Global Property Fund - REITS: Vaccines, Recovery & Value

By Nedgroup Investments

Marco Colantonio from Resolution Capital, the Portfolio Manager of the Nedgroup Investments Global Property Fund, provides an overview of the Fund’s performance in 2020 and where he sees value in the market in 2021. 

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2020 year in review
2020 was a tumultuous year. The listed real estate market achieved a total return of -11% in local currency terms. However, there was significant bifurcation since the beginning of March. The sectors most vulnerable to the effects of the pandemic, such as hotel, retail and office, produced a total return of -14%. They materially underperformed the more resilient sectors, some of which benefitted from the pandemic, such as data centres and towers, industrial, residential and self-storage, which returned 9%. Major news impacting markets in November was the announcement of several successful vaccine trials, which provide a path towards social normalization. This has generally meant a reduction in risk for the most challenged property sectors.

Fund performance
Over 2020, we outperformed the benchmark quite significantly and over the long term we continue to also produce better than benchmark total returns. We did keep back some of that alpha in Q4 during the vaccine rally and we attribute that to three things. Firstly, our portfolio is skewed towards the more resilient sectors and while they still produced positive returns during the quarter, they didn’t participate in the rebound. Secondly, we were underexposed to value stocks that did well despite some ongoing operational challenges. Thirdly, we were underweight the more highly leveraged REITS that still face quite significant structural headwinds, some of which were very strong performers in Q4. We had selectively increased our exposure to some of the Covid impacted value segments in recent months, e.g. student housing and select retail, which did experience a good bounce, but we didn’t have enough. We’re still concerned about ongoing poor visibility in terms of rental cash flows and credit in a number of those sectors. Over the year, we did outperform the benchmark by about 450bps.

The strongest contributors in 2020 were our underweight exposure to retail, some stock selection in residential and office as well as our overweight exposure to industrial. Some of the specific names that contributed positively in 2020, were detractors in Q4.

Portfolio changes
Since the onset of the pandemic in February, we increased our exposure to retail in the safer end of the retail spectrum, which focused on non-discretionary oriented or value retail formats, which we believe are more resilient to e-commerce. We increased our residential exposure, mostly via student housing, which is very resilient during recessions and self-storage, which usually thrives in times of turmoil. We very quickly reduced our office exposure from overweight and our US healthcare exposure around concerns with senior housing. Regionally, we increased our exposure to Hong Kong following the social upheaval and geopolitical events of 2019 that negatively impacted those stocks even before the onset of the pandemic. We thought they would be better prepared than most to handle the pandemic and the stocks were relatively cheap with good balance sheets.

Portfolio positioning
The vaccine is obviously good news, but a lot of questions remain in terms of the lasting impacts to society, the economy and how we use real estate going forward. Despite these uncertainties, the equity markets seem to have priced in a relatively smooth recovery . We predict a fair bit of disruption to many businesses, particularly our traditional property segments like retail, office and hotels. We continue to focus on holding a diversified portfolio of real estate that can generate resilient cash flows with robust balance sheets, such as residential property, logistics, cell towers and data centres. We’ve selectively increased our exposure to value segments in retail, office, self-storage and healthcare. 25% of the portfolio is in residential, 16% in industrials, 16% in retail, 9% in office, 10% in diversified, 8% in self-storage, 7% in data centres and towers, 5% in healthcare and 4% in cash.

Market outlook
While hotel’s EBITDA have been negative and they’re not covering their costs, in many other segments of the property market, rent collections are above 95%. This has translated into reasonably resilient earnings for the sector as a whole. On a cumulative basis, REITS are slightly behind the S&P 500. However, the S&P did benefit from Trump’s tax cuts in 2018 whereas REITs did not. Adjusting for that tax cut, REITs and general equities have been level pegged in terms of compound earnings growth since 2012 with REITS being less volatile. This resilience has also been evidenced by dividends, which is an important driver of total returns. At the end of Q4, 94% of our portfolio had either held or increased dividends through the pandemic.

REITS are trading at a discount to private markets
Given the discounts that are available in the listed markets, we think private equity companies will look to take advantage of this dislocation by both buying stakes in listed REITS and making approaches to take them private. 

REIT performance has lagged the broader market
Despite pretty supportive credit markets for the REIT sector and resilient earnings and dividends, the real estate sector has underperformed the broader equity and bond markets, creating an opportunity as the virus subsides and social norms return.

Things that matter for REITS
Two things that really matter are supply and leverage. Supply remains moderate in a historical context, evidenced by construction as a percentage of inventory, which only got back to its long-term average of 1.8% pre-Covid and has since dipped. This bodes well for reasonably tight supply conditions going forward. REITS have prudently reduced leverage and are positioned to take advantage of private duress. Credit markets remain open for most property sectors, at lower costs.

Sector impacts
Office: Work from home will be more widespread, but will not be the end of the office, but net office utilization will probably be lower. Don’t confuse the long-term structural decline in demand, which might be quite moderate, with the short-term spike in vacancies.
Retail: This is one of the most challenged sectors operationally. We’ve seen a spike in e-commerce penetration and stores closing. Omni channel is the key to retail success.
Logistics: The ongoing adoption of e-commerce has led to a surge in investment for distribution supply chains, which has generated strong returns for industrial and logistics properties.
Data centres & towers: The surge in demand and usage of data for work from home, education, entertainment, ecommerce, etc. has led to a huge surge in data and mobile data usage. Cloud spending has surged, which bodes well for data centres.

Outlook: stay focused amid turmoil
The news of successful vaccines is clearly a positive. In the short term, this has had the most impact on the more challenged areas of the market, such as retail, hotel and office. We clearly see some risk continuing in these sectors and it may take many years for them to return to their pre-Covid levels of cash flows if at all. The global REIT sector is well positioned, credit is available and attractively priced for most property types. The sector remains well capitalized and we don’t see oversupply of new building. We think it offers relative value having derated versus equities, dividend resilience and is trading at a discount to direct property markets. We think that positions the sector well for the future as we emerge out of Covid.