 5-20 years.
What income and capital growth to expect from global REITs
We are a total return investor and try to find a total return that includes an income component. We start by looking at the quality of the real estate and its potential to generate pricing power, cash flow growth and then to build a spin-off yield. High yield is not a particularly good predictor of good future returns.
GRESB and the ESG component of the investment approach
GRESB (Global Real Estate Sustainability Benchmark) is one of the better ways of measuring the environmental characteristics of a property. More sustainable buildings tend to have lower operating costs and are more attractive to more tenants who are looking for such characteristics because of their own policies. Analysing ESG factors within REITs is good, sensible protocol and makes investment sense. We constantly engage with our managers on what they’re doing and where they can improve. We’ve always been believers in corporate governance and the best possible alignment between management and ourselves. Then management aims to derive the most return from the asset base for the benefit of all shareholders.